SEC: More Than Half the Private Equity Firms Gouge on Fees

Today, two stories broke on the SEC’s activities in private equity, one in Bloomberg, another in Reuters, and they look to be based on authorized leaks. Together, they suggest that the SEC, which obtained new oversight authority for private equity firms under Dodd Frank, has been turning over rocks and found so many creepy-crawlies that even the normally complacent agency felt compelled to take notice.

The Bloomberg story gives broad outlines of the scale of the violations the SEC has found, that over 200 firms examined have engaged in fee abuses:

A majority of private-equity firms inflate fees and expenses charged to companies in which they hold stakes, according to an internal review by the U.S. Securities and Exchange Commission, raising the prospect of a wave of sanctions by the agency.

More than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors…While some of the problems appear to have resulted from error, some may have been deliberate, the person said..

The private-equity model lends itself to potential abuse because it’s so opaque, according to Daniel Greenwood, a law professor at Hofstra University in New York and author of a 2008 paper entitled “Looting: The Puzzle of Private Equity.” The attraction of the funds is that the managers have broad discretion, which also means that investors have a hard time knowing what the managers are doing, he said.

“The SEC and SEC enforcement can now see problems that probably existed all along and probably were actionable all along, but there was nobody to bring the action,” Greenwood said. “The big change has got to be the disclosure.”

The private equity industry is nowhere near as concentrated as the banking industry, so the odds are high that this probe has uncovered abuses at some of the leading firms. Of course, this scrutiny into fees will also correctly embarrass the heretofore complacent limited partners, since some practices that people would consider from a commonsense standard to be abusive, like charging the use of private jets as a fund expense, would be considered kosher by the SEC if disclosed in the investment manager’s annual disclosure document, known as Form ADV. But how do you think it will play among retired cops, bus drivers, and teachers to learn their pension fund dollars are paying for private jet use by firms that are plenty rich enough to pay for that sort of thing on their own nickel?

Reuters tells us the SEC has uncharacteristically decided to staff up significantly to improve supervision of alternative investment managers:

Dodd-Frank required most midsize and large private equity and hedge funds to register with the SEC. Many hedge funds and private equity firms hold complex and illiquid investments that are harder to value than those at traditional asset managers. This has spurred the need for specialist SEC examiners….

The SEC’s new private fund unit is co-chaired by Igor Rozenblit and Marc Wyatt, the sources said. Rozenblit joined the asset management unit of the SEC’s enforcement division in 2010 and is a former private equity professional. Wyatt is a hedge fund veteran who joined the SEC in 2012 as a private funds examiner.

Initially, the private fund unit will comprise existing staff in four of the SEC’s regional offices that will work part-time with Rozenblit and Wyatt on fund examinations, one of the sources said.

If successful, the SEC plans to expand the unit over the course of the next six to 12 months to more regional offices, that source added.

One has to think that the SEC warning in advance that it is will be launching actions is meant to both warn the private equity funds to clean their collective act up and to put the limited partners (the investors) on alert that they need to be more vigilant. But unless the media gets its teeth into a major scandal, it’s hard to see how this effort will do more that curb the worst abuses. Both private equity manager high-handedness and limited partner complacency are deeply entrenched.

The SEC’s first action is aimed at a small fry, which may be easy to dismiss by cynics. Bloomberg again:

Last month, the agency filed a civil case against Clean Energy Capital LLC and its founder Scott Brittenham, accusing them of misusing more than $3 million in funds to pay for office rent, tuition costs, bottled water and group photo sessions. The money should have gone to investors, the SEC said.

But while this may look like penny-ante abuse, this is also a prudent way to start in a new enforcement area: start first with small guys engaged in unquestionably bad practices, and move to bigger perps as you get more experience. So while the “start small” could point to small goals, the SEC could also be warming up carefully for bigger actions.

Moreover, regardless of how aggressive the SEC proves to be in slapping down these bogus expenses, there’s upside regardless. Recall that the private equity has been petitioning to be exempt from registering as broker-dealers, which would subject them to vastly more disclosure and scrutiny. The PE firms had floated a trial balloon asking to be exempt, despite the lack of any basis in securities laws for them to get a waiver. Their argument basically boiled down to, “Well, we haven’t behaved badly, so why don’t you just trust us?” Such widespread cheating blows that rationale out of the water. So this investigation means the SEC will be hard-pressed to let the PE firms wriggle out of registering as broker-dealers, which would be a significant step towards exposing the magnitude fees they extract from the funds they manage.

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  1. OpenThePodBayDoorsHAL

    When do we ring the bell? When do we collectively as a society acknowledge that every single last solitary financial product and market is totally utterly and completely corrupt? Forex, gold, mortgages, munis, stocks, LIBOR, PE, HFT…SP 500 index fund payment for order flow…Don’t we get some moment of acknowledgement that every single emission from Wall St is a thieves bundle of scammery?
    Somebody Please step up and cite me ONE financial product or market that is honest. Wait I just thought of one: Bitcoin. LOL that will get Yves going.

    1. diptherio

      Well, the CDs my credit union offers seem to be on the up-and-up…of course, that isn’t originating from Wall Street, so maybe those don’t count.

  2. Jim A

    “Start Small” will also give the firms time to buy up enough congressmen to reign in the SEC before it targets the big boys.

  3. Moneta

    In Quebec, the public plan invests in private equity as a form of social policy… it buys up small firms from all those boomers who do not have heirs to take over. I kind of like the idea of funding locally instead of the money going outside the country. But this is till limited because we are stuck in a cycle where investors are getting older, want good returns with low risk…. this contributes to TBTF. If we want more jobs we have to invest in startups… but who wants to lose money?

    So instead of investing locally, which is too risky, public plans invest internationally using the pretext of diversification. They buy international assets such as utilities in the UK which makes me scratch my head… if the UK also has a pension funding issue why in the world would it sell performing assets to fund Canadian’s retirements instead of keeping these assets for themselves?

    And with debt-to-gdp growing, governments are going to look for more ways to hide their liabilities… such as guaranteeing debt on PPP projects which will get funded by pension plans and banks…

    I don’t see this changing until we let firms fail. This would lead to higher rates and put a damper on PE funding. Failures would lead to pension plan defaults and this would lead us to the creation of pay-as-you-go pensions.

    1. Moneta

      Fixing our financial system would lead to many pension plan write downs and this would probably trigger a revolution.

      1. steelhead23

        Ah, I believe you have discovered the grand extortion. Not just private equity but all forms of finance have exerted intense pressure on our regulators and politicians. “There is a complex, interrelated systems of finance and commerce. Much of it rife with frauds and abuses. But it works. Bills get paid. People go to work. Products are made and sold. Remember those photos of folks selling apples and pencils and themselves to buy food during the depression? Remember the risks of revolution then? It isn’t far from a bread line to a firing line? And never forget that without us, you could never be elected (pols), or look forward to our golden revolving door (pols and regulators). Good, now be good little ducks and do everything in your power, including screwing the public, to keep us humming along. And please, temper your language. Never forget that we have you by your ba***.”

  4. Tim

    A more cynical take on the “start small” hypothesis is that the SEC will end up going after institutions that are Too Small To Donate and leave it at that. You have to admit that this fits the Obama Administration’s established behavior pattern much better.

    1. Yves Smith Post author

      If they are investigating over 200 firms, they will get into bigger players. The industry is not hugely concentrated.

      And even small guys are well off. But PE has not lobbied very often as an industry.

  5. middle seaman

    Some equities charge low fees and they are typically well known. Many employees, though, have no say in the their company’s selection of pension managing body. Teachers of all levels typically use TIAA-CREF. The latter fees are substantial. Some of us have alternatives but I doubt whether their fees are any lower.

    Businesses, in general, tend to extract as much pay for their products and services as they can. Unless you buy your clothes at Target, you pay an arm and a leg for any decent piece. The huge mark ups go to huge salaries, private jets, etc.

    We typically shut up and pay. Recently, I visited a country where customers went on buying strike at stores, e.g. supermarkets, with particularly high prices. We tried something similar, i.e. OWS. The police came in to beat up the protesters. (Probably because we are a democracy.)

  6. Jim Haygood

    Meanwhile, Norway’s central bank is agitating to ADD private equity to the country’s sovereign wealth fund:

    Norway will wait to see whether real estate investments by its $850 billion sovereign wealth fund pay off before considering new asset classes including infrastructure and private equity.

    Prime Minister Erna Solberg’s Conservative-led government, in power since October, has backed away from pre-election talk of restructuring the fund.

    Central bank Governor Oeystein Olsen says it must take on more risk to raise returns. In addition to infrastructure and private equity investments, he advocates raising stock holdings to 70 percent from the current 60 percent.


    Even more so than a public pension fund, Norway’s sovereign wealth fund is going to run head-on into the conflict between its mandate for transparency and the PE industry’s opacity.

    Longer term, Norway is likely to find that after fees, PE offers no return advantage over public equity. Its apparent lower volatility is an illusion of valuation smoothing.

  7. Martha Gonzales

    These kinds of abuses are rampant in this shadowy practices of many financial institutions, especially dealing with equities. In fact, these practices in a way adversely affect investor confidence too, when it comes to investment. This recent revelation will at least help to regain investors’ confidence. Moreover, the investors’ will also be cautious and more informed while investing through these private equity firms. SEC’s move is well appreciated.

  8. bh2

    While this is all good theatre, it remains that the SEC and its sister financial “regulators” are corrupt to the core and their employees will never bite the hand they know will eventually feed them generously for doing nothing when they pass through the revolving door.

    A retiring SEC lawyer bluntly states this reality:

    The only possible conclusion is that breathless news reports about how government “regulators” are going to get tough with big players in the industries they regulate is no more than marketing eyewash. Money talks. BS walks.

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