We’ve pointed out that private equity investors, known in the trade as limited partners, enter into agreements with private equity firms that do a terrible job of protecting the investors’ interests. That sad reality is contrary to the urban legend propagated by the general partners, that the agreements are negotiated, that the limited partners are sophisticated and understand full well what they are getting into.
The evidence on the ground strongly suggests otherwise. Sophisticated parties who used their bargaining power, for instance, would not enter into contracts where the other party controls the money flows and they lack audit rights, which are standard provisions in adequately negotiated licensing agreements, vastly simpler relationships than private equity funds. While the limited partners can indeed see the books and records of the fund (but even then with some inconvenience), they have no right to see the financial records of the companies that the fund has purchased. And that’s where the real opportunity lies for chicanery, since the general partners control the management of those firms and can impose all sorts of self-serving contracts on them. Perversely, the limited partners know about and accept monitoring fee agreements that Oxford professor Ludovic Phalippou has described as “money for nothing“; even worse from a legal perspective are undisclosed fees and expenses that general partners charge to the investee businesses.
In keeping, the SEC’s head of examinations, Andrew Bowden, pointed out in a widely publicized speech last May that private equity agreements did a poor job of protecting investors, and were unduly vague on far too many key points. That’s the big reason that general partners have huffed and puffed that they are within their rights to be extracting as much as they do from the portfolio companies. The tricky, ambiguously drafted agreements give them broad discretion and contain multiple waivers of fiduciary duty.
The logical question then becomes: how do supposedly sophisticated investors sign up for such one-sided deals? One part is the idea that these agreements are negotiated in any normal sense is a myth. For instance, the core contract, the limited partnership agreement, is presented to the investors only three weeks prior to closing. They are told to have their comments in ten days later. Ten days is not remotely enough time for limited partners to coordinate their objections and present a unified front in insisting on changes. Thus any fights usually boil down to a few headline items, such as the percentage of fees to be rebated to the limited partners and key man provisions, with the general partner making an art form of agreeing to relatively inconsequential change requests so as to look like he has given ground, while keeping the contract almost entirely intact.
Another looming issue is that the limited partners do not have attorneys representing them that are aggressive advocates. One can argue that the problem ultimately rests with the clients, since most lawyers that do contract negotiations regard their role as being deal makers rather than deal breakers. But most of the investors are fiduciaries and therefore are held to high standards of accountability. Their legal representatives should be cognizant of that and mindful that they meet their duty of care.
The real issues are twofold. First, the private equity firms command the attention of the top lawyers at the best law firms. Any firm that does not do a lot of private equity work aspires to. The general partners create massive amounts of legal work. The lawyers on the other side of the table don’t have strong incentives to cross them, since it’s an uphill battle to begin with, and many of the law firms representing limited partners also do work for the general partners. Getting in better graces with the limited partners is a vastly better business strategy than doing a bang-up job for the limited partner.
The document below illustrates the magnitude of this problem. It was presented last June, meaning a month after the Andrew Bowden speech describing in usually vivid terms how more than half the private equity industry was engaged in serious misconduct. The venue was a conference organized by the National Association of Public Pension Attorneys. We have all the presentations from this conference. The one we’ve embedded at the end of this post, despite its short length, is meaty enough that we’ll spend more than one post on it. But it is also written in a sufficiently user-friendy way that you’ll learn quite a lot simply by reading it yourself.
Note first who the authors are. The lead is Dulcie Brand, a partner at Pillsbury Winthrop and a board member of the NAPPA. She regularly negotiates (if you can call it negotiation) private equity agreements. Her clients have included CalPERS, the Los Angeles County Employees Retirement Association, and the New York State Common Retirement Fund.
What is disconcerting about this presentation is that it was made at all. Here, a month after Bowden tells the world that limited parters have done a terrible job of protecting their interests, a top outside attorney makes a presentation to the general counsels of the biggest and supposedly most sophisticated fiduciaries and says, “The agreements are even worse than you thought.” What does this say about her culpability and that of everyone in the room in allowing that to happen?
While one can’t know what Brand said in addition to the material on her slides, they present evidence that the general partners continue to move the terms of the governing agreements, which were already skewed in their favor, even more in their direction. If you’ve followed our posts on private equity, including our releases of limited partnership agreements, you’ll recall that we’ve already flagged some remarkable lapses from an investor protection standpoint, including clawback language that does not work as advertised, advisory boards that provide Potemkin oversight, and sweeping indemnifications and clever conflicts of interest language through which the general partners try to waive their fiduciary duties.*
Here are a few of the striking that Brand flagged:
Consent terms designed to make it remarkably easy for general partners to push through amendments, including allowing for numerous instances where no consent is needed
An affirmation by ERISA investors that their investment will not make the private equity fund subject to ERISA**
A waiver of fiduciary duty hidden in the subscription agreement
Other critical terms sunk into the subscription agreement, like waiver of the right to trial by jury and stunningly, a waiver of the right to make any claims with respect to conflicts of interest, when you’d expect to find terms like that in the limited partnership agreement
It’s already hard to fathom how investors accept the basic terms of a private equity fund: the general partners get to call the funds on a five to ten day notice, have near-complete investment discretion, subject only to very broad investment parameters, with inadequate oversight and reporting, and return the money pretty much when it suits them. The fact that the detailed terms are so one-sided should lead anyone with commercial sense to run for the hills. Yet the limited partners aren’t merely intellectually captured by the private equity kingpins; worse, they actually trust them and are afraid to rock the boat.
And since no one wants to look like a dupe, the reflex of the limited partners has been to circle the wagons with the general partners or simply remain silent. But investors are going to find themselves caught between professing they didn’t know how bad things were, which is tantamount to admitting that their due diligence and oversight was lax or trying to cop that the revelations are no surprise. And it’s even harder to defend the role of hired guns like Dulcie Brand who have clearly failed abjectly in making sure private equity agreements served their clients, as opposed to the interests of voracious private equity overlords.
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*Notice this issue is not clear cut. The SEC in presentations takes the position that general partners are fiduciaries under the Investment Act of 1940.
** This is a belt and suspenders provision. Private equity funds are not subject to ERISA if less than 25% of the fund’s assets come from ERISA investors. Needless to say, general partners are very mindful of this limit and exercise great care to stay below it.
Pillsbury-Winthrop-on-Problematic-Provisions-in-PE-Documents-slides
Pillsbury Winthrop on Problematic Provisions in PE Documents slides
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Yep, that’s how I see it. The pension fund management cashing their outsized paychecks that are paid for the sole purpose of managing the pension are the ultimate party responsible.
Just for the record, the staffers at public pension funds are paid modestly by the standards of the investment management industry.
The staffers at public pensions are paid handsomely compared to the wages and benefits of the workers who’s pensions they are mismanaging.
So you are saying that public pension funds should not hire good general counsels either because they make more money than ordinary workers? What kind of reasoning is that?
The reason that Singapore’s Lee Kwan Yew was able to have Singapore, an island with no industry or commodities to exploit, become a success was he recognized the importance of clean government. To achieve that, he made sure that top government officials were paid on the same level as top private sector professionals (think law firm or accounting firm partner). Similarly, international comparisons show that paying teachers better is correlated with better educational outcomes: http://blogs.lse.ac.uk/politicsandpolicy/pupil-performance/.
It is penny wise and pound foolish to let class jealousy get in the way of having qualified people working on your behalf.
Did I really say that public pension funds should not hire good general counsels because they make more money than ordinary workers?
It seems though, that it doesn’t matter what the public pension funds do when it comes to hiring counsel, as this excerpt demonstrates.
The real issues are twofold. First, the private equity firms command the attention of the top lawyers at the best law firms. Any firm that does not do a lot of private equity work aspires to. The general partners create massive amounts of legal work. The lawyers on the other side of the table don’t have strong incentives to cross them, since it’s an uphill battle to begin with, and many of the law firms representing limited partners also do work for the general partners.
No matter how high pay is for counsel, it isn’t possible to truly get council that works for any limited partner.
As for higher pay for top government officials, why not. Would paying $4 million per year to the Federal Reserve chief yield a smarter Fed? Would Yellen work that much harder and smarter if her pay was goosed by a factor of ten? There might even be some obscure payoff down the road, because of a smarter, less corrupt decision made in the present.
Private equity is a wealth absorbing activity. Look at the pay of the top executives. $millions per year, to strip mine society. The best that money can buy.
Yves, these are really interesting responses to unpack. I don’t expect a response, just food for thought, perhaps exploring a different perspective. You seem to be suggesting that pension fund managers, whose sole job is to allocate the capital assigned to them, aren’t responsible for the thing that is their sole job.
1) Why is that standard relevant? What is the link between the compensation of an investment manager and the performance of the portfolio?
2) Why should managers of public funds be compared with “private” investment managers? (I quote private since in a larger sense the entire financial industry is backstopped by the federal government anyway at this point). Public policy is the antithesis of markets. Entrenched inequality is one of the fundamental problems with public policy today.
3) If somebody is that motivated by money, then I say good riddance. We don’t want those kinds of people in public institutions. Those are the kinds of people that will do (or not do) anything to further their career. You seem to have this implicit assumption that competence is an extremely limited resource in our society, an assumption I find absolutely fascinating since the vast majority of workers would happily step in if there was some kind of neoliberal bogeyman mass exodus of The Indispensable Technocrats Who Know How To Do Things.
4) I notice you switched from my language of management to your language of staffers. I believe the rot in our institutions starts at the top. I wonder if that was a subconscious effort to lower expectations of responsibility and accountability? Or does the word staffer mean something specific in the context of financial management?
1) Apparently the general counsels aren’t good(!). Having the appearance of legal review without the substance of it is worse than not having legal review.
2) Whether they are good or not, they are responsible. They are part of the management team at the public pensions that are responsible for how they are allocating capital in our society. It is their responsibility, not Wall Street’s (or anyone else’s).
3) The very fact that our society pays educated gatekeepers more than other workers is part of the problem, not part of the solution.
4) It’s a little bizarre complaining about lawyers specifically, because there is an enormous glut of lawyers who very desperately want a stable job doing something for public purpose. They don’t need to make huge salaries, just decent ones doing decent things for a change.
5) The conclusion I come to from things like this is that there is no way to lawyer up effectively. The problem isn’t a technical one that can be solved in contract language. That is obfuscation to direct attention away from the responsibility of pension fund managers to allocate capital.
The reason this is so important is that PE is just one example of how central planning doesn’t work. Government is not generally very good at picking winners and losers. Pensions should be funded by taxation, not investment returns.
The issue is not that general partners screw over limited partners in PE relationships. The issue is that somebody has to choose how finite resources are allocated. No amount of lawyering can change that fundamental burden.
I’m having a hard time understanding how the pension fund trustees aren’t violating their own fiduciary duties by signing on to these one-sided deals. Or is there just no one willing to sue their own fund?
The board members are personally liable, although they all have directors’ & officers’ insurance. So the better route would be to sue them rather than the fund.
What has prevented people from suing them as individuals? Is it the general lack of awareness about what is going on? And lack of easy means to coordinate/communicate to take action?
Or, is the legal world such that good lawyers would not want to go after their colleagues?
. . . how do supposedly sophisticated investors sign up for such one-sided deals?
The sophisticated investors aren’t and
. . . no one wants to look like a dupe . . .
Is it true that “many of the law firms representing limited partners also do work for the general partners.” My understanding was that law firms are obliged to avoid such conflicts. As to “Getting in better graces with the limited [should be general, no?] partners is a vastly better business strategy than doing a bang-up job for the limited partner,” I couldn’t agree more.
No, this happens all the time. The firms disclose the conflict and the clients provides a waiver.
We’ve written about this issue before. See this example:
http://www.nakedcapitalism.com/2013/07/memo-to-eliot-spitzer-if-harvards-own-pe-law-firm-is-really-more-loyal-to-bain-how-can-you-hope-to-get-good-representation.html
Liquidity: during boom times, nobody worries about it. But in a bust (e.g., 2008), liquidity is everything, to the point that those who lack it go BK or get a TARP infusion.
Too bad Ludovic Phalippou wasn’t invited to the NAPPA bash. He’s got his own PowerPoint presentation. And this is his key takeaway:
‘No alpha,’ biTcHeZ! Chew on that. You’d need five decimal places to measure any alpha added by attorneys.
Agreed, and we made that point yesterday: that all the effort and money spent in manager selection in PE is wasted. They should figure out an index-type strategy and be done with it.
But Philappou has separately pretty much said that investing in PE makes no sense unless you have a very very narrow strategy. See his advice to the Norway sovereign wealth fund:
https://www.regjeringen.no/globalassets/upload/fin/statens-pensjonsfond/2011/phalippou.pdf
On the legal aspects of this problem: Maybe we need to go back to the old version of legal structure where there were solicitors and barristers. The solicitors were client facing and the barristers were topic experts. Crucially, professional conduct required the barristers to work both sides, and prevented them from having direct client relationships. If a solicitor sought to hire a barrister to help his client, it was not legitimate for the barrister to turn the work down and exhibit a preference for one-sided cases.
That is, it used to be that legal ethics required area experts in law to serve clients on both sides of any issue, so the law couldn’t be distorted to favor a specific group.
Presumably there was a reason for this structure, and it’s not clear to me why it has been eliminated.
Why is it so taboo to even suggest the “k-word”? If indeed there is this great cloud of “looking like a dupe” anxiety, doesn’t Occam’s Razor point to at least some instances of k*ckb*cking? (You did after all point out that “staffers at public pension funds are paid modestly by the standards of the investment management industry”…)
The kickbacks come in the form of pay to play by politicians who can influence which firms and advisors get assignments. See David Sirota’s extensive reporting on New Jersey as an example.
The responsibility at the staff level of pension funds is too diffuse for kickbacks to work. But they do get lavishly entertained by the private equity companies when they visit their conferences, where the GPs sell how well they are doing, particularly the annual conferences. They’ll hire top music entertainers or speakers. But since all the GPs spend fund money entertaining their investors, there’s no competitive advantage (as in no fund is going to get hired because it does even better on the conference perks than another).
Yves, you were right that this presentation is surprisingly readable. Shockingly so.
Why indeed was this presentation given? Like you said, it just proves that the top legal experts in the field have their eyes wide open if they can spell out all the traps as clearly as described in this presentation. Who was the audience, anyways?
Or was the whole point that these are evil, crappy agreements and we all know it but TINA and investors will just have to accept this if they want a place to put their money? (In other words, it lets investors know that this is how the game is played–pun intended–but that’s what everyone does, so you’ll all just have to go along.)
Slide no. 28–what’s “Distribution through waterfall” and what’s good or bad about it for investors?