The SEC is up to its usual kabuki, of pretending that a mere cost-of-doing business punishment for a firm that has engaged in widespread abuses amounts to a serious effort at enforcement. The gap between misconduct and SEC action is particularly striking in the case of private equity. In May 2014, former SEC examination chief Andrew Bowden declared that over half the firms that the agency had inspected thus far had engaged in stealing and other serious violations of securities laws. But as we discussed, Bowden began walking his tough talk back in September last year, which was such a dramatic reversal that we wrote:
More than four months later, the SEC isn’t merely sitting pat. It has been making the rounds, both with insider private equity journalists and in closed door meetings. Bowden has been making so many conciliatory noises that it’s clear, absent more public pressure or continued media revelations of industry misconduct, that the SEC is unlikely to do more than engage in a few image-saving wet noodle lashings, such as its small dollar enforcement action this week against a private equity firm no one ever heard of.
Even worse, a careful reading of Bowden’s recent remarks indicate that the SEC isn’t merely retreating from its earlier bold talk. It appears to be actively enabling a massive coverup of these abuses. Mind you, this is even worse than the SEC’s limp-wristed enforcement of financial-crisis-related misconduct against the too-big-to-fail banks.
The real message is that private equity is too powerful to discipline.
The SEC actions to date are playing out true to form. The agency appears to be following the template it uses for CDO settlements, of one deal per firm, irrespective of the actual amount and value of underlying abuses. Yes, the form of the agreement is that it is limited to only the specific conduct described in the order, but the parties to the agreement understand that unless some sort of new revelations surface, the SEC is moving on. For instance, the attention-grabbing SEC filing against Goldman for a synthetic CDO that resulted in a $550 million settlement was for only one of 25 CDOs in its so-called Abacus program.*
After some penny-ante actions against small fry, the SEC went after KKR, ordering $10 million in fines and nearly $19 million in disgorgement and interest. That’s couch lint for KKR. What was troubling about the settlement was the SEC singled out a particularly simple-to-prove abuse, that of shifting certain expenses (“broken deal fees”) entirely to the limited partners, when 20% should have been allotted to co-investors, including KKR affiliates. The SEC chose to ignore an abuse that was documented extensively by Mark Maremont at the Wall Street Journal, that of KKR charging the fees of its captive consulting firm KKR Capstone to investors as an expense, when it regularly stressed that Capstone was part of KKR, leading investors to believe that KKR Capstone charges would be included in KKR’s hefty management fees, and not billed as a separate cost.** It also punted on a smaller, but fairly-simple-to-prove scam again reported in the Wall Street Journal, that of unauthorized group purchasing discount kickbacks taken by KKR as well as other big players like Blackstone and TPG.
That pattern of limp-wristed enforcement continued with a settlement the SEC announced yesterday, this one with Blackstone. We’ve embedded the order at the end of the post. It involves two types of misconduct. One was that Blackstone would take fees from former portfolio companies after the fund it had once owned them had exited the investment entirely. The device was a so-called termination of monitoring fees.
Monitoring fees are already an abuse that limited partners perversely tolerate; sadly, the SEC can’t protect them from their failure to negotiate remotely adequate arrangements. Monitoring fees are charges made to portfolio companies by general partners like Blackstone because they can. The agreements don’t provide for any actual services to be rendered. Oxford professor Ludovic Phalippou, who has reviewed many of these agreements, calls them “money for nothing.”
But that wasn’t good enough for firms like Blackstone. Blackstone had the monitoring fee agreements set up so that they were “evergreen,” meaning every year they would be extended a year so they always had a ten-year remaining life. Now here is the cute part, per the SEC order:
The monitoring agreements between Blackstone and the portfolio companies also provided for acceleration of monitoring fees to be triggered by certain events. For example, upon either the private sale or IPO of a portfolio company, the monitoring agreements allowed Blackstone to terminate the monitoring agreement and accelerate the remaining years of monitoring fees, in some cases including additional renewal periods, and receive present value lump sum “termination payments.” While a portion of these accelerated monitoring payments reduced management fees otherwise payable by limited partners, the net amount of the payments also reduced the value of the Funds’ assets (i.e., the portfolio companies making the accelerated monitoring payments) when sold or taken public, thereby reducing the amounts available for distribution to limited partners.
In some instances, Blackstone terminated the monitoring agreement and accelerated monitoring fee payments even though the relevant Blackstone-advised fund had completely exited the portfolio company, meaning that Blackstone would no longer be providing monitoring services to the portfolio company.
It’s adding insult to injury that the SEC blandly repeats the “monitoring services” fiction in its order.
The second abuse included in the settlement was that even though Blackstone was doing less legal business with its (presumably main) law firm that the funds that Blackstone was managing were, Blackstone negotiated an agreement with the law firm which gave it a bigger discount than the funds received.
One damming part of the settlement are the mentions of how the limited partners did nothing, even when they should have recognized that they were being fleeced. One reads the inclusion of this information in the order as an argument that Blackstone made for a lower fine: “If the investors weren’t bothered about this, why are you, the SEC, after us?” In fact, the limited partner complacency confirms the argument we made in a Bloomberg op-ed: that limited partners like public pension funds are too clueless to invest in private equity, and they need to be saved from themselves by being stripped of their “accredited investor” designation. Again from the order:
The LPAC [Limited Partnership Advisory Committee] of each Fund could have objected and arbitrated over the accelerated monitoring fees after they had been taken, but never did./blockquote>
That result is no surprise if you understand how these committees are designed to work. The general partner selects who sits on them. Needless to say, the general partners make sure that a it will have a comfortable majority consist of particularly clueless or complacent investors, such as fund of funds which would never dream of ruffling general partner feathers. But not surprisingly, Blackstone uses the entirely predictable “dog that didn’t bark” behavior to argue that it didn’t do anything all that bad. From Blackstone’s statement to the Financial Times:
“Each accelerated fee was, however, as the SEC order acknowledges, disclosed when received and our Limited Partner Advisory Committee did not exercise its right to object. Moreover, Blackstone voluntarily made changes to the applicable policies well before this inquiry was begun.”
Um, Blackstone made those changes “voluntarily” only after Dodd Frank passed, which meant that the firm would be subject to SEC oversight as an investment adviser. But we are supposed to believe that Blackstone is a good actor, as opposed to merely prudently getting out in front of the inevitable.
But this section reflects even more poorly on the limited partners (emphasis ours):
In early 2011, Blackstone voluntarily ended its disparate legal fee arrangement with the Law Firm. In 2012, Blackstone disclosed to all limited partners, without any resulting complaints, that historical discounts offered to Blackstone exceeded discounts provided to the Funds.
And remember, the overwhelming majority of limited partners are fiduciaries, yet they said not a peep when they were told they’d been cheated. No wonder Blackstone held onto its ill-gotten gains.
That’s also why the current SEC approach is indefensible. Both Andrew Bowden, and his successor Marc Wyatt, reportedly think that it’s fine for private equity firms to cheat their investors when these investors are particularly vulnerable by virtue of making long-term, illiquid investments, as long as the confess to having cheated in their annual form ADV filings and make some token payments to make the SEC look good. Since when are fiduciaries Catholic priests, where mere confession is adequate? I believe that the Church also requires penance, but that seems to be sorely lacking as part of the SEC orthodoxy.
* In fairness, Goldman was probably not guilty of misconduct on all of its Abacus CDO. The early ones in the program were believed to serve to generate hedges for Goldman’s own account, as opposed to being created primarily on behalf of third parties like John Paulson’s hedge fund for the purpose of shorting the subprime market, without that intent being and thus the shorts’ role in deal structuring being disclosed to the so-called protection sellers, who effectively went long the particularly drecky subprime exposures that the protection buyers wanted to short. But the majority of the Abacus deals were understood to have been created to suit the demand of wanna-be shorts.
** This is not as unreasonable an expectation as you might think. When you strip out KKR Capstone, KKR is particularly thinly staffed at the management adviser level relative to its peers, raising the question of why investors tolerate its level of management fees when they are supposed to cover reasonable management adviser overheads, ie, bear some level to their staffing, and not simple rent extraction.