An important story by Chris Witkowsky of PEHUb describes in considerable detail how CalPERS tried unsuccessfully to get the private equity kingpin TH Lee to pay back various fees that the SEC had deemed improper, in ordering other major players to make restitution and pay fines. To CalPERS’ credit, this wasn’t a casual query; the giant public pension fund went several rounds with TH Lee and also tried enlisting the support of the advisory councils of the two TH Lee funds where this misconduct occurred.
CalPERS’ failure in getting restitution for precisely the same kind of conduct that the SEC sanctioned shows the abject failure of the SEC’s selective enforcement regime. As we’ve discussed, the SEC has been adopting an enforcement policy that looks like “one and done”: cite only one firm for a particular type of bad conduct, out of the bizarre belief that the others will get the message and stop misbehaving, Mind you, that is not our interpretation; the SEC’s head of enforcement, Andrew Cereseny, as well as a former regional SEC office head, made precisely that claim at an SEC enforcement conference earlier this year. As we wrote , it’s clear this approach is not working:
The SEC’s own annual filings from private equity investors, the Form ADV due in at the end of March, shows that private equity firms are continuing to engage, on a widespread basis, in abuses that the SEC regards as serious enough to merit fines. While those filings came in the very day Ceresney was on his panel, former exam chief Andrew Bowden was claiming (on what we believed was pretty dubious intelligence) in the late summer and fall 2014, well away from the ADV reporting cycle, to be learning of changes in behavior. Thus the SEC believes it has insight on changes in the degree of compliance on an ongoing basis, and further communicates it with the public. The Form ADV disclosures suggest the SEC needs to do a better job of cross-checking the self-serving palaver that lawyers for the firms it regulates are serving up, particularly in informal venues, versus what they say in the far more carefully crafted documents they provide to the agency.
Another justification for the SEC’s weak enforcement is that investors like CalPERS are “accredited investors,” meaning they are assumed to be capable of taking care of themselves. But CalPERS has shown this view to be completely unrealistic as far as private equity is concerned. For instance, the SEC’s former head of enforcement, Andrew Bowden, described in a pivotal 2014 speech how the agency had found what amounted to stealing or other serious compliance violations in half the firms it examined so far. Bowden also pointed out that the investors had signed surprisingly vague agreements that by implication did a poor job of protecting their interests. This was prima facie evidence that investors like CalPERS are outmatched by private equity firms.
CalPERS even described in its private equity workshop how one-sided private equity agreements are and how it is unable to get better terms. The contracts are “take it or leave it,” with negotiations limited to a few terms, like the percentage of management fee offsets. The general partners present limited partners like CalPERS with a black line version of the agreement, showing where the language differs from the last contract. Thus the limited partners are basically told, “You accepted the other crappy language in the past, so don’t even bring that up. The only thing there might be to talk about is the new language.” Even worse, limited partners believe that from them to work together and negotiate as a unified group (even assuming many disparate investors could reach a common position) would constitute an anti-trust violation.
With that as background, CalPERS pressed TH Lee for reimbursement of two charges that the SEC had sanctioned. One was acceleration of monitoring fees, an abuse where Blackstone paid the SEC $39 million in fees and disgorgement, and improper allocation of broken deal expenses, misconduct that was part of the charges in a $30 million SEC settlement by KKR. Accelerated monitoring fees are particularly galling. Monitoring fees are what Oxford professor Ludovic Phallipou has called “fees for doing nothing.” The contracts with private equity portfolio companies call for the charges to be paid, regardless of whether any fees are actually rendered. This practice is being targeted as an IRS abuse, since for an expense to be tax deductible, it must be for the purchase of products or services. The very structure of these “fees” in fact makes them disguised dividends.
To add insult to injury, an accelerated monitoring fee occurs when a portfolio company is sold. The monitoring fee contracts are typically set up for a ten-year life, and some even have the contract be “evergreen”, as in the term automatically-re-extends so it always has ten years to completion. When a portfolio company is sold, there are still year remaining in those monitoring fee agreements. Those future payments for work that will never be done are “accelerated,” as in discounted back to present, deducted from the proceeds of the sale of the company, and paid to the general partner.
In correspondence obtained by Buyouts, Real Desrochers, private equity chief atCalifornia Public Employees’ Retirement System, late last year accused the Boston buyout shop [TH Lee] of collecting accelerated monitoring fees from portfolio companies without adequately disclosing the practice to investors.
He also claimed that the firm had not been sufficiently up front with limited partners about how it allocated expenses to general-partner-funded co-investment vehicles…
In his initial email (dated December 9) to TH Lee executives, Desrochers suggested that a Securities and Exchange Commission inquiry last year alerted the $293.6 billion pension and other LP advisory committee members to the practices in TH Lee’s Fund V, which closed in 2001, and Fund VI, which closed in 2007…
Desrochers asked TH Lee to reimburse Funds V and VI investors for the accelerated monitoring fees that TH Lee kept and for the expenses he says were improperly charged to the main funds.
He asked that the firm share the findings with all TH Lee LPs and the SEC. The dollar amount of the fees in question was not disclosed.
TH Lee executives responded in a multipage letter dated Dec. 17. They wrote that the limited-partnership agreements TH Lee signed with CalPERS gave TH Lee the ability to collect accelerated monitoring fees from portfolio companies and to share those fees with investors.
A side letter signed by CalPERS on Fund VI specifically allowed for the charging of termination fees, which TH Lee execs say includes what CalPERS called accelerated monitoring fees. They argued that the LPAs do not require the GP co-investment vehicles to pay fund expenses, and they pointed out that investors get reimbursed for all fund expenses.
The letter from TH Lee stated: “[W]e complied fully with our agreements, and disclosed to CalPERS and all other LPs, in detail and for a decade before November 9 of this year, exactly how we shared termination payments and how expenses to the funds were treated.”
Desrochers responded with heated language in a Jan. 11 email. “Your position appears to us to indicate that you believe that the legal agreements allow you to self-deal in all instances except where a practice was not specifically prohibited,” he wrote.
He added that “you should not self-deal unless the practice was fully and timely disclosed and specifically agreed to in the legal agreements.”
TH Lee responded in a Jan. 14 note. Managing Director Gregory White wrote: “[W]hen you make unsupported, unjustified — and frankly, defamatory — charges of self-dealing and non-disclosure, you threaten a reputation and relationships that we have worked hard to build.”
An LP with knowledge of the situation said that TH Lee surveyed LPs in Funds V and VI in late January, asking whether the firm should hire legal counsel to determine whether it owed LPs money based on CalPERS’s findings. The LP advisory committees for both funds did not support CalPERS’s request, the LP said.
Notice the basis for the dispute. Consistent with the SEC’s view, CalPERS has taken the position that TH Lee didn’t obtain permission to charge accelerated monitoring fees. At least as recounted by PE Hub, CalPERS didn’t frame the issue as the SEC did. The SEC’s argument was that private equity firms needed to disclose of the intent to charge these fees. CalPERS appears to have argued that TH Lee didn’t obtain the right to incur these expenses. TH Lee contends that the contracts gave them the wriggle room to do just that.
CalPERS further contends that TH Lee has engaged in self dealing. TH Lee has no defense beyond “You don’t dare say such bad things about us.” Even though limited partners have allowed the general partners to waive their fiduciary duty, and these agreements often allow general partners to consider their own interest, CalPERS does have a point in that all contracts rely on good faith and fair dealing. But that is seldom used as a cause for action outside of employment law (yours truly has used that claim successfully in a regular commercial context).
Notice the ugly bit, that the advisory committee would not back CalPERS. That was certain to be the result. As we’ve discussed, general partners make sure to stack the advisory committee so that they will always have a safe majority of captured and/or clueless limited partners so it will never be on the losing side of a dispute.
So now it becomes more obvious why 13 state and local pension fund officials wrote the SEC last year, asking for it to come in to their rescue and require more transparency on the fee front. We said at the time that this was proof of limited partner inability to act as accredited investors and fend for themselves.
That reconfirms what we wrote in a Bloomberg lop-ed last August:
The most realistic solution lies with the SEC — but it won’t be what the state officials have in mind. If public pension funds persist in feigning helplessness, the agency should consider rescinding their accredited status. This designation allows large and sophisticated investors to operate with minimal oversight. It requires that they be competent to review legal agreements and negotiate terms, including disclosure and audit rights, when the SEC has not reviewed the offering documents for accuracy and completeness. Without it, the pension funds would not be able to invest in private equity unless the latter submitted to the higher cost and disclosure of registering their offerings with the SEC.
Losing accredited status would be a huge embarrassment. As such, it could serve as a wake-up call, forcing complacent and captured public pension fund trustees and staff to just say no to private equity shenanigans.
The other solution is the one being pursued now, of state-level legislation, like the private equity fee transparency bills in California and Illinois. However, although both measures appear to be moving forward, we’ve also heard from knowledgeable sources that the private equity firms, not surprisingly, are dead set against them passing but are getting in-state public pension funds to act as their mouthpieces. The bills will probably still pass in some form, but how solid they’ll be is up in the air.
In the longer term, private equity is already past its sell-by date, but the desperation of investors for high returns and the long lock-up period of these funds means their decline will be gradual. General partners are already warning that returns going forward will be lower than in the past. Once it becomes undeniable that they aren’t delivering the profits commensurate with their egregious fees. you’ll see the same sort of shift in attitude that is underway with hedge funds: a reduction in commitments, some players offering much better terms to try to woo investors back, and more earnest efforts to find similar return profiles at lower cost, which for private equity would mean making investments in house. So these masters of the universe will lose some of their swagger and negotiating leverage when investors really are willing to say no, and close their checkbooks. But that ultimate day of reckoning is still years away.