At a recent Wall Street Journal conference, one of Blackstone’s top private equity executives tried depicting the firm at on board with SEC oversight and gave a high level sketch of a new private equity fee structure, which was presented as a change from the old regime of charges that were invisible to investors but imposed large costs on portfolio companies.
However, as we’ll show, the commitment to change is purely optical.
Even though Blackstone is eliminating its largest fees charged to portfolio companies – transaction fees and monitoring fees, and it uses this sacrifice to justify increasing its largest source of income, management fees. But how much sacrifice is really going on here? there’s every reason to believe Blackstone is leaving other mechanisms in place for extracting funds from portfolio companies. And even better from Blackstone’s perspective: these tricky fees are not offset against management fees as the old transaction and monitoring fees were, making the new scheme potentially even more lucrative than its predecessor.
Laura Kreutzer, Wall Street Journal: You know, we’ve seen a lot of enforcement actions by the SEC and a lot of settlements, with probably close to a dozen firms in the past two years, including Blackstone. Um, particularly over fee disclosure and a lot of it around disclosure, how has all of this SEC scrutiny affected the way you operate your firm, particularly when it comes to disclosure?
Joseph Barratta, Senior Managing Director and Global Head, Private Equity, Blackstone: Well, I think, to start I’d say the SEC was right to be, ah, scrutinizing the industry. It’s grown in importance. We manage, Blackstone manages money on behalf of 37 million retirees in this country and around the world. And that’s an important obligation. And so for the SEC not to be engaged in monitoring people who manage that kind of money would be inappropriate.
So that they’re looking I think is a good thing, shedding transparency and changing business practices, I’d say the business practices questioned were struck thirty years ago in the first generation of funds, where you had a buyout practitioner negotiating with sophisticated pension plans negotiating documents that weren’t meant to look like S-1 public company disclosures. And so, there was a lack of specificity in those agreements, and then operating practices cropped up over time that were well understood by buyer and seller, meaning LP and GP, which the SEC has come to question: Did you disclose this? Did they know about it? And those things are all fine.
So yes, the buyout industry, writ large, big firm, small firm, everybody acting in good faith, is changing its practices, which is right. How have we specifically changed our practices? In our recent funds, we’ve tried to radically simplify the relationship, the fee relationship, between ourselves and our limited partners. So get rid of all of the historical practices that were understood but weren’t explicitly disclosed, um, and increase disclosure of all sorts…
Kreutzer: What are some of those historical practices, like accelerated management [sic, she means monitoring] fees?
Barratta: Yes, the active transaction fees, monitoring fees, that were common industry practices. You know, that in our recent fund, we’ve eliminated those altogether in exchange for a higher base management fee.
In the bulk of this short segment Barratta gives a big dose of revisionist history: that the standards for private equity were set in the 1980s via “good faith” negotiations between pension funds, when the contracts then and now are “take it or leave it” arrangements with only some inconsequential modifications granted for appearances’ sake.1
Similarly, the weak effort to pretend that Blackstone is doesn’t mind being supervised at all may result of the fact that Blackstone CEO Tony James is on the short list of Treasury Secretary candidates in a Clinton administration.2
However, Barratta’s pious patter sets up the important part of his remarks, which come as if they were a mere afterthought, as if to suggest that they were a natural and easily-made concession.
But any change in an established, widely-used fee structure is actually a curious response to the SEC’s wrist slaps. Rather than clean up its definitions of terms and make fuller disclosures, Blackstone has foresworn all those long-standing, supposedly well-understood fees that the SEC exposed as tricky and not understood at all. The posture is that Blackstone is merely achieving a similar economic result to what it had before by raising its management fees and giving up the other levies.
But Blackstone is not in fact renouncing the ability to charge other fees. The only fees it has said it is giving up are ones like transaction fees and monitoring fees that have been the subject of SEC fines. That also happens to include most of the types of fee that are subject to management fee offsets.
That creates the real possibility that limited partners will wind up worse of, in terms of the total amount of charges extracted from the businesses acquired on their behalf. This would be a perverse outcome given that general partners, including Blackstone, have warned investors to expect lower returns in the future. If one were to believe the notion that that the general partners love to promote, that limited partners are “partners,” as opposed to users of a legal structure, the general partners should take a hit as well.
If you look at the second part of the Blackstone VI limited partnership agreement from our Document Trove on p. 56 (numbered page A-4)3, you’ll see it states that Blackstone can recover from portfolio companies as much as it wants in expenses incurred by its “portfolio operations group.” If you are familiar with monitoring fees, one of the types that Blackstone says it is eliminating, they are presented to limited partners as paying for overseeing the portfolio companies. In fact, as we’ve written, the monitoring fee agreements are pure rent extraction. They provide for fees to be paid irrespective of whether any services whatsoever are rendered. Professor Ludovic Phalippou of Oxford has called them “money for nothing“.
Monitoring fees can be reconstituted as “portfolio operations group” charges. While there is a $5 million per annum cap on expenses from this so-labeled group in what it can bill to the fund directly, there’s no limit on what it can charge portfolio companies, which is how general partners have managed to evade oversight and disclosure. And bear in mind that the portfolio operations group language was new in the Blackstone VI agreement. It may have been a toe-hold carve-out that has been in broadened in later funds (for instance, the $5 million limit on direct expensing to the funds could now be higher).
Also, keep in mind that the definition of fees to be offset against the management fee is net of out-of-pocket expenses. That is a major exclusion. It has almost certainly been preserved in the new Blackstone agreements that supposedly do away with monitoring and transaction fees.
Finally, and critically, despite Barretta trying to depict lack of clarity about terms in limited partnership agreements as an unfortunate historical accident, the term “portfolio operations group” is nowhere defined in the limited partnership agreement4. This suggests that Blackstone can designate every single one of its employees, up to and including Steve Schwarzman, as being included in this category. Likewise, “reasonable out-of-pocket expenses” is nowhere defined.
So you can see that discontinuing transaction and monitoring fees is meaningless, since Blackstone has other fee extraction mechanisms. And even better, none of these other channels for syphoning money out of the portfolio companies are subject to management fee offsets, which in Blackstone VI were 65%.4
So even when a Blackstone executive, in a very short remark at a conference, tries to depict the firm as turning over a new leaf with private equity, you can see it’s more of the same ole chicanery in familiar professional packaging. Nicely played.
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1 Barratta misrepresents the history of private equity norms. While Blackstone started in the mid-1980s the firm was a latecomer.I met Pete Peterson and Steve Schwarzman when they were having a tough slog raising their first fund), The industry had started in the 1970s and Henry Kravis had already become so rich by then that Peterson and Schwarzman were openly jealous.
Simialarly, contrary to what Barratta would have you believe, the early investors in private equity funds were wealth individuals, not pension funds. They couldn’t even contemplate investing until the Department of Labor issued a new interpretation of its rules in 1978 to allow risks to be judged on a portfolio basis, rather than investment by investment. Leveraged buyouts and venture capital would never have passed muster under the old standard.
Needless to say, wealthy individuals had neither the clout nor the lawyers of the same caliber as the early players in “bootstrapping” game, who came out of mergers & acquisitions, as Peterson and Schwarzman did. Public pension funds didn’t begin investing until the mid 1980s, when Washington State not only invested in KKR’s funds but promoted KKR to other public pension funds. And in the mid 1980s, private equity was coining money. No one was fussy about fund terms given how much money it was making.
And as for the insinuation that pension funds then or now understood the deals, the fact that Barratta acknowledges that some definitions were unclear or absent says otherwise. We’ve demonstrated at length how CalPERS, a long-standing and supposedly savvy investor in private equity, does not understand many of its basic features. And in its private equity workshop last November, CalPERS confirmed what outside experts have said: private equity agreements are “take it or leave it” contracts, where the general partners allow a show of negotiating by accepting limited partner changes on some inconsequential terms.
2 Two of many examples as to why it’s hard to see Blackstone as a supporter of more transparency and oversight:
Even though Blackstone has registered a broker-dealer with the SEC, which means that unit is subject to SEC oversight, there is good reason to believe that like its peers, it is not providing transaction services to its private equity portfolio companies through that entity. We’ve explained at length in earlier posts why this is a flagrant, long-standing violation of SEC regulations.
Blackstone has not endorsed the ILPA template which provides for extensive disclosure of private equity fees and costs.
3 The relevant section:
Such [portfolio company] fees (including fees received in respect of guaranties as contemplated by paragraph 5 .1.2 of the Partnership Agreement) shall be net of (x) reasonable out-of-pocket expenses incurred by the Advisor or its Affiliates (and not otherwise reimbursed) in connection with the transaction out of which such fees arose and (y) to the extent not reimbursed or paid as provided in clause (2) below, internal compensation (i.e., salary and bonus) costs specifically allocated to portfolio companies associated with employees in Blackstone’s portfolio operations group (which shall in no event include investment professionals or legal/accounting professionals), not to exceed $5 million in the aggregate in any Fiscal Year; provided, that such costs in each case shall be no greater than would be obtained in an arm’s length transaction for similar overall services as determined by the General Partner in good faith (but, in each case of (x) and (y), shall not be net of all other direct or administrative costs allocable to such fees); it is understood that the Advisor or its Affiliates (1) may seek to have all such reasonable out-of-pocket expenses reimbursed or paid by the company in respect of which such expenses are generated and (2) shall seek to have such internal compensation costs associated with employees in Blackstone’s portfolio operations group (as described above) reimbursed or paid by the company in respect of which such costs are generated (which in each case of (1) and (2) shall not be considered a fee described in any of the foregoing clauses (i) through (iii) above).
4 Even though the section above states “employees in Blackstone’s portfolio operations group (which shall in no event include investment professionals or legal/accounting professionals),” since none of “investment professionals” “legal professionals” or “accounting professionals” are defined terms, the parenthetical is meaningless.
4 According to p. A-4, “(iii) 65% of net monitoring,
transaction, directors’ and organizational fees received by the Advisor and its Affiliates” must be rebated to investors.
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The white washing continues anew. And one can only imagine how soft touch the SEC will remain under the next (likely Clinton) administration. The fact that Clintons top choice for the Treasury might be a Blackrock executive speaks volumes about how tightly the PE industry can be expected to be regulated.
Great article Yves.
Either way…fees or excess valuations via monetization through channeling Fed largesse….they win!
Your Tax Money Could Enrich Corporate Executives
The latest idea for government to improve the economy came from insider Larry Summers, who long ago sided with those in power vs. serving the public.
Summers floated a trial balloon for the government to buy stock on an ongoing basis.
My initial reaction was revulsion, after which I pondered how Larry’s idea would help the greed and power class.
1. Most executive compensation involves stock options which need rising share prices for the C suite to get millions more in pay.
2. Companies engineered earnings increases by buying back stock and reducing the float. Should they wish to re-float treasury stock they’ll need buyers.
3. Private equity underwriters (PEU) need investors to buy stock in companies they monetize via IPO. Also, most PEUs sell but a portion of their holdings in the initial offering.
Rising stock prices enable them to make the maximum in their final profitgasm exit.
I’m sure there are more reasons for the government to buy company stock to enrich corporate chiefs and their PEU sponsors. That’s the insider group Larry Summers serves.
The call for government to buy equities grows louder.
http://peureport.blogspot.com/2016/10/your-tax-money-could-enrich-corporate.html
I don’t want to steal craazyman or even craazyboy’s thunder, but when we direct so many smart people into these fields with tremendous ideological shackles, we reproduce medieval latin scholastic philosophy where every argument is circular and whatever your conclusion you never leave the point you’ve started from
The truth is —- generational wealth transfer ——
Negative interest rates
Reverse mortgage schemes
Property managers Overcharging the 40% of seniors that still have aging property in their name (condos)
Governments finding new ways of making seniors lose their vacation homes through capital gains taxes and fees since the surviving grand kids are living pay check to pay check and are obliged to sell their inheritances.
If you look at the most recent versions of ADVs for many private equity advisors one trend that stands out is that they are pushing their employee expenses into internal “operations groups”. The scheme is to setup an unaffiliated “operations group”, essential to “add value” to their portfolio companies, get a carve out in the LPA, and then funnel all kinds of expenses through that group. Now the beauty for PE managers is that they manage to shift the cost of their employees to the portfolio companies, or the funds, which means that the owners of the firm get to keep a larger portion of the management fee and profits. Now if investors are in the end paying the bill for inferior Bain or McKinsey like services, then why won’t they just setup an in house group that buys companies and then has Bain and McKinsey manage the operational improvements for them? Similarly, the investors end up paying the legal fees, so higher lawyers directly and have them manage the legal aspects. Given that fund performance is like throwing darts on a board, save yourself the management fee and profit sharing and fire all your managers. But the whole investor ecosystem is so corrupted with bad information and captured that such by the promise of higher returns that such an idea would never fly.
Like the Ontario Teachers’ Pension Fund does? They own chunks of many businesses directly through their Private Capital arm, a bit through funds but hey, they *are* PE, so they know PE and don’t get stung. Assets $ 171.4 billion CAD, and, oh, they have an average annual return of 10.3% since inception, Jan. 1, 1990. Not too shabby, I think.
Yves, I took a scan through the partnership agreement and that is an impressive piece of lawyering. Even though I read crap like that for a living, my eyes were glazing over after less than a minute. I was happy to see you included the Indemnification paragraph. (5.5) I like to start there when reviewing these sorts of things if nothing else to get a feel of how to treat the other side.
I direct your attention to paragraph 5.5.6. Just for fun, read down and see how far you get before you reach a period. Not a semi colon, but an honest to god period. Considering that the Indemnity paragraph is often the most dangerous section of a contract, I would advise my client to run, not walk away from such a piece of garbage.
If my negotiating partner/adversary has such a low opinion of my side, I would committing malpractice if I didn’t advise my client to think VERY, VERY HARD about ever working with someone like this.
Here is the single sentence that weinerdog43 is referring to:
5.5.6 The Partnership shall, to the fullest extent permitted by law, indemnify and hold harmless all Indemnitees and the Liquidating Trustee (and their respective heirs and legal and personal representatives) who was or is a party, or is threatened to be made a party, to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (including any action by or in the right of the Partnership), by reason of any actions or omissions or alleged acts or omissions arising out of such Person’s activities either on behalf of the Partnership or any Alternative Investment Vehicle (including a Corporation) or in furtherance of the interests of the Partnership or such Alternative Investment Vehicle (including a Corporation) or arising out of or in connection with the Partnership or such Alternative Investment Vehicle (including a Corporation) or as the Liquidating Trustee, if such activities were performed in good faith either on behalf of the Partnership or such Alternative Investment Vehicle (including a Corporation) or in furtherance of the interests of the Partnership or such Alternative Investment Vehicle (including a Corporation) and in a manner reasonably believed by such Person to be within the scope of the authority conferred by this Agreement or by law or by a Combined Limited Partner Consent, against losses, damages or expenses for which such Person has not otherwise been reimbursed (including attorneys’ fees, judgments, fines and amounts paid in settlement) actually and reasonably incurred by such Person in connection with such action, suit or proceeding; provided, that such Person was not guilty of fraud, gross negligence, willful misconduct, a material violation of securities laws or a material breach of this Agreement or the Investment Advisory Agreement or, in the case of the General Partner or its Affiliates, any other breach of fiduciary duty with respect to such acts or omissions (it being understood that taking or omitting to take any action which the General Partner was expressly permitted (other than the general authority of the General Partner to operate the Partnership) or required to take or omit for its own account pursuant to this Agreement shall not be deemed a breach of fiduciary duty hereunder) and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful, or such liabilities did not arise solely out of a dispute between or among members of the General Partner, the Advisor or their Affiliates; provided further, that the Partnership shall not advance amounts for expenses incurred.in connection with any claim that is brought, directly or indirectly, by a majority in Interest of the Limited Partners; provided further, that any Person entitled to indemnification from the Partnership hereunder shall first seek recovery under any other indemnity or any insurance policies by which such Person is indemnified or covered (other than pursuant to the terms of the operating agreements bf the General Partner, the Advisor and their Affiliates), as the case may be, but only to the extent that the indemnitor with respect to such indemnity or the insurer with. respect to such insurance policy provides (or acknowledges its obligation to provide) such indemnity or coverage on a timely basis, as the’ case may be, and, if such Person is other than the General Partner, such Person shall obtain the written Consent of the General Partner and an L.P. Advisory Committee Consent prior to entering into any compromise or settlement which would result in an obligation of the Partnership to indemnify such Person; and provided further, that if liabilities arise out of the conduct of the business and affairs of the Partnership and any other Person for which the Person entitled to indemnification from the Partnership hereunder was then acting in a similar capacity, the amount of the indemnification provided by the Partnership shall be limited to the Partnership’s proportionate share thereof as determined in good faith by the General Partner in light of its fiduciary duties to the Partnership and the Limited Partners; provided further, that as between the Partnership and the Blackstone Affiliates investing with the Partnership pursuant to paragraph 5.3. l(d), such Blackstone Affiliates shall bear their proportionate share (based on invested capital) of the amount of any indemnification relating to an Investment otherwise to be borne by the Partnership.
Lol, thanks Fraud Guy. I didn’t cut and paste because I was afraid people would think I was BSing them.
I would strike the entire thing and start over. It just guarantees future litigation because it’s completely meaningless. Sadly, I think it’s sole purpose is to ensure future employment for guys like me to fight the other guy about what it really means, but meanwhile generating many, many billable hours.
I was told that a lawyer in the family office of Extremely Rich Person You Have Most Assuredly Heard Of was asked to look at the limited partnership agreement for a private equity deal. This attorney had done a lot of M&A work in his prior life, so he knew well that in contracts like this, every word counts (plus he would recognize some of the language, that horrible indemnification language is super-larded up version of the indemnification language from M&A advisory assignments. And BTW that relationship is utterly different than acting as a fiduciary, which these PE guys ought to be but they manage to waive that duty too).
He said it took two full days to read the agreement. His comment: “People actually sign them?”
That is very beautiful. If you set it to Gregorian chants, it can put you in a bit of a trance.
https://m.youtube.com/watch?v=s7GqDZiI7d4
Private equity is a high-risk investment of public pension funds struggling to meet their 7.5% bogeys. S&P just published their annual review of state pensions, subtitled “Weak Market Returns Will Contribute to Rise in Expense.” Huh, that don’t sound good.
Here’s S&P’s “bottom of the barrel” roster of worst-funded state pensions:
On page 14, S&P takes a broader view. They tally not only pension liability, but also add OPEB (Other Post Employment Benefits, a term you’ll be hearing a lot in Depression II) and state debt.
On this broad measure, the two most badly indebted states are NJ (with about $24,000 per capita of state liabilities) and Connecticut (with about $20,000 per capita of liabilities).
NJ and CT are the two richest states in the country. But they have fouled their own nest by running up debt and pension liabilities, even as they were hiking marginal income tax rates to unpleasant levels.
Unless NJ and CT erect walls around their borders, some of the
victimsresidents they were counting on to pay these astronomical sums are likely to flee the coop.Great post and great comments.
This makes me wonder–can anyone out there point to an example where PE investment in a portfolio company increased and genuinely improved what that company offered to the world–as separate and distinct from executive salaries at the portfolio company, and fees and generous salaries and expenses for the PE firm, and speculators on share price changes? (And not through crapification of what the portfolio company offers, but the opposite.)
IOW, is there ever any justification in the “real world” output for the “investment”/financialization offered by the PE sector? Is there any value add at all, ever, to the customers/ecosystems/communities/employees of the portfolio companies?
Are there wonderful examples out there somewhere that I have missed?
Or is it just greed motivating 99.999% of the PE sector, but with the consent of portfolio companies whose executives are either seduced by greed, or the willing to deceive themselves into believing that their potential PE investors are different and will benefit the portfolio company and not rip off the world?
Oh, there are many examples, not that I can dig any up readily. In fact, Eileen Applebaum and Rosemary Batt, in their scrupulously researched and bending over backwards to be fair book, Private Equity at Work, both laid out an extremely long lists of where private equity didn’t remotely live up to its hype and created a great deal of societal harm. Yet they also concluded that for transactions under $350 million dollars, there was good evidence that the PE firms added economic value to the companies they bought. The big reasons were that companies in that size range were promising but often in need of external assistance to continue their growth, as in they needed to have their operations professionalized (better IT and controls), needed to go from a regional market to a national market, or needed to fill specific skill/product gaps. Those companies were also generally not robust enough to take the large amounts of debt that bigger companies could shoulder, again limiting how much the PE firms could use debt and financial engineering to achieve their returns.
While in terms of # of transactions, there is a lot of activity below the $350 million threshold, a significant majority of investment $ is in the funds that target bigger deals.
What I remember best about the Blackstone Group is that when Bill Clinton was first running for the presidency in the early 1990s, they gave him free office space to solicit donations.