This is priceless. Naked Capitalism beat the Journal by nearly four years reporting a “new” story.
On top of that, the Journal isn’t terribly exercised about conflicts of interest involving executives with clear legal duties to investors engaged in what looks uncomfortably like self-dealing. This complacency stands in stark contrast to press hysteria about Ivanka Trump selling schamattes out of the White House.
From the opening paragraphs of an above-the-fold story on the front page of the Wall Street Journal today, Wall Street’s New Problem: When Fund Titans Invest on the Side:
In 2010, a firm called Swift River Investments LLC put money into a software company developed by private-equity giant Blackstone Group LP. Five years later, a company Blackstone co-owned acquired the software firm, at a price that gave Swift River a fat profit.
Blackstone’s back-and-forth involving Swift River wouldn’t be notable but for one thing: Swift River invests personal wealth for Blackstone’s president and chief operating officer, Hamilton “Tony” James. A brother of his runs it.
Wall Street billionaires, their fortunes built by investing other people’s money, increasingly are putting some of their own in sideline investment ventures, while continuing to operate their hedge funds or private-equity funds for clients…
In the Blackstone/Swift River matter, Blackstone said its transactions involving Mr. James’s family investment firm were cleared by Blackstone’s conflicts committee, and Mr. James wasn’t involved in the decisions. He declined to be interviewed.
This is far from a “new problem”. We wrote specifically about Blackstone’s Tony James and Swift River in 2013 in How Private Equity Executives Like Blackstone’s Tony James Engage in Dubious Side Deals, as an example of the more general problem of possible self dealing. From that post:
Today, we’ll examine conflicts of interest involving principals at the private equity firms themselves. Here our object lesson is private equity kingpin Blackstone Group.
Tony James is the chief operating officer of the Blackstone Group, overseeing the entire firm across its large range of asset management and investment banking services. James also runs the Blackstone private equity investment business, meaning he sets policy and is the final decision-maker on its day-to-day activities.
One would expect these dual roles at Blackstone to keep James busy and give him an adequate income. But he also has a side business that he owns with his two brothers, called Swift River Investments, a “family private equity firm”. In other words, James is a substantial principal in a business that could theoretically compete with Blackstone. And, while it is unlikely that Swift River has enough capital to bid against Blackstone for deals, it is nevertheless clear in one case that Swift River is deeply involved with Blackstone. Moreover, in other cases, there is considerable potential for conflicts of interest between Swift River and Blackstone and investors are powerless to police them.
These actual and potential conflicts are particularly troublesome from a corporate governance perspective, since as a corporate officer of Blackstone, James has a duty of loyalty to Blackstone…
Let’s look at the situation where we know that James put himself into a conflict of interest.
Blackstone developed a software application internally called iLevel Solutions. Blackstone spun it out and, lo and behold, it wound up in the hands of the James brothers through Swift River. Blackstone shareholders have every reason to be concerned about possible self-dealing here. After all, why does it make any sense to sell a corporate asset to a top executive and his family members? And how could the board ever be satisfied that the price of the transaction was fair?
But it’s not just Blackstone shareholders who have reason to be troubled by an arrangement that looks an awful lot like self-dealing. Blackstone’s private equity fund investors – institutions like the NYC pension system – have reason to be concerned about Swift River’s investment activities.
Of the 10 investments Swift River lists having made, five of them are privately-held oil field services companies (and the sixth is the iLevel related-party deal with Blackstone). So the James brothers like oil services companies. What’s the big deal?
Well, it turns out that Blackstone has recently gotten into the energy investment business in a big way. In August 31, 2012 SEC filing, Blackstone disclosed that it had raised $2,074,621,000 for a new fund called “Blackstone Energy Partners L.P.” A clear focus of this fund is investment in energy exploration companies, as shown in a Blackstone press release issued shortly after the fund’s closing, where Blackstone announced an investment in an offshore drilling company. Now, you can see where this is going. Tony James is buying oil exploration companies with his investors’ money, and he happens to own a bunch of companies personally that service exploration companies.
On the one hand, there is no evidence that James is using his Blackstone position to have the Blackstone Energy Partners companies do business with the companies he owns. On the other hand, his iLevel deal with Blackstone shows that neither James nor Blackstone appear to have any reluctance to engage in related party transactions. Moreover, independent of any oil services transactions between Blackstone and Swift River, there are other ways that James and his family benefit from the shared interests and may cross the line into “improper personal benefit”. All of the information that James gets in his formal day job, such as contract, industry intelligence, and deal flow, can also be used to help Swift River. In fact, it’s hard to see how James could stop that from happening even if he wanted to. How can he erect a Chinese wall in his brain?
What makes these dealings particularly troubling is that Blackstone’s fund investors are absolutely powerless to even begin to monitor any of these potential related party transactions or resource-sharing in order to ensure that they are not abusive. In fact, private equity LP investors almost always sign up to fund terms (in the super-secret limited partnership agreements that are the only state and local government contracts not subject to FOIA) where the investors agree to let the PE firm executives compete against the funds they manage. This is undoubtedly the case with Blackstone’s funds, which demonstrates just how dysfunctional the entire ecosystem of private equity actually is. And remember, the dominant LP investors in private equity are your state and local governments, the universities you attended that constantly hound you for donations, and the mutual insurance companies that you theoretically own as policy holders.
We also discussed the software company at issue, iLevel Solutions. This was the focus of that post:
We will see that this company is built from the ground up as a vehicle to convince PE investors and the SEC that Blackstone and other PE firms have implemented robust financial controls over the companies they own. The reality, however, is the opposite: by design, iLevel gives PE firms unprecedented ability to cook the books of their portfolio companies while maintaining a facade of compliance.
In passing, we discussed additional conflicts of interest that escaped the Journal’s attention:
iLevel has also been ingenious in its implementation of the “Wall Street Rule” – the idea that bad practices are most untouchable by regulators when they become industry standard. In that spirit, iLevel in late 2011 announced that the Carlyle Group had become a part owner of the company. This is presumably in addition to the continuing partial ownership of the Blackstone COO. Nominally, Carlyle and Blackstone are competitors, yet they teamed up on iLevel. Working together, they have been able to promote the product’s adoption among a large portion of large private equity firms, including Apollo, TPG, and Cerberus, and more than 30 other firms, in addition to Blackstone and Carlyle.
And finally, in a coup de grace of seediness, around the same time as the Carlyle deal, iLevel brought in another investor in the form of Hamilton Lane. This firm is the dominant “gatekeeper” performing due diligence and making recommendations to pension funds and other institutional investors on private equity funds. So, in its fiduciary role advising pension funds, Hamilton Lane sits in judgment of Blackstone and Carlyle. But on the side, Hamilton Lane is also in a deal with the Blackstone COO and Carlyle. Though this appears to be a material conflict of interest, it is worth noting that the conflict does not appear to be disclosed in the “Conflicts of Interest” section of Hamilton Lane’s Form ADV filed with the SEC.
The Journal’s new information is that a company Blackstone “co-owned,” presumably but not necessarily a portfolio company bought back ILevel from Swift River, in 2015, for $75 million. From the story:
Blackstone said in regulatory filings that it had talked to about 20 potential investors before selecting Swift River as one of the primary 2010 buyers. It said negotiations were led by an outside investor not linked to the James family.
If you think this “outside investor” was operating independently, I have a bridge I’d like to sell you. Anyone with an operating brain cell would understand which buyer was preferred and would know full well it was in their economic best interest to curry favor with Tony James.
The other conflict of interest that was disclosed in regulatory filings involved oil-field services companies, which we flagged in 2013 as problematic. Again from the Journal:
In the other potential conflict it cited in filings as linked to Swift River, a Blackstone business-development affiliate provided financing to an oilfield-services company in which Swift River indirectly owned a stake. Blackstone filings said Mr. James didn’t work on the financing for the oilfield company, Allied-Horizontal Wireline Services LLC.
The Journal does discuss other of private equity fund principals having their own private equity businesses on the side. Apollo founder Marc Rowan’s real estate venture is supposedly kosher by virtue of him being involved only in strategy and “intended to have different durations and risk-return profiles than those made by Apollo’s funds.” TPG Chairman Eric Bonderman has both his own side investment firm, Wildcat Capital Management, and is also an investor in company started by a former TPG employee, Dragoneer. One result of these incestuous relationships: “Mr. Bonderman invested in Spotify both through funds that TPG manages for clients and through Dragoneer.” Fortress has “handful of employees work solely on the personal financial matters of co-founders, who reimburse Fortress.” That almost certainly means they get lots of free intelligence. Query also whether full overheads, like office space and the cost of admin support, are being allocated pro-rata to these staffers.
Despite Fortress’ bromides about employees being forbidden to get into conflict of interest with clients along with supposed further oversight of top people, the Journal discusses at length a “tangled situation” involving a donation pledge by a Fortress entity to Milwaukee just the Milwaukee Bucks were seeing funding from the city to help fund a new arena. The wee ethical and optical problem? Fortress Fortress co-founder and co-chairman Wesley Edens was also a co-owner of the Bucks.
Here are some additional shortcomings with this story:
Failure to discuss why these conflicts of interest are serious and troubling. The title of this story in the print edition is anodyne: “Fund Kings Open ‘Family Offices’”. The message of the entire piece is: “These firms had to reveal they have these cozy arrangements. But they all swear they have robust internal procedures, so this must be OK.” Notice the failure to get a reading from an independent expert or even to consult corporate governance standards, as we did in 2013:
From the American Bar Association (emphasis ours):
Generally, officers owe the same fiduciary duties as directors….Officers with greater knowledge and involvement may be subject to higher standard of scrutiny and liability…
Under state corporate law, directors of solvent corporations have two basic “fiduciary” duties, the duty of care and the duty of loyalty. The duty of care, which is governed by statute in most states, usually requires that directors discharge their duties in good faith and with the care that an ordinarily prudent person in a like position would exercise under similar circumstances and in a manner the director reasonably believes to be in the best interests of the corporation. See, e.g., Or. Rev. Stat. § 60.357 (1). In some states, including Delaware, the standard of care, though essentially the same, is established by judicial decision. See, e.g., Graham v. Allis-Chalmers Mfg. Co., 188 A.2d 125, 130 (Del. 1963). The duty of loyalty requires that directors act on behalf of the corporation and its shareholders and refrain from self- dealing, usurpation of corporate opportunity and any acts that would permit them to receive an improper personal benefit or injure their constituencies. See, e.g., Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939).
Failure to consider whether investor disclosure was inadequate. As we indicated in 2013, limited partnership agreements have broad language waiving conflicts of interest which legitimates the mind-boggling notion of fund managers competing with their own investors. However, the SEC, which now oversees private equity firms as investment managers thanks to Dodd Frank, has taken a dim view of marketing materials that are misleading, irrespective of what the fine print in the contracts actually says. So it’s not inconceivable, given that some vintage 2006 and 2007 funds are still in business, that some fund managers may have made airy assurances that are at odds with their current behavior.
And on a common-sense basis, any limited partner ought to be upset at the idea of a personal wealth management business of private equity principals getting anywhere near their investments, given how private equity firms have been caught cheating investors in just about every creative way imaginable.
Put it another way: if the general partners were even semi-serious about making sure everything looked kosher, they’d review these insider deals with the limited partner advisory committees of the appropriate funds. As we’ve discussed, the limited partner advisory committees are captured; the members are chosen so that the general partner has a large majority of friendly investors who would never cross them. But the one thing the minority of non-captured advisory committee members can do is vote with their feet on the next fundraising. But that is clearly more than the private equity kingpins are willing to hazard.
Failure to mention that some, perhaps most, of these disclosures came about thanks to Dodd Frank, which Trump is threatening to kill. All private equity fund managers over a not-large size are required to file an annual disclosure form ADV with the SEC. Many firms have revealed in these documents that they are engaged in practices that alert parties can ascertain are not permitted by their contracts with investors. Yet even this weak protection is likely to be scotched if Trump and House Financial Services Committee Chairman Jeb Hensarling get their way.
The Wall Street Journal exemplifies why limited partners are complacent in the face of private equity self-dealing and embezzlement. The reporters dug up some troubling material, called up the private equity firms for comment, and took their reassurances at face value. This is Potemkin journalism masquerading as the real deal. The rapid rise of a plutocracy means we need the Fourth Estate to help curb its power. Unfortunately, for the most part, vigorous journalism has become a relic.