Memo to Eliot Spitzer: Private Equity Firms are Scamming New York City

Eliot Spitzer, now the top contender to be the next New York City Comptroller, has said he wants to use the office to pursue financial reform. He has a ready, obvious, and comparatively easy target: the private equity industry.

There is clear evidence that private equity (PE) firms have been scamming their investors for decades. Most of these investors are public pension funds, like the funds invested by New York City on behalf of its employees. These PE investors have been largely clueless as to how their money is being stolen. When they have sensed that something is wrong, they’ve taken a collegial approach, relying on exhortation and negotiation. Not surprisingly, the “let’s handle this among friends” strategy has not been effective.

Despite being stymied and despite ample evidence of large scale abuses, public pension PE investors have been reluctant to use their bully pulpits, band together effectively, or take PE firms to court. This broken status quo is a great opportunity for what Spitzer does best, which is to use both the law and the media to tackle powerful, predatory interests. This is one big reason why his candidacy has evoked horror and aggressive attacks from the financial elite.

Let’s start by examining the relationship between private equity firms and the New York City Comptroller.

The New York City employee pension system is one of the largest private equity investors in the U.S., with $8.3 billion invested in this strategy. Though a board of trustees is technically the fiduciary for each of the City pension funds, and the Comptroller has only one seat on each of those boards, in reality, the City Comptroller is, to an extreme degree, first among equals on all of the boards. The reason for his disproportionate influence is that all of the City pension funds are managed day-to-day by a combined staff, and those staff members are all employees of the New York City Comptroller, making him effectively their boss.

Moreover, the super-secret contracts that the NYC pension funds enter into with PE firms are held at the Comptroller’s office, as are the super-secret cash flows showing what the pension funds contributed to the funds and what they got paid out in return. It’s impossible to overstate the importance of the Comptroller’s access to PE fund contracts (known as limited partnership agreements or LPAs) and cash flows. PE firms accomplish much of their investor scamming via fees that are contrary to LPA terms and that they take from portfolio companies owned by the funds they manage. The PE firms also scam by charging the funds they manage for expenses that the LPA says should be paid by the PE firm itself.

I’ve seen a tiny bit of this first hand through my work as a hired gun to PE firms. One of the things that PE firms do is manage portfolio companies. While a small subset of PE firm do have their staff roll up their sleeves and play a meaningful operating role, for the overwhelming majority, their oversight consists largely of financial engineering, possibly changing some of the executives of the portfolio business, and pushing like crazy for cost cutting.

The PE firm babysitting typically includes periodic meetings with the top employees of the portfolio company, in which the PE staffers harass the portfolio company management over their progress towards targets the PE firm has set. I’ve seen the actual and projected monthly financial statements used as part of this exercise. They clearly included as a separate line item a management fee paid to the PE firm. This was over and above the “management fee” paid by investors.* Yet most investors would assume that fund-wide management fee would cover the supervision of the portfolio companies. My understanding is that this second level of fee skimming is not disclosed to the investors in the PE fund.

And this isn’t the only type of double-dipping that has taken place. In the 1990s, following the practice of then industry leader KKR, it was common for large PE funds to charge “transaction fees” for buying and selling companies, again over and above their management fees, even though they often hired an investment bank, which charged its own fees, to do the work. This was such an egregious abuse that even the normally complacent investors eventually roused themselves to push back.**

The sad truth is nobody who invests in PE looks closely at whether PE firms are complying with the fee and expense provisions of their agreements. Part of the reason is that the PE firm lawyers draft the terms in these LPAs to be almost incomprehensible. Another reason is, astonishingly, that PE investors have accepted the argument of PE firms that these contract provisions are a form of “trade secret.” Public pension fund investors have almost universally acceded to the demands of PE firms to exempt the LPAs and cash flow reports from state FOIA laws, which keeps the eyes of the press and the public off the documents.

This information lockdown prevents a worst-case scenario for scamming PE firms, that a mid-level accounting employee at a portfolio company would use public documents to compare the payments made to fund investors with what was taken from the portfolio company where the accountant works. State qui tam laws, which are designed to prevent precisely this type of abuse by awarding a portion of the government’s recovery to people who uncover fraud, would provide a powerful incentive for employees at portfolio companies to rat out their PE overlords. But that’s not going to happen as long as public pension fund PE investors keep the contracts and cash flows behind the FOIA wall. However, the New York City Comptroller has access to this critical information. Hence the freakout at the prospect that Spitzer might get the job.

How do we know that private equity firms are stealing from their investors? It turns out that the SEC has been surprisingly vocal, though unspecific, in recent public statements about the fraud it is finding in private equity. Historically, the SEC had basically no nexus with the private equity industry, as virtually no PE firms in the past were “registered investment advisers”. That meant that PE firms were not subject to SEC supervision or the regular compliance audits that all registered investment advisers undergo. However, Dodd Frank changed the law that allowed PE firms to avoid registration. Virtually all institutional PE firms were required to become registered investment advisers by early 2012, making them subject to regular SEC audits (known as examinations).

Within months of the SEC corralling the private equity industry into its registered investment adviser program and initiating examinations, SEC Commissioner Elisse Walter spoke on a conference panel about early findings of these examinations. For instance, the law firm Ropes & Gray dutifully reported the SEC’s emerging awareness of PE fraud to its clients:

…SEC Commissioner Elisse Walter indicated that the SEC, in proceeding with its “presence examinations” of newly registered private fund advisers, has already noted many instances of poor controls, often regarding fees and expenses. Commissioner Walter elaborated that the staff has noted instances where advisers miscalculate fees, improperly collect fees and inappropriately use fund assets to cover their own expenses. Commissioner Walter noted that SEC staff will continue to examine and question advisers income and fees.

Note that, according to Ropes & Gray, Commissioner Walter described these impermissible fee practices by PE firms as “poor controls,” rather than fraud or theft.  It will be key for the next NYC Comptroller – as well as the interested public – to hold the SEC’s feet to the fire, so that the Commission doesn’t give PE firms a pass based on a “we didn’t mean to steal” defense.

Shortly after the Walter panel discussion, Bruce Karpati Chief, SEC Enforcement Division’s Asset Management Unit, gave a speech where he further outlined findings of the new SEC examinations of private equity. Like Walter, he noted finding instances of illegal shifting of fees to investor funds and the charging of dubious fees to portfolio companies.

These petty frauds by PE firms should be low-hanging fruit for Spitzer. The critical questions he needs to ask all of the PE firms doing business with the city’s pension funds are:

1. What is everything of value you receive, either directly or indirectly, from the portfolio companies owned by the funds you manage?

2. What are all the charges you have imposed on the funds in which New York City pension funds are an investor?

Once he has the answer to these questions, Spitzer should compare the fees with the language of fund LPAs and figure out which ones are impermissible. PE firms will stonewall on the first question, claiming that they already disclose to investors all the fees that they are required to share with investors. Don’t get caught in this logical trap. It’s the fees that the PE firms don’t share with investors that they don’t disclose. If the PE firms drag their feet, Spitzer should not hesitate to wield the Comptroller’s subpoena powers.

* Almost all funds provide for the right of the general partner to receive a management fee. While the media commonly describes the fees as “two and twenty” meaning a 2% annual fee and 20% of the profits (as defined), the 2% is the “rack rate” for management fees, meaning it’s the starting point for negotiations. Funds of less than around $500 million, particularly venture capital, can negotiate for and may obtain a higher fee.

Funds larger than $2 billion face enormous investor pressure to charge less than 2%. SEC filings for some of the biggest public funds indicate management fee levels in the neighborhood of 1.25%. Typically, the general partner does not get that level of management fees for the full life of the fund. Instead, the GP gets that rate for the duration of a fund’s “investment period”, the time during which the fund is expected to acquire a portfolio of investments.

Once the investment period ends, the management fee steps down. Using a 2006 KKR fund as an example, that rate through the tenth anniversary of the fund’s life is 0.75%. Unlike during the investment period, that percentage is applied only to the capital still invested in the fund, as opposed to the original fund size.

** We may return to this bit of history in later posts, since it’s revealing and the remedy was not straightforward. Suffice it to say that the resulting contractual provisions were drafted by attorneys for the private equity firms, and are sufficiently vague that skeptical insiders are not convinced they are as effective as most fund investors would like to believe.

Print Friendly, PDF & Email


  1. biskit88

    With all his first-hand knowledge of Wall Street, why is the mayor allowing this to happen?

      1. nonclassical

        hmmmnnnn….someone needs to view “Client 9″…Spitzer does not appear to be “on the scam”…though his girlfriends have him on “scam”…(as do repubLIEcon apparatchiks)..

  2. Jim Haygood

    ‘Public pension fund investors have almost universally acceded to the demands of PE firms to exempt the LPAs and cash flow reports from state FOIA laws, which keeps the eyes of the press and the public off the documents.’

    Secret FISA courts to authorize NSA spying; secret FBI national security letters which can’t be disclosed; secret private equity LPAs for public pension funds.

    The zeitgeist trickles down from the top.

  3. chris

    I’m not clear on the criminality you are alleging — firms charge a management fee (2% but usually less), and then also charge a variety of other fees like ‘transaction fees’, ‘monitoring fees’, ‘director fees’. These fees have been under pressure from LPs, and one thing firms do is use some percentage of those three fee streams to offset LPs’ management fee. The fee offset has steadily increased from 65% to frequently 100% these days.

    Is that what you’re referring to, or something else?

    One thing that has come up recently, and will likely continue to be an issue — is fund expenses. These aren’t fees at all, but expenses that LPs would likely never see unless they looked hard at financial statements. Firms have in the past gotten away with shoving all kinds of spending under fund expenses — including at times outsourcing due diligence on transactions, which is ironic being that GPs are supposed to have the best eye for the best deal.

    Separately — Spitzer may not be the best man for the job you propose … under his watch, private equity and public pensions in NY lived very comfortably in a pay-for-play system that gave political fixers huge profits for pressuring GPs to pay phony fixer fees in exchange for pension capital. That system didn’t get revealed and prosecuted until Cuomo.

    1. Fred

      I think that the impermissible fees that the SEC is referring to are things like bogus consulting fees that PE firms charge for their own services, over and above monitoring fees. The only limit on the types of fees that a PE firm can charge a portfolio company is the imagination of the GPs. You could charge a portfolio company “referral fees” for introducing them to prospective customers. You could charge them “recruiting fees” for placing an executive at a portfolio company. As I understand the business, having been around it off and on for decades, the LPs generally get no comprehensive disclosure of every fee that GPs take from portfolio companies. I think they do get disclosure of the “main fees” (i.e., monitoring and transaction fees) charged to portfolio companies, but everything else tends to be hidden.

      1. chris

        Guess I would need to see a hard example … the SEC has made such statements for several years now, starting back in 2010 or so when the agency formed its private equity/hedge fund investigative unit. However, no really meaningful action has come out of that team that has impacted a big name, or even relatively well-known name, in private equity. The one exception is the Oppenheimer PE funds that got slapped for inflating their performance in a prior fund to LPs while trying to raise a new fund.

        Other than that, enforcement action to date has involved small, mostly illegitimate firms that don’t generally include institutional investors.

        What hasn’t happened yet is the SEC coming down on a well known, big name firm for something like this. Not saying it doesn’t happen, but SEC has been all talk up to now. I’m not convinced the majority of PE firms have been doing anything outright illegal, even if the fees seem excessive, because surely it would have been discovered by now by one of these massive institutional investors sophisticated enough to sniff it out — or by the SEC, which has been looking for a few years.

        And firms are under more scrutiny than ever these days by LPs (and their attorneys) since the financial crisis. Everything is under spotlight, fees, fund size, deals, track record, etc. Firms live in a hyper-scrutinized environment these days and it’s hard to believe the entire universe of PE LPs would be missing outright criminality.

    2. Yves Smith Post author

      Please re-read the post.

      1. The funds are charging fees (as you call them, “expenses”) at the company level that are not permissible.

      2. The SEC is saying via its “poor controls” language that the funds are taking out amounts that don’t reconcile. Do you think for a nanosecond that they’d take out LESS than what they are entitled to?

      The post states that the LPs don’t check actual fee disbursements to the GPs v. what the contracts allow and that this is being abused. I separately have senior insider accounts to that effect. Unfortunately given the trade secret prohibition, they are providing this to me on a background basis. Rest assured it includes cases where the conduct is clearly “impermisisble” as in illegal.

      And to your later comment, the LPs are most assuredly complicit. The very fact that they’ve gotten laws in pretty much every state to exempt the contracts (unlike every other agreement save ones related to national security matters) from FOIA tells you how much the LPs meekly accede to GP dictates. You can see this on other fronts too: the failure to insist on fee structures that reward fund managers only if they deliver on their promised returns (hundreds of basis points over equity indexes) and the lame way they deal with clawbacks (agreeing when the GP suggests it be rolled into the next fund, and then only the amount owed AFTER deducting the GPs taxes. Why is the GP’s tax problem the LP’s problem? If the GPs are worried about taxes, they could adopt fee structures that don’t create this problem, like a European-style waterfall. GPs don’t offer this and for the most part, LPs don’t push

      1. chris

        Actually, the Euro-style waterfall is a big issue these days, with more LPs pushing for it and many GPs (not all) complying.

        Issue with Euro waterfall is that the large majority of PE houses — those that are ‘small’, with two or three funds, will have to keep fee revenue high if they move their carry to the back-end, in order to keep funding salaries and retaining talent. Something has to give. That is the case for smaller or even mid-size funds that have not yet amassed wealth through fees; totally not the case for the larger funds.

        I agree Euro waterfall should be the standard, and perhaps it will be, but as always, as long as an LP’s overall private equity portfolio is driving return and generating the kind of yield they can not get from other asset classes, they will keep investing in the space — even when that means tolerating seemingly anachronistic terms and conditions.

        I have seen a few big name LPs take themselves out of the game because of this intransigence on the part of the industry to better align interests with investors. But again, with the ever-growing need to meet obligations in defined benefit structures (PE’s current biggest funder, US state retirement systems), most institutions are going to keep private equity a core part of their investment programs, and in fact, probably continue to increase exposure.

        1. Yves Smith Post author

          There has been tug of war that has gone on over terms for some time and we did indicate that LPs negotiate fees. I am told there has been some movement towards the LPs on these and other issues since the financial crisis. But even a pretty recent report ( paints a different picture than the one you suggest, that of widespread investor complacency on numerous issues important to their interest.

          As for the European waterfall issue, to the extent it’s happening, I’m told it’s not at the big funds, so on a dollar-weighted basis, this is still not a significant phenomenon (and Kauffman beefs about it, which says as of a year ago it was not much if at all used in the VC space, where smaller funds are the norm). So I’m not sure this is as prevalent as you imply. And this is after decades of this being an issue that was begging to be addressed.

          What you don’t seem to appreciate that the fight (to the extent there is a fight) over a set list of terms and conditions That terrain is defined by terms used by GPs . There’s a whole set of issues that falls out side this terrain goes under the radar.

          As for the return issue, that’s the basis for the LPs not pushing all that hard when they do push, the perception that the PE guys are essential because they can produce returns the investors can’t get elsewhere. And we’re going to address that shortly. The basis for LPs calculating returns is fundamentally flawed and systematically exaggerates the return levels you’d report if you were to calculate returns after all the payments from a specific fund (as in Bain IX) were calculated after the fund was terminated. The LPs have an incentive not to think too hard about this bad established practice because in the overwhelming majority of cases, their paychecks are based on this computation of fund performance.

          Also, I’m not alleging criminality, so your starting point for this entire thread is a straw man.

          1. Capo Regime

            As a young un interned in the New York City Comptrollers Office. Sadly, not much has been done with the great powers of the office. After Golden there was great hopes after the election of Liz Holtzman a 4 term member of contgress (went after nixon) and a zealous Brooklyn DA. What did she do? Pursue Crakcer Barre for alleged anti gay practices and liabiliy for gun manufacturers–very innovative but not much else. Alan Hevesi who followed was a disaster. Point the institutional apparatus is such that Spitzer will not be able to do anything–Mayors Office, the Office of Finance and Council and even Unions will stymie Spitzer every step of the way.

            Also, there are issues with the “new” city charter with respect to the comptroller–yes improvement over the old board of estimate days but the powers you cite have never been tested….

            1. Ed

              I’m curious about how Bill Thompson handled the job. Its hard as a voter to find out much about his tenure, and he is running a campaign for Mayor that is stronger than it looks (mainly because all the other candidates have major problems).

    3. nonclassical carefully what Yves is disclosing-there are intentional “transfers” of portions of funds, on yearly basis, from one “investment” to another, and even back to original…at each “transfer” of funds, a fee is imposed…a fee created by
      said “investment transfer”…which private equity managers create to impose fee…and not just for themselves-for “investment banker” intermediaries…

  4. polistra

    Excellent article. I’d been wondering why Spitzer wants to be Comptroller, and why the Street doesn’t want him. I didn’t realize Comptroller was such an important office in NYC. The name usually means an auditor who checks for math errors and improper expense accounts, which isn’t a powerful position.

  5. readerOfTeaLeaves

    Nicholas Shaxson had a post over at his Treasure Islands blog that is highly relevant to this post, and has some excellent links as well:

    The hedge fund and PE worlds appear to thrive on secrecy, i.e. bamboozelment:

    The sad truth is nobody who invests in PE looks closely at whether PE firms are complying with the fee and expense provisions of their agreements. Part of the reason is that the PE firm lawyers draft the terms in these LPAs to be almost incomprehensible. Another reason is, astonishingly, that PE investors have accepted the argument of PE firms that these contract provisions are a form of “trade secret.”

    It looks as if the veil is beginning to be lifted, and those of us outside the High Church of Finance are notably unimpressed with the bogus claims of PE.

    Spitzer is a sign of the times.
    More, please.

  6. allcoppedout

    I don’t think they will remove the ‘we didn’t think we were stealing’ pass. I have never seen a credible set of evidence for ‘financial alpha’ and the tales we hear from the likes of Warren Buffet are almost my first in finance 101 and cannot be the answer. Fees are broadly criminal at point of sale as the promise at this point is so much money will be made you’ll only be paying from profits (Ho ho ho – but people are swayed to this in the pitch). Our courts are not used to proper statistical evidence (some of the mistakes being made on DNA are horrifying) and one has to wonder how any PE/Hedge is not committing fraud in a pitch claiming to outperform the relevant market given statistical evidence on how they perform. If not suckered by this pitch, it’s hard to see any non-corrupt reasons for a municipality or pension fund to be in play with these jokers anyway when average alpha is negative (if you can’t pick the stocks why think you can pull positive alpha from the hat)?

    I sense a stronger smell than routine over-charging allowed by municipal executives meek and dumb in the presence of financial genius and slick lawyers. I’d expect kickbacks for the meek and dumb.

  7. Dikaios Logos

    Yves, this is a such a great post–really the kind of stuff I only find at NC. And I appreciate your using the title to get the attention of those in a position to influence LPs’ attitudes going forward.

    I have long thought PE was full of very focused kleptomaniacs. The lawyer who helped put together the ‘legendary’ 1981 purchase of Gibson Greetings from RCA, Frank Pearl, was found in death to be playing just about everyone, including his creditors and his own PE firm, for a fool. A recent WaPo story details the last chapter from this manipulator:–of-mystery/2013/07/19/5719a108-ef30-11e2-bed3-b9b6fe264871_story.html

      1. Dikaios Logos

        I really want to believe that hilarity was intentional. unfortunately with big journalism being what it is I think it was accidental! Since the people he seems to have defrauded and embarrassed were rich and powerful, as with Madoff, big journalism managed to care. Otherwise this would have gotten minimal ink.

  8. rob

    So will the “debt counted as expense” allowed by the tax code ,which reduces the tax burden to these companies( who don’t do much of anything without incurring debt for the companies they exert leverage over); be abolished? Right now the tax payers are subsidizing the Private equity industry, by allowing these exemptions which seem to make their entire business model work. Without these debt write offs, their entire business model seems like it would have to revert back to the days of yore, when PE firms were actually using their own money. Which might bring rationality back from the dead.

    After the point they stop getting these taxpayer subsidies to fund their growth expectations; THEN, they can try and get these public monies fund managers to get on board. If they are only using their actual effectiveness as an enticement for people to invest with them, then I suspect they will wither and die. As they should.
    Then we won’t have to worry about what fees they are charging. They won’t have the clout to keep basic,fair rules from applying to them.

  9. observer123

    There are several other issues with PE funds, that are still within the current interpretation of regulation, and yet impact investors in a way that should be regulated completely differently.
    A few one can mention here are:
    1. Super trench fees – some of the largest well-known funds have customary fees everybody is aware of, and then enjoy extremely high untaxed capital gains under some circumstances. Digging deeper there would reveal how the industry truly operates and who benefits above and beyond what most people would find acceptable.
    2. End of life – as many(!) funds approach their maturity with no exists, yet to what extent are funds regulated to improve transparency or act in the interest of the investors? Who is watching secondary markets as liquidation takes place? Mass liquidation may be a long and painful process for some more than others, with the funds having a strong hand at negotiating the terms for the next 7-12 years…
    3. Valuation – illiquid assets are valued with a clear bias, often keeping failed investments on the books for many months/years under different pretense.
    – One could go on, but which politician (regulator?) would assume the daunting task?

Comments are closed.