In our last post on questionable practices in the private equity industry, we saw how Harvard, whose long-standing law firm Ropes & Gray also acts as lead law firm to Bain Capital, was unlikely to get tough-minded representation in negotiating Bain deals. But even worse, Harvard has managed to allow Ropes to invest in a preferred position relative to Harvard in certain (likely cherrypicked) Bain deals. If a sophisticated PE investor like Harvard with a 150 year relationship with its main law firm can’t rely on its counsel to watch its back, how can any investor hope to be able to protect himself when investing in private equity funds?
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. 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).
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 sent this post to Blackstone early last week for comment. Their head of public relations replied promptly with “we will get back to you” but has not made any response. We will publish their comment if and when they provide one.
This is the pervasive reality of private equity–there is nothing particularly unique about Tony James or Blackstone. PE firm executives can and do engage in related party transactions on a continuous basis with the companies owned by their investors, and there is nothing the investors have been able to do about it until now.