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.
I don’t understand how public pension funds rationalize signing up to private equity funds where the manager is explicitly allowed to compete against the fund.
The supposed returns. Public pension funds (and many big investors like defined benefit plans and endowment) hire consultants to tell them how to allocate assets among investment strategies (stocks, bonds, real estate, foreign equities, commodities, etc). Private equity has managed to get itself treated as an asset class. The basic rule of investing is you spread your investment across asset classes, and being in more asset classes is better (it does not increase returns but reduces risk). So public pension funds HAVE to be in private equity.
But it is worse than that. Based on the returns attributed to these funds, investors would put 100% in public equity if they could. I will be posting later on this issue, that no one calculates the returns for PE properly and they are overstated, particularly if you adjust for illiquidity.
On top of that, PE returns are basically leveraged equity returns. In fact, I guarantee someone could synthetically replicate PE returns using liquid market instruments at a lot lower fees than PE funds charge (when I was working with O’Connor in the early 1990s, they said they could replicate the returns of any mutual fund at much lower cost, but decided not to launch that as a product, being in the mutual fund business was too much hassle).
New York Life Fires Private-Equity Lending CEO
New York Life Insurance Co., the largest U.S. life insurer owned by policyholders, fired Trevor Clark, the chief executive officer of the Madison Capital Funding LLC unit, for violating policies tied to personal investments.
Hugh Wade, a co-founder of Madison Capital, was named acting CEO, the New York-based insurer said today in an e-mailed statement. New York Life also fired Christopher Williams, a senior managing director at the unit, the insurer said.
Clark and Williams had been suspended amid a probe into whether personal business activities violated company policies, a person familiar with the matter said last week. The men in 2001 helped found Chicago-based Madison Capital, which lends to private-equity firms, according to New York Life’s website.
… “I follow the old dictum: There’s never just one cockroach in the kitchen.” —Warren Buffett, The Washington Post; October 31, 2007 (through Google.com)
Let’s hope two of today’s stories — Blackstone and Rolling Jubilee — don’t turn out to be the same story: Self-dealing by insiders.
In documents which were released as part of the lawsuit investors brought against Bain, KKR, Blackstone, Carlyle and other private equity firms who collectively and cunningly colluded to avoid competing on various deals, Tony James of Blackstone wrote in a truly sweet and loving email to George Roberts at KKR “We would much rather work with you guys than against you guys…..Together we can be unstoppable but in opposition we can cost each other a lot of money.”
This is the “pervasive reality of private equity” as Yves so succinctly puts it, and “That’s the way, aha, aha I like it, aha, aha…..” as KC sings on behalf of the Private Equity Shadiness Band.
Both Blackstone and KKR in the US, have extensive capital market and hedge fund operations, in addition to their private equity outfits, but gorging on uncontrolled “American Pie” alone has only left them “masticaturbating” for more. So they’re “Stayin’ Alive” by betting on rising inflation, possessing as much global real estate as possible, borrowing as much as possible, for undoubtedly as long and hard as possible. Simply put, Private Equity are rapacious angels banking on a “Stairway to Heaven”, whilst the rest of us take the “Highway to Hell”……
In addition, the fact that Blackstone and KKR investments include the interconnected revolving doors of mining, engineering, defence, energy and pharmaceuticals, means that the depth of commitment to create real change ie. regulation and accountability in their industry, will severely remain under question. It is simply too easy when you are on top, to get rich jerking off other people’s money without delivering caviar-like outcomes to justify earnings.
Despite the present funding dry-patch in the US too, and a few smacks of the hand here and there, no serious butt-scratching for new funds has been necessary. Being “Hot Stuff”, Blackstone and KKR have simply sauntered off overseas to dine and woo new endowment funds, pension funds and sovereign wealth players. This has been their “Bridge Over Troubled Water” and indeed, they now exquisitely control significant unrestricted energy sources in drought-hit regions of the world ie. Africa, India and Asia.
This will ensure almighty-mother-of-profits for years, if not centuries to come, for both KKR and Blackstone. Yet, it starves the rest of us who will “Blame it on the Boogie” of greed, and struggle to “Imagine” what life would have been like without “Le Freak” of Private Equity because our Members of Congress forgot how to “Get Up (We feel like being) a Fighting Machine” for their citizens.
Just to add context, I believe that the general legal rule is that a corporate officer or director does not violate the duty of loyalty if the self-dealing transaction is fair to the corporation.
Depending on the relevant law, some kind of disclosure may be required to the directors of the corporation. But, even with disclosure, I gather the rules are very permissive with regard to disinterested directors ratifying the deal.
In short, I’m not sure the duty of loyalty does much if no one is asking questions.
Another posting you won’t find elsewhere….nice, and thanks.
What ever happened to Rule-of-law? I know it is a quaint term that has quite a bit of history, which I thought gave it some staying power, but we are seeing it applied only on a class basis with any teeth.
When is the public going to rise up against this class level fraud? I hope soon.
Great piece, looking forward to the next in the series.
Any future site redesign should spotlight your original work so it doesn’t get lost in the cross-postings.