SEC Official Describes Widespread Lawbreaking and Material Weakness in Controls in Private Equity Industry

Posted on by

At a private equity conference this week, Drew Bowden, a senior SEC official, told private equity fund managers and their investors in considerable detail about how the agency had found widespread stealing and other serious infractions in its audits of private equity firms.

In the years that I’ve been reading speeches from regulators, I’ve never seen anything remotely like Bowden’s talk. I’ve embedded it at the end of this post and strongly encourage you to read it in full.

Despite the at times disconcertingly polite tone, the SEC has now announced that more than 50 percent of private equity firms it has audited have engaged in serious infractions of securities laws. These abuses were detected thanks to to Dodd Frank. Private equity general partners had been unregulated until early 2012, when they were required to SEC regulation as investment advisers.

Bowden heads the SEC’s examinations unit, and his rap sheet was based on his two years of experience in auditing private equity firms. As bad as embezzlement and other sharp practices are, at least as troubling is the revelation that the limited partners have been derelict in their duties. They’ve agreed to terms in their relationship with the general partners to make it easy for the general partners to abuse the investors. The general partners can steal from their limited partners because the limited partners are asleep. The LPs have failed to negotiate for contractual protections when they have the most leverage, prior to investing, and they’ve been unwilling or unable to monitor their investments effectively once they’ve handed over their money. Note that the industry was warned about this possible outcome; it corresponds to the worst scenario, ” A Broken Industry,” in a 2011 paper by Harvard Business School professor Josh Lerner.

Bowden pointed out that private equity is unique among the investment advisers the SEC supervises. The general partners’ control of portfolio companies gives them access to their cash flows, which the GPs can divert into their own pockets in numerous ways. Naked Capitalism readers may recognize that this arrangement is similar to the position mortgage servicers are in: they control the relationship with the funds source, and they are also responsible for records-keeping and remitting money to investors. And as we’ve chronicled at considerable length, servicers have shown remarkable creativity in lining their wallets and investors have been unable to discipline them.

Bowden described some of the ways that general partners can filch:

[A] private equity adviser is faced with temptations and conflicts with which most other advisers do not contend. For example, the private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services … or to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company … or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment.

Translation: private equity provides uniquely lucrative temptations and opportunities to steal from investors. Yet, perversely, limited partners have blinded themselves to these risks. For over 30 years, their relationship has been been shrouded in secrecy, a “trust me” operation. As Bowden noted, “Lack of transparency and limited investor rights have been the norm in private equity for a very long time.” Even worse, limited partners defend the general partners’ obsession with secrecy and reflexively reject requests for information even when it isn’t confidential.

Needless to say, this overly cozy arrangement has proven to be a ripe breeding ground for illegal conduct. Again from Bowden:

By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.

He went on to describe some of the common fee skimming models. For example:

Some of the most common deficiencies we see in private equity in the area of fees and expenses occur in firm’s use of consultants, also known as “Operating Partners,” whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not independently afford.

Here’s how this scam works. PE firms raise funds by showing prospective investors a strong team of professionals who are going to find attractive companies to buy and manage them. The limited partnership agreement, which is the contract between the private equity firm and the investors, typically says that the private equity firm has to pay for the wages of people working on the fund’s behalf. However, unbeknownst to the investors because it was never disclosed, part of the PE firm “team”, usually the members that work with portfolio companies, are actually being paid as independent contractors. The private equity firm then bills most or all of these sham independent consultants to the portfolio companies with whom they interact.

In other words, the private equity general partners are trying to have it both ways: the operating team members are an integral part of the private equity firm “team” for marketing purposes, but when it comes to who pays their bills, they are mere independent contractors referred to the portfolio company by the private equity firm (as if the portfolio company is in any position to reject these “referrals”).

From an economic perspective, every dollar that comes out of a portfolio company this way is effectively stolen from the limited partner investors, since they would otherwise have the first claim on the portfolio companies’ cash flows. And of course, we are also assuming these “independent contractors” were doing useful work. Bowden described a related con as “Hiring related-party service providers, who deliver services of questionable value.”

Bowden cited other scams as well, for example:

[A]dvisers bill their funds separately for various back-office functions that have traditionally been included as a service provided in exchange for the management fee, including compliance, legal, and accounting — without proper disclosure that these costs are being shifted to investors.

It’s not clear whether the SEC yet understands the objective of all these maneuvers. Many PE firms try to achieve the goal of having the management fee, which investors believe is a charge for the service of making and overseeing the investments, actually be pure profit. That can be achieved only by shifting all of the expenses of firm operations onto funds they manage and portfolio companies.

Most troubling of all is that we have reports from industry insiders that Bowden failed to mention the most egregious forms of stealing, which may cost investors billions of dollars annually. As we understand it, the SEC is on to a couple of large-scale scams perpetrated by some of the biggest firms.

The SEC may be pulling its punches because it may be uncertain about what to do with the rot it has found. Side by side with the the unprecedented, detailed litany of numerous forms of lawbreaking and bad conduct, Bowden was also peculiarly deferential, which gave his speech a schizophrenic feel. For instance:

Some questioned why we would show our hand in this way, to which there’s a simple and sensible answer. We believe that most people in the industry are trying to do the right thing, to help their clients, to grow their business, and to provide for their owners and employees. We therefore believe that we can most effectively fulfill our mission to promote compliance by sharing as much information as we can with the industry, knowing that people will use it to measure their firms and to self-correct where necessary. Put another way, we are not engaged in a game of “gotcha.”

Please tell me how to square Bowden’s “most people in the industry are upstanding” patter with the discussion that follows of how more than 50% of the firms reviewed thus far are engaged in serious bad conduct.*

Woven into his litany of scams, of which we have provided only a starter list, Bowden also set forth how limited partner investors fail abysmally at protecting their own interests. He noted:

Investors may not be sufficiently staffed to provide significant oversight of managers. When they are, and even when they conduct rigorous due diligence up front, they often take a much more hands-off approach after they invest their money and funds are locked up. This is especially true when managers have completed their investment period and the investor does not plan to reinvest.

Investors’ best protection against getting scammed is via making sure their rights are protected contractually. However, Bowden reports that investors have been remiss: the contracts that govern these deals, the limited partnership agreements, are poorly drafted to achieve that end:

But we’ve seen limited partnership agreements lacking in certain key areas. Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies (as opposed to being borne by the adviser). This has created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors.

State legislators need to understand what is going on here. They have granted public pension funds and public endowments across the U.S. the exorbitant privilege of secrecy in private equity investing, even to the point of making these contracts virtually the only ones that are exempt from state-level Freedom of Information Act laws.

Now we learn from the SEC that these secret LPA contracts are often a joke in terms of protecting investor interests. Though taxpayers are on the hook for pension shortfalls, we are not allowed to see just how badly our interests have been served. The magnitude of negligence makes it clear that public investors in private equity can no longer be allowed to act in secrecy. State FOIA laws need to change.

*The obvious answer is that the “most people” includes all the working oars, who have little or no direct role in the questionable conduct. But as readers and the SEC should know, the people who count are the ones driving the bus, and it’s hard to see them as innocents.

SEC: Spreading Sunshine in Private Equity

Print Friendly, PDF & Email


  1. Ben Johannson

    I’ve lost track of the document, but I recall a paper from way back when which pointed out Ivy League graduates were disproportionately moving into tech during the late 1990’s until the dot com bust. Later I began noticing (at least it felt like it) that every other schmuck in investment banking was Ivy League, that was up until the Great Recession. Following 2008-2009 I got the sense that Ivy Leaguers were crowding into PE. I can’t confirm any of this (or rather I just don’t have the time); anyone else have observations? It occurred to me a couple of years ago that if this were true we might have a method of forecasting bubbles and pandemic fraud.

    This is not to say that graduates from elite universities are all creeps, only that many are following the (parental/elite) approved track for people of their social station in getting rich quick. In fact getting rich quick appears to be one of the primary reasons people compete to get their children into these institutions in the modern era.

    1. James Levy

      I told my own kids that if they really wanted a good education, they’d apply to Williams or Amherst or Grinnell or Oberlin (or for my daughter, Mount Holyoke). There they’d get continuous access in small classes to first rate professors. No TA crap or 200 student lectures (or, god help them, lectures teleconferenced in from points unknown). But they and their peers had other ideas.

      1. Larry

        I’m not sure how those colleges deter one from going to Wall St. or a PE firm. Williams and Amherst have a pretty robust track record of sending kids into those lines of work. And frankly, the whole idea that a liberal arts education will make you a thinking and good person is rubbish. Plenty of assholes get liberal arts educations that don’t change them into good people. They just make better small talk at cocktail parties.

    2. Ed

      There is a relationship, but it works the other way. This is not exactly common knowledge, but recent Ivy League graduations are close to unemployable anywhere except the high level bubble economy of whenever it is they graduate (investment banking, tech start ups, private equity, big law). They don’t get the contacts with local industries of their peers in state schools, not much in the way of practical skills -the Ivies still try to use the liberal arts model, and are considered to be overqualified to boot.

    3. Dan Kervick

      Yeah, Ivy Leaguers are smarter than the rest of us. They are always staying one step ahead in the race for new forms of parasitic fleecing.

  2. Moneta

    Some questioned why we would show our hand in this way, to which there’s a simple and sensible answer. We believe that most people in the industry are trying to do the right thing, to help their clients, to grow their business, and to provide for their owners and employees. We therefore believe that we can most effectively fulfill our mission to promote compliance by sharing as much information as we can with the industry, knowing that people will use it to measure their firms and to self-correct where necessary. Put another way, we are not engaged in a game of “gotcha.”
    We don’t have the guts to go after them so now that you know what is happening, you are fully responsible for your losses.

    1. James Levy

      What the FUCK is a regulator doing if NOT playing a game of “gotcha”!!! That’s like a cop showing up at a crime scene and saying “I’m not here to play arrest people.” Insane. Even when you want to give people credit for speaking the truth, you can’t, because this man obviously doesn’t have any will, balls, or real outrage, just a good brain and a nagging conscience. That’s not enough to earn my encomium. To know and not to act is just as unethical as committing the illegalities in the first place.

      1. monday1929

        As Bill Black pointed out recently, they are making blatantly self-incriminating statements now. They are so immersed in the criminogenic culture that they no longer realize they are not supposed to openly admit to their crimes and dereliction of duty.
        This was a perfect example.

        1. susan the other

          The SEC is the biggest racketeer of all. Above prosecution itself for all of its RICO criminality – an accessory with a job in the administration; an accomplice. An enabler. Derelict to the same extent as the DoJ. We do not need this “Securities and Exchange Commission” fiasco any longer. It’s just another convenient agency of both the government and Wall Street. Like the Fed, the OCC and et. al. They are the “General Partners” at the highest level.

      2. gordon

        It’s a grand tradition in the US. Didn’t J. Edgar Hoover deny the existance of the Mafia?

  3. Ishmael

    Having worked with PE at an owned company here is a little of my feedback.

    On one transaction they kept a junior staffer in my office night and day as I did the transaction. Actually it was three because two ended up in the hospital because of car crashes falling asleep driving home – I made it home every night. In the end I wrote out a $15 million dollar check to the PE firm for their assistance.

    Later when we were owned by another company and I refused to book a material unsupported entry that made the company hit its numbers I was showed the door. We do not need your services any more. Later the company was caught in massive fraud. PE control things. They should be held just as accountable as management for accounting fraud. That would cut out a lot of the accounting sheninagans.

    PE is the worse thing that happened to US business.

  4. allcoppedout

    This is effectively the normalisation of crime and massively widespread. We need to recognise this is a class problem and the vast majority of people who are involved with professional money are liable to it. As soon as “professionals” are involved money disappears at a vast rate. £280K in police, social work and lawyers over a problem family existing on £10K. £500K on management development to to firm run by the girlfriend. £250K in legal aid recovered by selling the family home. Millions untold in public enquries paid to lawyers for no result at all. Vast fees for useless advice on pensions and investments when we’d all be better off if it was done by the Post Office.rather than feeding non-existent alpha. Bank clerks selling you PPI by just popping it on your bill. University fees – I could realistically teach and service all subjects for 60 students paying £540,000 in fees – that’s half-a-million more than the standard teacher salary. Baumol’s cost disease?

    I’ve seen the mechanism in the PE stuff everywhere, from teeming and lading scams to crash for cash insurance. The only difference is suit quality. Once you know about transfer pricing it’s easy. Finger-in-the-dyke legislation won’t work. This is the widespread corruption of the educated class.

    1. Jay M

      “This is the widespread corruption of the educated class.”
      There has to be some competitive advantage for possessing the requisite sheepskin.

      1. allcoppedout

        Indeed. Doing some evaluation work at McSkimsy years ago I was surprised to find them dishing out the same gruel were served at the Fagin Business School and an extended version of my own Pick-pocketing 101.

    2. Lambert Strether

      Your comment:

      [T]his is a class problem and the vast majority of people who are involved with professional money are liable to it.

      dovetails neatly with what Yves wrote here:

      Naked Capitalism readers may recognize that this arrangement is similar to the position mortgage servicers are in: they control the relationship with the funds source, and they are also responsible for records-keeping and remitting money to investors.

      The professional classes are handling the records keeping, remittances, and no doubt doing scutwork on the relationships; Jane Jacobs thought that the collapse of self-regulation in the professional classes was one sign of the Dark Age Ahead. It’s almost like there’s a Looting Handbook being passed around, isn’t there?

      1. allcoppedout

        Thanks for that Lambert. Dick Hobbs has tried to show how crime has been normalised in a combination of de-industrialisation, financialisation and neo-liberalism (Lush Life). As I’ve mentioned before, I think we need to look at this from a lot of different perspectives, including the embedded racism (Ebagum – the hidden Mugabe jive is one). We see African corruption easily enough. Drive a truck from, say, Kigali to Mombasa and you pay $800 in bribes at a dozen toll booths (as own the Rhine in 1250) and may even lose the lot. The days you and I couldn’t play Bogarde and Wayne with a couple of shotguns – you have to hire in the crooked chain itself. Now what’s $800 against a $20,000 load compared with a £8000 administrative take on the £9000 a UK student pays to be taught? And though we could drive that truck to get empirical detail, how can we ‘drive’ the money trail of PE and lots more finance? We might be delayed two days on a train to Dar-es-Salam because the fat controller has spent the fuel money on his mistress. Yet in HE what about the VC driving a Bentley and giving his mistress a £55K job?

        If we weren’t so racist/classist we might see these crimes for what they are – almost the systems notion of applying what you know of an obvious system to one more currently opaque. If we revalued on productive capacity and human skills, I’d guess we’d find half of what we call money in the hands of suited thieves, but I also think this system prevents nearly all the investment we actually need. In my thick cop brain version of “opportunity cost” they have stolen the sensible world we could have had. Yves does a good job raising the secrecy issues, yet these crooks more or less operate in the open because we are ideologically blind to what they do. What scientist would calibrate her measuring equipment to “opaque”, as money is?

  5. Berial

    Why aren’t the investors protecting themselves better? If this practice is going on as much as they say wouldn’t that mean the investors KNOW this is happening to them?

    Are they in on the ‘crime’ somehow? Or are they simply willing to be fleeced a bit so others won’t look to hard at what THEY are doing? You don’t just let yourself be robbed unless it’s to cover for something (intimidation, extortion, etc.)

    1. susan the other

      There is a mindset behind the scam that perpetuates it. Investors believe that if they behave like good limited partners then they will be shielded if the shit hits the fan and they will not be held liable for any of the irresponsible (criminal) actions of the generals. But that’s how they get got. General partners know their weakness. Limited partners don’t want to be responsible for the crimes, they just want to make some level of return on them, and get away with it Scot free. And in addition, if limited partners get together and complain they not only become decision makers and therefore liable, they also lose their tax exempt status, right? This is not to excuse PE business plans and CEOs. They are inexcusable. It’s just a reality.

    2. Yves Smith Post author

      One issue that isn’t obvious unless you’ve had some contact with the industry is that everyone, and I mean everyone, who handles pension funds hires tons of advisors: pension fund consultantst to vet the various funds, and attorneys to review and negotiate the contracts.

      So one might ask, what were these gatekeepers and minders doing for their money? Why did they bless such private-equity-firm-favoring arrangements?

      You can blame the investors for being complacent and overly trusting once the deals were done. But there were a lot of enablers on the front end who did a lousy job and should also have their conduct reviewed.

      1. allcoppedout

        And then we hire more consultants to write 150 page reports on what went wrong. Hidden in copied textbook drivel will be a key line. The myriad of previous consultants didn’t examine the toxic assets/loan/order books because the guy selling them said everything was OK. No one gets sacked, goes to jail – and that’s another $8 million in fees where a police prosecution might have cost $4 million. And then hire another consultant to restructure – ker-ching!

  6. rich

    First They Killed
    The Accountants
    How Big Banks,
    Corporations & Government
    Made Themselves Unauditable
    This one is at least a 4* essay .. it doesn’t get to what we consider the source of the problem, but gives a great review of the evolution of a system where fraudulent behavior is not criminal .. excerpt from The Reckoning: Financial Accountability and the Rise and Fall of Nations by Jacob Soll .. highlights conflicts of interest in credit ratings agencies & auditing/consulting firms .. describes the blame games between the regulators, auditors & investment bankers leading up to the financial crisis & during the financial crisis on who/what/why caused the financial crisis .. emphasizes the politics which developed between these organizations to create an environment against transparency: “In spite of laws, regulations, and an active financial press, powerful forces are aligned against financial transparency. By the sheer complexity and scale of their operations, banks, corporations, and government bodies have rendered themselves unauditable. How many accountants would it take to truly audit Goldman Sachs? Ten thousand? Forty thousand? It might not even be possible. The fact is that government and the auditing companies cannot keep up with the tricks of banking. At the same time, it is unclear that governments can effectively audit themselves. The world financial system is threatened by disaster from bad municipal and government accounting, as countries like Greece and major cities like Detroit go bankrupt because of poor planning but also poor bookkeeping. There has been little outcry about bad government accounting by a public unfamiliar with the risks of long-term municipal and government obligations… there have been no reckonings on Wall Street or in government. And without one, there can be little incentive for true reform.”

  7. Mel

    “””Please tell me how to square Bowden’s “most people in the industry are upstanding” patter with the discussion that follows of how more than 50% of the firms reviewed thus far are engaged in serious bad conduct.*”””

    At that point it’s not arithmetic, it’s rhetoric. You catch more flies with honey than with vinegar. Bowden needs a quick way to appeal to the 48% or 49% of the audience who aren’t breaking the law with every deal they make. Not that he will certainly win them over, but at least he won’t lose them. And it’s a feel-good thing to suggest the majority is on your side.

    In re the limited contracts, passivity on the part of the people who hand over money, be they “customers” or “investors”, is a huge part of the game everywhere. Maybe it’s a Consumer thing. This got touched on in the late argument about shareholders as owners. Customers, if they don’t like a store, will (about 9/10) not try to change the store, they’ll just never come back. Institutional investors won’t typically try to reform a company, they’ll just sell out, take their loss or profit, and go find something they do like. _Liars’ Poker_ mentioned “thinking like traders” — don’t do anything complicated, just ditch a bad position and move on.
    Finance has simplified thinking drastically. Good number? Keep. Bad number? Flee.

    1. Yves Smith Post author

      I have to tell you, based on the input I am getting from insiders (and see Ishamel’s confirmation above), fee abuses are close to pervasive in the industry. Some firms are more egregious about it than others. This isn’t a case of “a significant minority are honest”. There is a lot of fleecing going on at the portfolio company level that the LPs can neither see nor police.


    I have been maintaining a blog outlining all kinds of scams that will hurt the public university system in future. This post (private equity scam) is one aspect, because it affects the pensions of professors. The other aspect is reckless increase student debt and the third one is ‘inverted pyramid’ pay structure of professors, with the economists and psychologists being at the top.

    Please spread the word around and thanks Yves for the excellent commentaries.

  9. Dryly 41

    During the 2012 GOP primary campaign Texas governor Rick Perry referred to Mitt Romney’s leveraged buyout “industry”, now euphemistically called “private equity”, as “vulture capitalism not venture capitalism”. At the time I thought Perry proved the adage that even a blind squirrel finds an acorn once in a while.

    I did not know, and, I doubt Perry knew just how corrupt these people really are.

  10. impermanence

    Anything that has to do with money, finance, and/or investing is a scam, by definition.

    Convert labor-value into its money-form [or worse] and let the fun and games ensue!

  11. The Dork of Cork

    People are forced to rob cheat & launder because money is scarce.
    Its as simple as that baby.

    Various types of pond life have their own breaking point but its there somewhere.
    The few rotten apples line is a sick inside joke.
    Fucking over the other guy for tokens is a integral structural part of the present control system.

    Go right to the top – if not don’t bother your pretty little tits about it.

  12. McWatt

    “Catch-22 says they can do anything we can’t stop them from doing.” Heller

  13. The Dork of Cork

    Yeah – for some reason this discussion reminds me of the best bit from Air America.(36.00 – 39.00)
    Yves Smith is the concerned AId worker.
    Drew Bowden is the concerned Senator.

    The senator got it right though………
    they are all working for the same team.

    Frankly Gentlemen I am concerned – seriously when we hear rumours of Americans lining their own pockets with dirty money then that jeopardizes Capitalism………

    I pledge to you sir we will find those Rotten Apples………
    NC is begining to crack me up.
    The Irony of the title coupled with this absurd American puritism is just too much for me stomach.

    1. allcoppedout

      There is a current of that Dork, though I tend to see it as not being able to put boots through the right doors and so end up in rather weak description.. One might talk of having a tapeworm, yet it feels like living in one rather than having one. We are living with no sense of real history, with your pissedoffness (and mine and god knows what suffering) “described” in aggregates of figures like ‘living on less than $1.50 a day’ – or in our cases ‘being malcontents’.

      Not one of the UKs 60 universities has moved to an obvious model of electronic delivery, ‘despite’ have groups of 10 – 50 wonderkind at the top to organise efficient, innovative businesses. The kids pay only £1 in £9 for ‘teaching’ that amounts to textbook peddling – and we don’t see this as massive white collar theft. And far too many see education changes as possible by changing universities – a lot of good for the 75% who can’t do academic stuff anyway!

      The other day, some cross posted stuff originated in the Sydney Morning Herald, on 75% of economists not being able to do an opportunity costs sum completely missed any consideration of what we remember about education anyway – ‘not much’ being the answer once good stuff behind the bike sheds or bullying fades. The ‘bad apples’ are a joke across our society. But how do we organise rather than slap each other about? Not that we don’t need the odd slap to keep us awake in the parasite’s glare.

Comments are closed.