Over the next two weeks, we’ll be posting on some of the things that the public can discern now that we’ve called to their attention that 12 super-secret private equity limited partnership agreements were unwittingly made public (see here for more of our recent coverage).
While we plan to go over many of the intriguing details of these contracts, it’s actually more revealing to start by looking at what is not in them. We’ve flagged the fact that in a recent speech, Drew Bowden of the SEC went out of his way to point out that the limited partnership agreements in many respects do a poor job of protecting investor interests by being vague or even silent on critical points. Now that we can look at these limited partnership agreements, there are so many of these lapses that rather than try to cover all of them in one post, we’ll review a particularly significant one today and continue with others tomorrow.
What You Don’t Find in Private Equity Limited Partnership Agreements
Here are some of the surprising missing elements:
Portfolio company accounting and reporting. Limited partners have no right to see the accounts of the companies that they own. That matter because, among other reasons, control of the portfolio companies’ checkbooks is a great opportunity for grifting by the general partners. As Drew Bowden put it:
[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.
But if you can’t see what is going on, you are hardly in a position to seek recourse. If you read the sections of the limited partnership agreements that set forth the reporting and accounting obligations of the general partners, you’ll see that effective oversight by the limited partners is made well-nigh impossible. The industry has long argued that venture capital companies are too fragile to take that kind of disclosure, when that position is dubious (after all, the industry managed to keep limited partnership agreements confidential for decades). But even if you could take this notion at face value, only about 15% of industry assets are in venture capital investments. Private equity firms have never made a credible case as far are more mature companies are concerned, yet investors have accepted this general-partner-serving lack of disclosure.
For instance, there is a reasonable list of record-keeping obligations as far as the general partnership itself is concerned. But limited partners can get access to those records by visiting the location where they are kept, and then on 5 or 10 days written notice. In other words, they don’t have the right to ask the general partner to provide selected information out of the books and records. Admittedly, partner would presumably want that only an an exception basis. But still…
The general partners typically provide certain information at the partnership level annually, like income statements, balance sheets, changes in capital and financial position, information needed for tax filings, and valuations of portfolio companies, which are prepared by the general partner. The information for the intervening quarters consists of items like unaudited reports of the balance in each partner’s capital account and updated balance sheets and income statements for the partnership. Mind you, only some of the funds stipulate that these reports be prepared by outside auditors.
The general partner also provides various reports within 120 days of fiscal year end (a balance sheet, a narrative account that includes significant developments for the partnership and portfolio companies, an audited report, and K-1s, as well as unaudited quarterly statements with a discussion of important events at the partnership and portfolio company level, and a quarterly capital account summary. Note, however, there is some variation in terms across these funds. For instance, Silverpeak Legacy Limited Partners II and III allow the limited partners to discuss “the affairs, finances and accounts of the Partnership” with its independent public accountants.
Some agreements do provide for disclosure of transactions that aren’t kosher. For instance, the Milestone Partners IV agreement requires that the quarterly capital account summary include
a summary of any transactions not contemplated by this Agreement between the Partnership and the General Partner or any of its Affiliates during the applicable quarter
But this affirmative obligation exists at the partnership level only. If you try finding what the Milestone Partners agreement provides for at the portfolio company level, you come up empty-handed. In fact, if you examine the section regarding records and information to be provided to the limited partners, in all but one, you won’t find any requirement to provide financial information of the portfolio companies themselves (admittedly, two are credit funds, so the relevant universe is ten funds). The lone exception is Incline Equity Partners III, which allows for:
11.3. Reports. The General Partner shall furnish the Limited Partners:
(a) within 45 days (subject to reasonable delays in the event of the late receipt of any necessary financial statements from any Portfolio Company) after the end of each of the first three Fiscal Quarters of each Fiscal Year, (i) unaudited summary financial and descriptive investment information for each Portfolio Company….
(b) within 120 (subject to reasonable delays in the event of the late receipt of any necessary financial statements from any Portfolio Company) days after the end of each Fiscal Year…(ii) an annual review providing annual financial information and descriptive investment information for each Portfolio Company (to the extent reasonably practical, based on audited financial statements for such Portfolio Company..)
Now this is better than nothing, but look at how weak it is. This General Partner isn’t required to have the portfolio companies prepare audited financials which seems perverse, since an IPO requires audited financials, and any private buyer would presumably apply a lower valuation to a company that didn’t have audited financials. And the General Partner is allowed to decide what items from the income statement, balance sheets, and statement of cash flows to present to its investors.
Another exception is that the larger funds courteously offer to pass along financial information about portfolio companies to its limited partners when the great unwashed public gets it too. For instance, the KKR 2006 fund has this provision:
And in those cases, only if they agree to keep that information confidential.
The failure of limited partners to require the general partners to maintain portfolio level accounts to a specified standard and make that information available to investors has led to abuses. As we noted in an earlier post, Why You Should Not Trust the Financials of Private Equity Owned Companies:
…we are going to examine iLevel in greater detail. 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.
At first glance, iLevel appears to provide legitimate and important services to PE firms. It extracts, compiles and analyzes the financial and operating data of the dozens of portfolio companies that a firm like Blackstone owns….
But a closer look shows that one of iLevel’s main claims, that iLevel performs anything that could be fairly labeled as “automated data collection,” is false. Instead, individuals at portfolio companies manually enter data into an Excel spreadsheet on a monthly basis, or use macros to export data from other Excel spreadsheets, and the populated spreadsheet is then uploaded into the iLevel database. The “automated” part of the data collection, to the extent there is any, consists merely of the iLevel software generating the blank Excel spreadsheet template every month and automatically emailing it to the portfolio company employee responsible for inputting the data. The completed spreadsheet then has its data “automatically” extracted into the iLevel database…
The key issue is that PE firms want their investors and the SEC to believe that their iLevel database has been constructed in a tamper-resistant fashion, which is always a central design goal of accounting software systems. If an accounting system allows people to change entries after the fact, that system is absolutely, utterly worthless. But that’s what iLevel explicitly allows to occur because, rather than extracting the data directly, it requires portfolio company employees to re-enter information into iLevel from their general ledger accounting system. Moreover, iLevel presents as one of its advantages that “key stakeholders” can “verify and approve the data”. That’s code for “tamper with”.
Now members of the private equity industry may contend that general partners provide a good bit of information to the limited partners at annual meetings and in their meetings with the limited partner advisory committee. But as we’ll discuss next week, these are highly scripted gatherings and only on very rare occasions do the limited partners ask pointed questions. From the perspective of protecting your rights and making sure you can do an adequate job of oversight, the only way to make sure you get information is by having the right to obtain it, whether by having it delivered on a routine basis or setting forth what you can require to be produced on request. Relying on the general partners to provide carefully chosen financial crumbs should not be considered to be adequate oversight, but perversely, it’s become established as perfectly fine conduct among private equity limited partners.