The Financial Times weighed in today with a long, well-researched piece, Private equity: A fee too far, on an issue we’ve discussed for some time, that of private equity firm oh-too-cleverness and too often, outright pilfering, in its dealings with investors, who include public pension funds, foundations, endowments, and insurers.
This article is far more comprehensive than previous reports on this topic by the Wall Street Journal and the New York Times. The pink paper filed an article earlier on anger and upset among investors when they were told by the SEC in May that the agency had found evidence of stealing and serious compliance violations in over half the firms they’ve audited so far. The fact that the FT thought these abuses were important enough to merit an extended treatment, as well as some of the quotes in the article itself, suggest that the the limited partners in the funds are not taking much comfort from the answers they are getting to their queries.
It’s not hard to understand why. It’s increasingly clear that two things are at work. One is that the private equity general partners, much like mortgage servicers, have been unable to resist the temptation of having control of the cash flows of the true wealth of America, that of its corporations. And that isn’t our surmise. The SEC said as much in May. As we wrote then of Drew Bodwen’s speech:
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.
The second is that the private equity firms engage in precisely the same behavior that Elizabeth Warren decried on the consumer end as “tricks and traps”. For instance, during the marketing of private equity funds, they present a “team” that the hapless limited partners assume are all on the private equity firm’s dime. Only now are they learning that a substantial portion of those “team” members are treated as independent consultants and are charged to the portfolio companies, meaning their investment.
But as we’ll discuss, even though the Financial Times account flags many of the key issues, and does a fine job of assembling information, it nevertheless misses some critical points.
One of the most important, which is sadly buried in the article, is the arrogance of the private equity firms. It starts by discussing First Data, a KKR acquisition, and tallies how KKR-related units sucked $117 million in various fees out of the company over three years. Note that First Data featured prominently in the Wall Street Journal story flagging how KKR is trying to maintain that its captive consulting firm, KKR Capstone, is not an affiliate and therefore it does not have to share those consulting fees with investors. We shredded that argument in an earlier post.
Here is an indicator of the private equity firms’ reaction:
In private, executives scoff at the SEC’s examination. “They are going after odd micro concerns,” says the founder of one leading US private equity firm. “They dispute what is the equivalent of footnotes in our agreements with our investors and try to knock down the industry with legalistic disclosure issues.”
He recalls the time when SEC staffers auditing his firm objected to clauses in agreements similar to First Data’s on the grounds that they were “too much in your advantage, and saying ‘we want money from you’.” He says defiantly: “I told them we didn’t do anything wrong and we wouldn’t pay.”
“Legalistic disclosure issues”? This is an industry that fetishizes the use of very cleverly and carefully crafted documents to protect its interests, above all its right to collect fees. These firms can hardly expect to get any sympathy for not living up to their agreements and well-known regulatory requirements, particularly since they hire the best attorneys that money can buy.
But this intransigence should come as no surprise. After all, it was private equity firm heads who’ve made the most egregious statements of a misplaced sense of persecution, specifically, Steve Schwarzman of Blackstone calling the notion of getting rid of the loophole that allows what would otherwise be private equity firm labor income at capital gains rates as akin to Hitler invading Poland, and Tom Perkins more recently claiming that criticism of the super-wealthy would lead to a Kristallnacht.
Investors are not amused:
“Those fees pump substance out of portfolio companies. It is the sort of greed you would typically see in investment banking,” says Georges Sudarskis, an industry veteran who advises Asian and Middle Eastern sovereign wealth funds….
Even though these fees are increasingly refunded to investors, prominent institutions including some top university endowments are reluctant to back the most high-charging fund managers. “They have come up with a formula to enrich themselves more than their investors,” says the chief of one leading US endowment.
The conundrum is that while investors are unhappy, it’s not clear whether they will act. In the Financial Times article, for instance, all that the authors envision, reflecting their sources, is that the funds share more of these fees (the common level now is 80%). Some private equity firms are willing to do that…..provided they get higher management fees (the annual 2% of the prototypical 2% and 20%). That means this is not so much a concession as another pricing option:
Stephen Schwarzman’s Blackstone returns 80 per cent. KKR also proposed an 80 per cent rebate in its 2006 US fund. For its most recent US fund, it allowed investors to increase the rebate to 100 per cent in return for higher management charges – an option also offered by Carlyle, founded by William Conway, Daniel D’Aniello and David Rubenstein. European groups, most of which charge monitoring and transaction fees, followed the same trend.
However, “if eventually none of those fees end up in the fund managers’ pockets, the justification for their existence vanishes”, says Mr Phalippou. “Yet those fees are still being charged, with all the conflicts of interests and possible abuses arising.”
Yves here. The article misses a glaring issue: only specified fees are subject to rebates against the management fees. There are instances of private equity firms charing fees that do not fit into defined categories and hence are not subject to rebates. Moreover, if the rebated funds were to exceed the annual management fee, in most case, the private equity firm would get to keep all of the excess amount.
And the The Kauffman Foundation, a long-standing investor in venture capital funds, pointed out in a widely-read 2012 paper, We Have Met the Enemy and He is Us, that investors accede to all sorts of unreasonable provisions with the general partners, and they argued forcefully that investors shouldn’t put up with a fixed percentage management fee, that it instead should be budget-based:
Investors are light-years away from taking up that fight.
Needless to say, the fees become more glaring when they are extracted from portfolio companies that go bust. But private equity investors are too craven to clear their throats and raise the issue of fraudulent conveyance (which is lawyer-speak for taking cash out of a company when it is clear it is going bankrupt).
The article extend the US reporting by noting how European private equity firms are emulating these dubious US practices. It also included the dubious defense that the limited partnership agreements are negotiated, when the SEC has criticized the investors for accepting remarkably vague, one sided language. And we’ve written repeatedly about how badly captured the limited partners are. They routinely put the interests of the general partners over those of their beneficiaries and the general public on routine requests for information. If they are afraid to buck them on issues like that, it’s a no-brainer that they lack the resolve to negotiate anything beyond token issues.
And the Financial Times article presents the industry’s pet fallback, supplied by a MorningStar analyst, Stephen Ellis:
“Investors see the returns and don’t ask too many questions. As long as the returns are there, they can justify their allocation and they are happy not to dig into it.”
Ellis is not much of an analyst if he’s still running the “private equity delivers great returns” meme, which we debunked long form. Industry stalwarts like CalPERS and Harvard are cutting allocations precisely because returns have lagged and they don’t see that changing any time soon. But yield-desperate investors may well cling to the old myths and stay loyal to their abusers.
I don’t understand why the investors are being portrayed as victims here. I don’t think that there exists a single one of these PE clients that would have with a person being short sold, in fact I think many of them were thinking they were doing the selling. When you hand over your money to someone else to invest, as in the case of stock or the PE investors, it is because you are too incompetent to satisfactorily invest your money yourself and thus you must seek out someone who is. These investors claim they have natural rights to autocratically wield vast power and resources, enough to decimate a nation state several times over and so severed from all ties of obligation and even every sense of decency that this may be done lawfully. The super-rich are no longer citizens of any state but that of their own person.
The reality is that the kind of freedom we afford property can only healthily co-exist when inequality exists in miniscule proportions. Globally nation states have handed over vast amounts absolute authority over social wealth to individuals who claim that they are far more competent than the average person, who they no doubt puzzle over how they manage to wipe their asses themselves, and everyone is shocked that they wrecked it and ran off with the lion’s share.
I suggest you reread the post. The most important investors in PE are public pension funds, about 25% of industry assets. That means state and municipal government employees are making these investments. See this post for more detail:
The next biggest group of investors is fund of funds. That allows smaller investors, like smaller foundations, endowments, pension funds (both public and private) and wealthy individuals to invest in a diversified portfolio. To the extent wealthy individuals are in this group, it’s the low end wealthy.
Third is private pension funds (around 10%). Foundations and endowments and insurers are among the next biggest groups.
Oh, and most of these players, certainly the pension funds, the fund of funds, and foundations and endowments, hired professionals who helped them vet the firms and lawyers to review the contracts. So what were these gatekeepers doing for their fees?
Yes, some wealthy investors are big enough to invest directly in PE, but they aren’t the ones with clout. It’s the institutional investors, who invest on behalf of other people.
Your ire is really misplaced. Do you serious think a pension fund representing pipefitters has a chance against PE funds? And who pays when these investments come up short? For public pension funds, it’s taxpayers, via higher taxes. But no, you’ll get mad at “investors” because you’ve fallen victim to class jealousies and would rather hate the wrong guy than the right guy. For instance, the PE funds are singularly responsible for the now-established trend to squeeze workers to increase profits. And extensive macroeconomic works shows they are MUCH more aggressive than public companies in that regard.
And there is another way PE takes from you that I didn’t bother covering in this post which is they’ve brought aggressive GE style tax tac†ics to much smaller companies who otherwise would never have access to such fancy tax games. So you are also losing out that way too, by their large-scale success in having companies pay close to nada in income taxes.
Moreover, ERISA, which was passed in 1974, changed the parameters for how pension funds invest (private pension funds must comply with ERISA; ublic pension funds are not required to but pretty much all do). They now use modern portfolio theory to guide their investment strategy. That greatly reduced the importance of evaluating individual investments v. looking at diversification within an asset class and across asset classes. But that means investors can fall for problems that exist all across an asset class (and MPT virtually requires you invest in a strategy if it is considered to be an asset class, and PE is treated that way by pension fund consultants).
You’ve fallen for the classic 0.1% trick of going after people who ought to be your allies, and letting the people you ought to be targeting off the hook, the PE firms, who are alpha rentiers.
Thank You, Yves!!!
“Translation: private equity provides uniquely lucrative temptations and opportunities to steal from investors. ”
More than health care, higher education, government [in general] and the rest of the FIRE economy? After all, the very purpose of the organization of society to steal. Sometimes you can keep in it under control, but most times, you simply can not.
The lesson to be learned here is to minimize social organization and therefore weaken both the tendencies and mechanisms which facilitate the base desire for much of humanity to attempt to procure something for nothing.
PE controls the true wealth of America, about 20% of its companies when you allow for leverage. And they own hospital chains and for profit colleges. HCA is a PE owned company and a big driver of industry practices:
I am hearing from well placed sources that one of the best HMOs, Kaiser, is not making it income-wise and expects it will have to sell out to one of these players.
So PE is bigger than the entire health care sector and its business practices, of squeezing labor, crapifying products, and driving to get oligopoly power via consolidation, have been big drivers of why corporations have been able to increase profits at the expense of ordinary people. Its practices have been widely emulated by non-PE firms.
It’s pretty sad.
Limited Partners would gag at the sausage making. And speaking of the slaughterhouse: Why, if corporations are people, don’t they have any defenses against these vultures? Maybe Scalia can explain this in strict constitutional terms. Talk about making sausage.
What might a “budget-based” fee structure look like, in contrast to the conventional 2% fee? (What expenses would be included in the “budget”, for example, and how would this be better for investors than 2% of the funds invested by the investor?)
Do investors such as large pension funds have enough power to negotiate a better deal with PE firms, if they wanted to?
Would it be possible for a number of pension funds to develop their own PE firm as a cooperative?
Kauffman addresses the budget idea in more detail in its report. They also want to know the compensation structure within the PE funds, since that tells you a lot about how stable they really are (as in if you have people who are important who aren’t getting a fair share, they might bolt for another fund or set up their own).
The large funds could negotiate better deals, but they have only pushed for some financial concessions. They haven’t made any effort to fight against some of the much bigger problems, like the lousy disclosures, the sweeping indemnification language, the refusal to clarify who of the “team” presented during marketing is an employee v. a consultant, etc. One fund, even a CalPERS, probably could not do it alone, but if a CalPERS plus a couple of the other big investors got together, it would be hard for the PE funds to resist. They’d get really bad PR too, if the investors were smart and raised the issues in the business press first. But they’d also need to get really bloody-minded counsel to represent them.
On your third point, YES, and that is the investors’ most potent threat: “You don’t shape up? We’ll take it in house.” Seven pension funds in Canada have started doing PE in house, and they’ve gotten better results that PE funds deliver, precisely because the general partners are taking out so much in fees.
AltoBerto wrote: “When you hand over your money to someone else to invest, as in the case of stock or the PE investors, it is because you are too incompetent to satisfactorily invest your money yourself and thus you must seek out someone who is.”
I have a very small personal portfolio/pension fund. Any time I wish to change any holding in that portfolio I have to pay a broker 2.5% of the proceeds of sale and 2.5% of the value of the purchase because I am required by the exchanges to employ an authorised middle-man. That 5% drain on capital any time I might want to change a holding is a serious disincentive to active management while the hugely reduced brokerage fees the Financial Industry is able to take advantage of makes its promised returns comparatively attractive.
Partly for this reason I have been considering ‘surrendering’ and handing the portfolio over for professional management. We’re only talking $1million or so and, interestingly, if you make a forecast of what the fund can do with my money using reasonable estimates of growth, etc, its share by way of fee out of the income left after deduction of tax and inflation is – 22%.
The PE industry referred to in the article is way out of my league as an investor, yet the ‘money management’ industry for small-fry like me feels like a reinstitution of the Medieval Guild System. The only other equivalent I have come across personally is the equally affluent and ‘privilaged’ British Bar system, under which access to barristers is only possible after first paying large sums to a solicitor to act as intermediary.
I’m not sure in where your fund is (although it sounds like US if you say it’s about $1m), but I’m pretty damn sure there are brokers who would charge considerably less than 2.5% to buy/sell on a US exchange. In fact, with some of them, your biggest cost may be the data provision (say NYSE has much different cost structure for retail and profressional investors, and if you’re incorporated you’re automatically treated as the latter) – but unless you trade daily, you don’t really need that.
I don’t want to belabor the point, but readers really should be paying attention to this stuff. The PE guys are, as Yves puts it, “alpha rentiers.” They’re running the show. The opportunity cost focusing on people further down the food chain is not knowing your enemy. How much sense does that make?
A percent based fee is the worst thing ever in the finance industry. It drives a whole set of bad behaviours and at the same time serves only the management.
If there was one, single, piece of regulation I could institute, it would be barring any proportional renumeration except where risks are shared proportionaly.
Sounds like a good idea to me!