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.