If you want to understand why private equity general partners have gotten away for so long with what the SEC has come perilously close to calling outright embezzlement, along with other serious compliance abuses, you need look no further than the last CalPERS board meeting to get a clue.
Recall that CalPERS is seen as an industry leader and has one of the very largest private equity portfolios. One proof of its clout: the giant public pension fund’s recent decision to cease investing in hedge funds sent shockwaves across the industry and generated widespread commentary in the financial press.
Yet CalPERS, along with its industry peers, has taken no visible steps to combat private equity grifting. Nor does it appear to have considered how to toughen up limited partnership agreements that the SEC has said are far too vague and skewed in favor of the general partners. One telling example: virtually all limited partnership agreements contain provisions that amount to a waiver of fiduciary duty. Sometimes the language is surprisingly explicit, as Gretchen Morgenson found when she got her hands on the full text of a 2012 KKR limited partnership agreement. The usual form is that the general partners point out that they have conflicts of interest and say that they may consider the interest of other parties in how they manage the fund, including their own interest.
To give you a flavor of how perverse this is, public pension funds generally are so worried about fiduciary duty that everyone who has a contract with them, even parties that aren’t remotely involved in fund management, sign up for having a fiduciary duty. Public pension funds would never never never allow a stock or bond manager to try to wriggle out of their fiduciary duties. Yet they let the managers of their riskiest strategies do just that.
It is difficult to comprehend how the limited partners like CalPERS accept the general partners having effectively shifted this liability onto them, particularly given that they are passive. And having achieved that, you have a perfect “no one effectively has a fiduciary duty”. Sure, the beneficiaries could sue their pension fund, but they’d be suing themselves. The only people you might be able to sue and have it stick are the fund trustees/board members, who are in theory personally liable (although they also carry directors and officers insurance).
Given the SEC having told the industry of this compliance train wreck, you’d expect to see some serious pushback, such as coordinated efforts among marquee general partners or at least some hand-wringing by the industry association, the Institutional Limited Partners Association, or ILPA. Instead, the posture seems to be that the limited partners are circling the wagons with the general partners, taking the attitude that any cheating at cards should be discussed privately, among members of the club.
Worse, limited partners are in the dark as to the degree to which they are being fleeced by their general partners. To the extent they’ve tried to find out, it has taken the form of upset phone calls and letters asking about specific types of fees. But we’ve been told that the overwhelming majority of letters from public pension funds, which are the biggest single group of investors in private equity, are so poorly drafted as to give the general partners plenty of wriggle room to uninformative responses. In other words, for the most part, to the extent that public pension funds are asking questions, it appears that they are going through the motions rather than risk alienating the general partners, who in theory could deny them access to future deals.
With this as background, let’s look at what an interview of prospective private equity consultants by the members of the investment committee of CalPERS’ board say about this generally sorry picture. Fund consultants are a critical part of the liability avoidance: if you hire reputable soi-disant experts to help you choose particular funds, you can claim to have ticked all the right boxes if the investments come a cropper.
But the investment consultants, along with the attorneys that represent limited partners in negotiating these agreements, bear a large measure of blame in the compliance cesspool that the SEC has unearthed. Do we see any acknowledge that they missed that there was gambling in Casablanca? Do they at least feign consternation, as Claude Raines did?
It’s even worse than that. Part of the problem is the constrained format of these interviews. The board is presented with three candidates screened by CalPERS staff. Two, Meketa Investment Group and Pension Consulting Alliance, are established CalPERS advisors. There’s one newbie candidate, Albourne America. Each contender makes a presentation and then the board gets a grand total of 20 minutes for questions and answers for each of them. This isn’t a format for getting serious.
To make a bad situation worse, most of the questions were at best softballs. For instance, Dana Hollinger asked what the consultants thought about the level of risk CalPERS was taking in private equity program. Priya Mathur asked if the advisors could do an adequate job evaluating foreign managers with no foreign offices. Michael Bilbrey asked how the consultants kept from overreacting to positive or negative market conditions.
One board member, however, did manage to put the consultants on the spot. The answers were revealing, and not in a good way. The question came from JJ Jelincic, where he asks about a particular type of abusive fee, an evergreen fee.
Evergreen fees occur when the general partner makes its portfolio companies, who are in no position to say no, sign consulting agreements that require the companies to pay fees to the general partners. It’s bad enough that those consulting fees, which in industry parlance are called monitoring fees, seldom bear any resemblance to services actually rendered. Over the years, limited partners have wised up a bit and now require a big portion of those fees, typically 80%, to be rebated against the management fees charged by the general partners.
So where do these evergreen fees come in? Gretchen Morgenson flagged an example of this practice in a May article. The general partner makes the hapless portfolio company sign a consulting agreement, say for ten or twelve years. The company is sold out of the fund before that. But the fees continue to be paid to the general partner after the exit. Clearly, the purchase price, and hence the proceeds to the fund, will have been reduced by the amount of those ongoing fees, to the detriment of the fund’s investors. And with the company no longer in the fund, it is almost certain to be no longer subject to the fee rebates to the limited partners.
You can see Jelincic’s question and the answers from the three consultants via the embedded video below. The meat of his question is more complicated than the overview above, since he refers to a questionnaire that another limited partner gave to the general partner of a fund in which CalPERS is also an investor, WCAS IX, or more formally, Welsh, Carson, Anderson & Stowe XI, L.P.
Jelincic describes the how the response said that the fees are shared only if the fund has not fully exited its investment in the portfolio company. Jelincic asks if that’s an example of an evergreen fee, and if so, what CalPERS should do about it.
The start and stop times are at 34:30 to 38:30 for Albourne America, 1:04:35 to 1:08:30 for Meketa Investment Group, and 1:37:30 to 1:40 for Pension Consulting Alliance.
The response from Albourne is superficially the best, but substantively is actually the most troubling. The first consultant responds enthusiastically, stating that CalPERS is in position to stop this sort of practice by virtue of having a “big stick” as the SEC does. He says that other funds aren’t able to contest these practices.
The disturbing part is where he claims his firm was aware of these practices years ago by virtue of doing what they call back office audits. That sounds implausible, since the rights of the limited partners to examine books and records extends only to the fund itself not to the general partner or the portfolio companies (mind you, some smaller or newer funds might consent). But the flow of the fees and expenses that the limited partners don’t know about go directly from the portfolio company to the general partner and do not pass through the fund. How does Albourne have any right to see that?
But if they somehow really did have that information, the implication is even worse. It means they were complicit in the general partners’ abuses. If they really did know this sort of thing and remained silent, whose interest were they serving? It looks as if they violated their fiduciary duty to their clients.
The younger Albourne staffer claimed a lot of the fees were disclosed in footnotes and that most limited partners have been too thinly staffed or inattentive to catch them. That amounts to a defense of the general partners and if Albourne really did know about these fees, Albourne’s inaction.
However, The SEC doesn’t agree with that view and they have the right to do much deeper probes than Albourne does. From SEC exam chief Drew Bowden’s May speech:
[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.
For these fees to be properly disclosed, they had to have been set forth in the limited partnership agreement or the subscription docs for the limited partners, meaning before the investment was made, to have gotten proper notice. Go look at any of the dozen limited partnership agreements we have published. You don’t see footnotes, much the less other nitty gritty disclosure of exactly who pays for what. Not very clear disclosures after the limited partners are committed to the funds, to the extent some general partners provide them, do not constitute proper notice and consent.
Meketa was clearly not prepared to field Jelincic’s question and waffled. They effectively said they thought the fees were generally permissible but more transparency was needed. They threw it back on CalPERS to be more aggressive, particularly on customized accounts, and urged them work with other large limited partners.
Pension Consulting Alliance was a tad less deer-in-the-headlights than Meketa but in terms of substance, like Albourne, made some damning remarks. The consultant acted if evergreen fees might be offset, which simply suggests he is ignorant of the nature of this ruse. He said general partners are looking to do something about it, implying they were intending to get rid of them, but said compliance was inconsistent. Huh? If the funds intend to stop the practice, why is compliance an issue? This is simply incoherent, unless you recognize that what he is actually describing is unresolved wrangling, not any sort of agreement between limited and general partners that charge these fees on this matter. He also said he would recommend against being in funds that have evergreen fees. But there was no evidence he had planned to be inquisitive about them before the question was asked.
You’ll notice that all of the answers treat the only outcome as having CalPERS, perhaps in concert with other investors, be more bloody-minded about evergreen and other dubious fees. You’ll notice no one said, “Yes, you should tell the SEC this stinks. You were duped. You should encourage the SEC to fine general partners who engaged in this practice and encourage the SEC to have those fees disgorged. That would to put an end to this. Better yet, tell the general partners you’ll do that if they don’t stop charging those fees and make restitution to you. That’s the fastest way to put a stop to this and get the most for your beneficiaries.” Two of the three respondents said CalPERS is in a position to play hardball, so why not take that point of view to its logical conclusion?
But this is what passes for best-of-breed due diligence and supervision in public pension land. Imagine what goes on at, say, a municipal pension fund.
The fact that the investment consultants are too captured to do their job makes an even stronger case for tough SEC enforcement. But with the agency walking back its tough talk on private equity, unless media pressure continues, the perps look likely to get away with their abusive conduct with only a bit of SEC-mandated tidying up around the margins.