The Wall Street Journal describes how some private equity firms are attempting to clean up their act by admitting to dubious practices in revised regulatory filings with the SEC.
There’s a wee problem with this approach. Securities law is not like the Catholic Church, where confession and a promise not to sin again buys you redemption.
And it isn’t as if these firm are even making a sincere confession. The abuses mentioned in the Wall Street Journal account have been reported in media stories. The pattern is that general partners have engaged in charging fees they didn’t report to investors or shifting expenses to the fund that the investors were led to believe were on the general partner’s dime. This grifting has been the subject of SEC whistleblower filings. SEC speeches and news reports have led investors to ask the general partners in funds in which they’ve invested about undisclosed charges. So cleaning up SEC filings is a bare minimum effort to feign compliance.
The Journal story reports that a dozen firms so far have taken the unusual step of revising forms that are filed annually in the middle of the year, and has an interactive graphic that lets readers see how the reports from four of the firms changed, including those of industry leaders Apollo and KKR. Note that KKR has admitted to group-purchasing rebate abuses that were outed in an earlier Wall Street Journal report by the same writers, Mark Maremont and Mark Spector, proof that the press scrutiny is forcing the miscreant general partners to adjust their behavior. The changed language for Apollo is for an abuse described by Gretchen Morgenson earlier this year, that of charging fees for the termination of monitoring agreements and not sharing that income with fund investors.
As much as these revised filing show that the private equity firms are beginning to feel some discomfort from SEC and media pressure, let us not kid ourselves as to where we stand. Until the SEC cracks down on a firm for abuses, a high proportion of industry players will have succeeded in getting away with what amounts to embezzlement. So far, the SEC has fined firms only in what amount to penny-ante cases. But at least one of them appears to be based on an insider report that preceded the SEC’s new audit program. And the SEC would want to document a case very well before it went up against a large player. Under Mary Jo White’s financial firm friendly leadership, there is good reason to be skeptical that serious enforcement actions are forthcoming. But given the timetable for developing cases, and the seriousness of these abuses, it’s not out of the question that the SEC might crack down on some of the worst behavior at top firms to send a message.
It’s important to understand that these revised filings don’t serve to get the private equity kingpings out of trouble. First, the revisions amount to an admission that the original reports were inaccurate. Second, and far more important, is that changing these reports does not do anything to remedy the underlying issue, that of misleading investors at the time the investments were made. Yet lawyers for the private equity firms try to pretend that telling investors now, after they are stuck in these funds, should be more than satisfactory. If you buy that, I have a bridge I’d like to sell you. From the Journal:
“Everyone is doing it in response to the regulatory climate and the statements that have been coming out of the SEC,” said Marco Masotti, a lawyer at Paul, Weiss, Rifkind, Wharton & Garrison LLP who represents buyout firms, adding that he was making general observations and not speaking about his clients. Various fee and expense practices are now being “made crystal clear” to “avoid any misunderstanding or ambiguity.”
Private equity limited partnership agreements have standard contractual language that limits the agreement to specific documents and disclosures. So if you as a general partner intend to make certain charges to portfolio companies bought by funds you are managing for investors, those limited partners thought they had a decent understanding of what charges and fees were being taken out of those companies. And the SEC understandably isn’t buying this “disclose after the fact” posture:
But he [SEC director Andrew Bowden] said an amendment to a buyout firm’s investment-adviser form “alone is unlikely to be viewed by us as a sufficient cure for a past material omission in a limited partnership agreement or offering materials.”
The SEC’s statements and follow-on media investigations show that investors had allowed themselves to be fooled and fleeced. Their agreements with investors allowed for poor oversight and very limited disclosure of portfolio company financials. And the way the various fee sharing agreements were set up in many cases deliberately misleading. For instance, investors thought that all fees pulled by general partners out of portfolio companies were being significantly rebated to them. In reality, general partners like Apollo and Blackstone dreamed up clever charges like termination fees that fell outside their careful language, allowing them to take all of those fees for themselves.
Even with the private equity investors not being very press accessible, the Financial Times and industry specialist publications have discussed, repeatedly, that private equity limited partners were shocked and upset at the SEC’s speech in May on the fact that they had found fee abuses and other serious compliance failures in more than half the private equity firms they’d examined. And the limited partners were particularly upset that even though the SEC was unusually pointed in describing the type of misconduct they were finding, it still left them in the dark as to the exact nature of abuses and whether they were taking place at funds they had invested in.
As the article points out, “The disclosures reflect a cat-and-mouse game now playing out between regulators and the buyout-firm industry. ” The private equity firms are hoping to make enough of a show of compliance to appease the SEC. Whether is does will probably depend in good measure on how much pressure the media and the general public put on the industry.
The fact that David Sirota, in parallel with the mainstream media reporting on investor abuses, has been documenting the extent of pay to play abuses, suggests that the focus on industry bad conduct will only increase. Sirota’s campaign is starting to draw blood, as his relentless investigation of failures to adhere to New Jersey’s strict pay to play laws led to the resignation of long-standing Chris Christie crony Robert Grady as chairman of the state’s pension fund committee. Today, The Intercept publicized Sirota’s work, and the underlying problem of how much public pension fund money has been invested in “alternative” investments that too often are far more lucrative for Wall Street than for investors. From the story, Wall Street is Taking Over America’s Pension Plans:
But behind the scenes, another major story has been playing out. Wall Street spent upwards of $300M to influence the election results. And a key part of its agenda has been a plan to move more and more of the $3 trillion dollars in unguarded government pension funds into privately managed, high-fee investments — a shift that may well constitute the biggest financial story of our generation that you’ve never heard of.
Illinois, Massachusetts, and Rhode Island all recently elected governors who were previously executives and directors at firms which managed investments on behalf of state pension funds. These firms are now, consequently, in position to obtain even more of these public funds. This alone represents a huge payoff on that $300M investment made by the financial industry, and is likely to result in more pension money going into investments which offer great benefits for Wall Street but do little for the broader economy.
In other words, the private equity industry’s clever lawyering won’t hide the fact of its extractive fee structures and its flagging performance. And the more and more its practices are exposed, the harder it will be for them to maintain their worst, as in most lucrative, practices. While private equity is unlikely to come out a loser, don’t underestimate the ability of public, legal, and regulatory pressure to cut down its ill-gotten winnings considerably.