Gretchen Morgenson of the New York Times released an important story over the holiday period on how a mid-sized private equity firm, Freeman Spogli, with $4 billion under management, was found to have made serious violations of its investment agreement. The SEC’s fund examination unit stated that Freeman Spogli, in two of its older funds, FS Equity Partners V (“FS V”)and FS Equity Partners VI (“FS VI”), looked to have repeatedly violated of fee-sharing agreements and to have operated as an unregistered broker-dealer. It asked for Freeman Spogli to make full restitution of the failure to reduce management fees and provide evidence that required reimbursements that looked to have been, um, ignored were actually made.
While Morgenson has done a fine job of presenting the facts of the case, we beg to differ with her as to some of the inferences she draws. She sees this case as a real step forward for investors. We see it as showing how loath both investors and the SEC to take serious action even in the face of clear-cut evidence of misconduct.
An investor obtaining a copy of the SEC’s deficiency letter though its routine compliance process with its general partners. That apparently led to other investors raising concerns about investing in a new fund that Freeman Spogli was raising. Freeman Spogli offered concessions to investors in its new fund, FS Equity Partners VII (“FS VII”), specifically the right to bring in independent professionals to review fund books and records as well as conflicts of interest. Morgenson took those concessions to represent a significant change in disclosure and thus represent an important precedent*. As we’ll discuss, we see them as cosmetic.
The fact that these Freeman Spogli amendments amount to face-saving for investors that ought to be running from the firm** based on the SEC’s allegations about its conduct in its prior funds, also confirms another sad fact about the private equity industry: that investors are clueless, complicit, or cowardly. As private equity consultants said in a recent CalPERS board meeting, limited partners bizarrely believe that they can’t stand up to private equity general partners, and look to the SEC or an industry leader like CalPERS to do their job for them.
In addition, by organizing her piece around the notion of that these Freeman Spogli concessions represented meaningful change, she likely unintentionally wound up downplaying Freeman Spogli’s broker-dealer violations, which the SEC is also citing at other firms. Those could be hugely significant were SEC to act on them.
However, we remain skeptical about the likelihood that the SEC will crack down on the industry despite troubling findings like these. Even though the Freeman Spogli deficiency letter shows that the examination unit is doing a serious, thorough job of reviewing the areas under its purview, enforcement sits in another part of the agency. That unit has yet to saddle up on anything other than trivial violations. As we’ll discuss, that is particularly troubling in light of severity of the punishments the agency can hand out for the broker-dealer violations. It has a nuclear weapon that we strongly suspect it will fail to deploy, or even threaten to use.
We are embedding two critical documents that were obtained via FOIA at the end of this post: the amendments that Freeman Spogli offered to limited partners, and the SEC deficiency letter, so that readers can make their own assessment.
Freeman Spogli Non-Concession Concessions
It’s possible that Freeman Spogli offered its investors a Potemkin monitor to forestall the SEC putting in place a real one. The summary of the amendments to the limited partnership agreements makes clear that it was investor concerns, and not SEC prodding, that led to these changes. And Freeman Spogli, as is predictable for this industry, teed up just about nothing of substance.
Notice exactly how Freeman Spogli describes the critical concession:
Some of Morgenson’s sources used the term “independent monitor: but that is an exaggeration of the role of the independent professionals:
• Expenses are borne by the new fund, and not by Freeman Spogli. If a regulator had appointed a monitor, odds are high that the Freeman Spogli would pay the freigh
• There is no additional protection for investors in existing Freeman Spogli funds. If these funds have not been wound up, you’d expect a regulator to have included current and any funds launched by a date certain to be included
• The amendment “permits” the Advisory Committee to engage professional advisors and have them report to the Advisory Committee. Presumably they will exercise this option, but note this is an option that the Advisory Committee has to take up. No professional supervisor has been appointed.
Standard LPA language has the general partner deciding who is on the Advisory Committee. They select the most complacent and clueless investors in their funds. Now since there are only four investors in this fund, one would imagine that they are all on the committee. But as a precedent for other funds, the fact that Advisory Committee has to choose to act further waters down this provision.
• There is no increase in disclosure. This merely lowers the bar somewhat for action by the Advisory Committee. The previous process would have been for one or more members of the Advisory Committee to hire experts and bring their concerns to other Advisory Committee members. Shifting that cost onto the fund rather than getting approval for the expenditure is a weak plus.
• Any hired guns will not have sufficient power to find many fee abuses, including the very ones cited in the deficiency letter. Payments by portfolio companies that do not go through the FS VII would not be detected, such as fees paid from the portfolio companies to affiliates of the general partner, questionable payments of general partner expenses, like billing private jets charges for trips to the Hamptons, and termination fees. The SEC is still the one that has the reach to find these abuses through its regular examination process.
The Unregistered Broker-Dealer Bombshell
To the credit of the SEC exam unit, it isn’t buying much of what the private equity industry is selling. Importantly, it refuses to accept the idea that private equity firms can waive their fiduciary duty, which they attempt to do through two types of provisions in their limited partnership agreements. One is via broad indemnification, the sort that was originally used in merger and acquisition fee letters. There, the principals are actively involved and have their own experts providing professional counsel on critical decisions, which they make. The sort of indemnification, which is defensible with an active and extensively advised client, is overreaching in the case of a fiduciary acting on behalf of a passive investor. Yet that has managed to become the industry norm.
The second device the industry uses to try to wriggle out of its fiduciary duty is via cleverly crafted conflicts of interest language (see our collection of limited partnership agreements for examples and search on the word “conflict”). Although there is more verbiage involved, the form often amounts to: “We have conflicts of interest and we can consider other interests, including our own interest.” Another variant is to have the limited partner grant the general partner the right to do all sorts of other business and restrict them only in specifically stated ways.
But the real potential biggie is the unlicensed broker-dealer issue. From Morgenson:
The other practice cited by the S.E.C. involved Freeman Spogli’s apparent acceptance of fees for providing investment banking-type services even though it was not registered as a broker-dealer. The same two funds were cited in the letter.
“It appears as though Registrant,” the letter said, referring to Freeman Spogli, “and its Affiliated Executives may be and have been acting as unregistered broker-dealers based on the receipt of such compensation.” The letter added, “Please explain any legal analysis conducted by, or on behalf of, Registrant in determining whether broker-dealer registration is appropriate, including any legal basis or authority on which Registrant has relied.”
The commission has questioned other private equity firms about their brokerage activities. One is the Clearlake Capital Group of Santa Monica, Calif. After an S.E.C. examination in 2013, Clearlake also received a deficiency letter about unregistered broker-dealer activities.
In July, Clearlake, responding to questions by one of its pension investors, said it had replied to the deficiency letter, and that the S.E.C. had requested additional information on the matter, according to documents made available to The Times…
Securities laws state that “any person engaged in the business of affecting transactions in securities for the account of others” should register as a broker and submit to heightened oversight intended to ensure that its customers are treated fairly…
Most large private equity firms, including Apollo Global Management, the Blackstone Group and KKR, are already registered as broker-dealers.
Morgenson isn’t quite right on the status of Apollo, Blackstone, and KKR. While they do have units that are registered broker-dealers, those units are not the ones that receive transaction fees from private equity portfolio companies. And it is those fees that raise the “unlicensed broker-dealer” issue.
So why is this such a big deal? This is an unambiguous securities law violation. Anyone with any contact with the mergers and acquisition or investment banking business is well aware of broker-dealer registration requirements. Even your humble blogger was very careful to operate her small consulting practice so as to stay well away from broker-dealer registration obligations.
And the liability is huge. The fines for broker-dealer violations are dollar for dollar of transaction value. For example, KKR’s 2006 fund raised $17.6 billion. Assume it used the industry norm of 30% equity and paid itself transaction fees on every acquisition it made. That means the SEC has ready grounds to assess fines of $58.7 billion for that fund alone. By contrast,KKR’s total assets as of September 30 were $66.3 billion.
In other words, the SEC has all the leverage in the world to deal with private equity abuses, at least for the large portion of the industry that charges transaction and monitoring fees, which is where the serious misconduct is taking place.
Why Freeman Spogli Bodes Ill for SEC Enforcement
Readers are welcome to correct me, but I cannot think of a single case anywhere, evah, where a financial services industry enforcement action went down this way, as in private companies rather than a regulator pressed for an increase in oversight. If normally spineless investors like private equity limited partners thought they needed more power (even if in the end they really didn’t get any), the conduct was clearly egregious. Freeman Spogli’s finesse may lead the SEC to do less rather than more, particularly in light of the generally laudatory Morgenson article
In addition, keep in mind that the deficiency letter came from the examination unit. All that unit can do is ask investment advisers to repay money. They are then supposed to refer the situation to the enforcement unit. In theory, the enforcement team could still impose fines. But this appears unlikely to happen.
The SEC’s pattern, and that of settlements generally is to wrap actions into one package. The threat is that if you don’t settle, you file a claim. The power in filing a claim is not just in the possible damages, but what is unearthed in discovery. The process of deposing customers and supposed allies can be even more damaging than what the public sees. And that notion is confirmed by enforcement actions against penny-ante private equity firms, the only cases the SEC has pursued thus far. The settlements covered both reimbursement/restitution as well as fines. And in one case where fines were assessed, Lincolnshire, the cause might well have been terrible record-keeping rather than malfeasance. So why is Freeman Spogli presumably getting off so easy?
I’d love the SEC to prove me wrong, and more and more critical attention by influential writers like Gretchen Morgenson are a powerful spur to action. But I’m not holding my breath absent more external pressure on the agency.
* Morgenson did hedge herself near the end of the piece: “With private equity firms under the regulatory microscope, the balance of power may be shifting — at least a bit — away from fund executives and toward investors.”
** In fairness, most investors in FS V and VI are shunning FS VII, but whether that is due to the deficiency letter being circulated or disappointing fund performance is unclear. Note that we do have access to returns of the earlier funds. However, Preqin data shows that none of the investors in FS V invested in FS VII, and only two of the twelve investors in FS VI invested in FS VII. Moreover, FS VII has only four investors: Florida State Board of Administration, Kansas Public Employees’ Retirement System, New Mexico State Investment Council, and New York State Common Retirement Fund. So investors may be voting with their feet rather than relying on the idea that they could push for a tougher agreement.