It often seems hard to fathom is how supposedly sophisticated investors like public and private investment funds give private equity firms so much discretion with inadequate oversight and controls. Try as they might, it is impossible for limited partners to find seasoned advisors, such as pension fund consultants and attorneys, who are not beholden to private equity sources of income.
We’ll look at a case study today, that of a top pension fund consultant and one of its clients, the Los Angeles City Employees’ Retirement System, or LACERS. LACERS is a roughly $14 billion pension fund with a 12% allocation to alternative investments. LACERS uses leading private equity consultant Hamilton Lane for private equity. We’ve embedded a Hamilton Lane report to the board at the end of this post; you can also view it here. To give you a full picture of the extent and caliber of analysis that goes into tens of million dollar investment decisions, we are also embedding a report that Hamilton Lane made to LACERS staff on a different investment, Apollo Investment Fund VI (“Apollo VI”), which you can also access here. Note that I have obtained and reviewed a full copy of Hamilton Lane’s Apollo VI report, including all the appendices, as well as the Apollo VI private placement memorandum
As you can see, the Hamilton Lane reports do not contain sufficient business and financial analysis for a potential investor to make a reasoned decision whether to risk a substantial equity investment. Their role is to provide due diligence theater.
We’ll focus on the first embedded document, the board presentation on EIG Energy Funds XVI. An observant reader will notice:
1. The report to the board on an investment of up to $25 million is all of two substantive pages, plus an appendix tallying the work force composition. And virtually all of the information is compilation from the general partner’s marketing materials and private placement memorandum. A college student could have assembled those sections. As Oxford professor Ludovic Phalippou describes at some length in a 2009 paper, term summaries like the “Carry/Hurdle: 20%/8%” are inadequate to make proper comparisons, since key details in the contract often lead to higher fees than the structure would lead an investor to believe.
2. The analysis is pathetic:
• Attractive risk-adjusted returns with limited write off ratio
• Experienced and cohesive team of investment professionals supported by a broad technical staff
• Transactions structured to mitigate downside risk and J-Curve effect
Subjective judgments like “The management team is cohesive” are far less than clients paying fees for big buck investments ought to be getting. For instance, venture capital limited partner the Kauffmann Foundation stressed the importance of understanding how the general partner works as a management team, and called forcefully for disclosure of the economics of the general partners themselves, such as partner capital contributions by partner, ownership structure, partner compensation structures. Mind you, no one gets that, but Hamilton Lane pretending that it understands how a firm functions by sees how nicely its partners play together at important photo ops is due diligence legerdemain.
Oh, and if you read the Kauffmann report, you’ll also see that one of the three investment rationalizations (they do not rise to the level of being rationales) is that the transaction is structured to mitigate the J-curve effect (early losses followed by gains). Hamilton Lane is revealed to be promoting investment urban legend. Kauffmann notes: “The J-curve effect is mostly notable by its absence.”
Private equity professionals will point out that pension fund consultants prepare summaries of their reports for the board; the investment staff gets longer documents. But if they were being honest, they’d also tell you that the staff versions contain almost nothing more in the way of useful information, as we’ll see soon.
3. On the final page, a table labeled “Discretion in Box” sets forth the roles of the LACERS Board of Directors, LACERS investment staff, and Hamilton Lane. Notice this part in the far right column for Hamilton Lane:
• With staff concurrence, approve investment of up to $25 million for new partnerships, and up to $40 million in follow-on funds….
• Negotiate legal documents
Read that again. Hamilton Lane make the investment decision, subject to “concurrence.” which is a weaker word than “approval,” of investments as large as $40 million. And the staff doesn’t get anything resembling adequate work product for them to understand what thinking, if any, when into the Hamilton Lane decision to pull the trigger.
If you look at a representative report to LACERS staff, the report on Apollo VI at the end of this post, you will see that it is longer. But longer does not mean that it is more substantive that the board versions. Most of it is a summary of the private placement memorandum; the table at the top of page 10 and Appendices A and B are lifted straight from it.
Here’s one of the sections that does contain what passes for Hamilton Lane work:
Over the course of its relationship, Hamilton Lane has performed numerous reference calls
regarding the General Partner. Hamilton Lane has performed diligence on several of the
General Partner’s prior funds, and as a limited partner of these funds has remained in constant
contact with various investment professionals throughout the years. The Principals have been uniformly viewed as individuals of high integrity and intelligence. Specifically, the Principals
were consistently complimented on their restructuring and turnaround skills. The General
Partner is viewed as one of the top buyout firms in the market, with a deep, experienced team
and a long history of performance.
If you’ve ever hired a headhunter, the reference checks provide far more information, such as quotes from the interviewees.
And this part is what Hamilton Lane considers to be competitive analysis:
The General Partner typically competes with other mega-buyout funds, including Blackstone
Capital Partners, Thomas H. Lee, Bain, Texas Pacific Group, and KKR. Within the distressed
environment, the General Partner may encounter competition from hedge funds. However,
since the General Partner often targets more complex investments, competition is typically
What is noteworthy about the report is what is missing. The Apollo VI private placement memorandum includes the usual lengthy section on risk factors. As a minimum step, a fiduciary would want to know that someone had taken a serious look at those issues, particularly to see if any risks were new to this fund or greater in this fund that previous funds by the same general partner. There’s no indication that any review of this sort took place; indeed, the Hamilton Lane narrative instead regurgitates the sales pitch from the front of the Apollo VI private placement memorandum:
Apollo has consistently employed downside risk protection in its investments through conservative transaction structures. The Firm frequently structures its investments to minimize risk without foregoing upside potential. Apollo has considerable experience in building varying degrees of downside protection into the structure of its transactions.
The fact that Hamilton Lane negotiates legal agreements on behalf of LACERS is even more troubling, but we’ll turn to the contract negotiations in future posts.
You can see how low the standards are for soi-disant expert review of private equity funds. In some ways, it’s not quite as crazy as it might seem, given that general partners are selling hope rather than a product.
Keep in mind that Hamilton Lane is one of the top firms in this industry. The fact that it can get away with such flimsy work is proof of how low the prevailing standards are. And there are reasons that the limited partners can’t do any better. The entire industry is rife with conflicts of interest. But in Hamilton Lane’s case, they are even worse than the norm.
Hamilton Lane Runs a Ginormous Amount of Private Fund of Funds. According to its 2014 Form ADV, Hamilton Lane has approximately $29 billion of discretionary private funds under management.* That’s comparable to the current size of the private equity portfolio of CalPERS, the biggest public pension fund. Nearly all private equity consultants are in the fund of fund business; Hamilton Lane is an outsized example.
For Hamilton Lane, performing advisory work for funds like LACERS is a nice, reputation-burnishing side activity to their big money marker, running various private fund of funds.
Consider what Hamilton Lane’s incentives are. Pursuing their fiduciary duty vigorously would put Hamilton Lane in conflict with their general partners. Since pension fund consultants are typically paid a flat fee to review all prospective investments for funds like LACAERS, playing collegial with the general partners minimizes hassle and effort.
But it’s even worse than that. If pension fund consultants became more rigorous on the advisory side of their business and did real due diligence, those same firms acting on the advisory side of the business would wind up asking managers like Hamilton Lane on the fund of fund side of their business much tougher questions.
Moreover, remember that until recently, the Holy Grail of private equity investing was to get into top quartile funds. Never mind that nearly 80% of the industry could cut its results in a way to claim to be top quartile, and that top quartile performance no longer persists. The reason for hiring a firm like Hamilton Lane is supposedly to make better fund selection. Peculiarly, these same investors understand that trying to outcompete other investors is a fool’s errand as far as stock and bond investing is concerned. As a result, the overwhelming majority are index investors. But rather than save money and hassle and try to act like an index investor in private equity, limited partners work hard at fund-picking.
Given that Hamilton Lane has a large number of pension fund clients it advises, as well as running its own fund of funds, which compete on results, where do you think Hamilton Lane ought to deploy its investment expertise, on the charitable assumption it has any? Pension consultants who are also running funds would be much better served to use it in their fund management activities. Thus it should hardly be surprising that low-information-content reports are the norm. It’s what you’d expect to see from an industry that wanted to keep its best cooking for itself.
Hamilton Lane is an Investor in a Widely-Used Program That Allows Private Equity Firms to Cook the Books of Portfolio Companies. One of the worst ways in which private equity is a non-transparent, “trust me” business is that the limited partner do not have any right to see the financial statements of the companies the private equity fund has bought on their behalf. That is also, as Andrew Bowden pointed out in his speech last year describing widespread misconduct, why so much chicanery is possible: they can have the portfolio companies pay all sorts of fees and costs that may not have been authorized by the governing agreements and the limited partners have no will clue.
Hamilton Lane, as both a fiduciary through operating fund of funds of its own, and as an advisor to major investors like LACERS, should be particularly cognizant of financial reporting risks at the portfolio company level and should strive to reduce exposure to them. Instead, Hamilton Lane is a shareholder in iLevel Solutions, a venture that allows general partners to tamper with portfolio company financials. Since Hamilton Lane clear does know, or could easily know, which general partners use this system, one would imagine that its responsibility to the investors would require it to avoid committing client funds to any general partner that used iLevel Solutions. If you think that’s what Hamilton Lane actually does, I have a bridge I’d like to sell you.
We wrote about iLevel Solutions in 2013 and we urge you to read the post in full. Here are the key sections:
We will see that this company is built from the ground up as a vehicle to convince PE investors and the SEC that Blackstone and other PE firms have implemented robust financial controls over the companies they own. The reality, however, is the opposite: by design, iLevel gives PE firms unprecedented ability to cook the books of their portfolio companies while maintaining a facade of compliance.
At first glance, iLevel appears to provide legitimate and important services to PE firms. It extracts, compiles and analyzes the financial and operating data of the dozens of portfolio companies that a firm like Blackstone owns…
iLevel’s website gives the impression that the purpose of the company’s software is to bridge portfolio companies’ disparate accounting systems…
But a closer look shows that one of iLevel’s main claims, that iLevel performs anything that could be fairly labeled as “automated data collection,” is false. Instead, individuals at portfolio companies manually enter data into an Excel spreadsheet on a monthly basis, or use macros to export data from other Excel spreadsheets, and the populated spreadsheet is then uploaded into the iLevel database. The “automated” part of the data collection, to the extent there is any, consists merely of the iLevel software generating the blank Excel spreadsheet template every month and automatically emailing it to the portfolio company employee responsible for inputting the data. The completed spreadsheet then has its data “automatically” extracted into the iLevel database….
The key issue is that PE firms want their investors and the SEC to believe that their iLevel database has been constructed in a tamper-resistant fashion, which is always a central design goal of accounting software systems. If an accounting system allows people to change entries after the fact, that system is absolutely, utterly worthless. But that’s what iLevel explicitly allows to occur because, rather than extracting the data directly, it requires portfolio company employees to re-enter information into iLevel from their general ledger accounting system. Moreover, iLevel presents as one of its advantages that “key stakeholders” can “verify and approve the data”. That’s code for “tamper with”.
Bear in mind that this software is deployed at the portfolio companies of many of the very biggest private equity funds. In addition to Blackstone, which first funded iLevel, and Carlyle, which invested later, it has over 30 clients, including Apollo, TPG, and Cerberus. Hamilton Lane does business with all these funds as a fiduciary and ostensibly reviews them for its advisory clients.
If you look at Hamilton Lane’s 2014 Form ADV on file with the SEC, you’ll see nary a mention of Hamilton Lane’s ownership stake in iLevel Solutions in its “Conflicts of Interest” section. Yet from the perspective of investors and clients, this represents a glaring divergence from their aims.
Hamilton Lane no doubt takes the position that their iLevel stake is not material from a financial standpoint and therefore does not have to be disclosed. But from a business perspective, it’s hard to see how profiting through pulling a fast one on the SEC and Hamilton Lane investors and clients in funds that have general partners that use iLevel, is not significant from a managerial and operational integrity perspective.
Need for Access Prevents New Entrants From Setting Higher Standards. Given the evidence of the caliber of Hamilton Lane’s work product and its glaring conflicts, readers might assume that a new pension fund consulting boutiques that stayed out of the fund management business and did actual due diligence rather than due diligence theater would quickly develop a following among the more discerning private equity investors.
Guess again. If any upstart tried digging into the documents and operations of general partners in a suitably rigorous, skeptical manner, the general partners would put them out of business pronto. All it would take would be a few words to the right people at the limited partner about how disruptive the new consultant was, how they were asking questions that no one asked. Given how most limited partners accept the industry mythology that the are at risk of not having general partners beg them for money, the implicit threat that they might not be “invited” into deals would be enough to cow limited partners into abandoning a firm that did solid due diligence.
Well, isn’t the SEC on to some of these conflicts? Last May, the SEC’s examination chief Andrew Bowden described widespread lawbreaking by private equity general partners. He also stressed that the contracts between the general partners and their investors, the limited partners, are vague on too many critical points and thus fail to protect the limited partners. Bowden noted, “Lack of transparency and limited investor rights have been the norm in private equity for a very long time.”
Bowden, who should know better, parrots the standard SEC view that conflicts of interest are perfectly fine as long as they are disclosed and managed. In fact, the proof is in the pudding: conflicts cannot be managed when a party nominally serving you has too much to lose in being an effective advocate.
* Note that this is not just private equity. It includes venture, private real estate, and infrastructure funds.