SEC Starts Issuing Wells Notices to Private Equity Firms (Updated)

We tweeted last week:

Our source was correct. Two days later, the Wall Street Journal reported that private equity firm Fenway Partners had received a Wells notice, which means the agency is planning to lodge an enforcement action. Bear in mind that Wells notices do not mean that an enforcement action is inevitable; as the Journal story points out, in about 20% of the cases, the recipient is able to muster enough of a defense so that the SEC does not move forward.

Our source was quite disappointed that only one case has yet hit the press; he’s heard of quite a few more firms getting Wells notices. The SEC, quite sensibly, seems to be taking particular interest in zombie funds like Fenway. From the Journal account:

Between its founding and 2006, Fenway raised three buyout funds ranging in size from $500 million to $900 million. Despite some lucrative deals, the funds have been middling performers. None has returned better than 1.5 times investors’ money, according to public pension-fund data, and Fenway has told investors it wouldn’t raise another.

As with Fenway, zombies result when a private equity general partner has had such lackluster performance that it is unable to raise new funds. Recall the typical cycle of private equity: most firms launch a fund 4-5 years after their last offering (megafunds may offer specialized funds, such as sector or geographically focused funds, more often). But the life of most private equity funds is ten to fifteen years. So if a fund manager is effectively in runoff mode, his incentives are to milk his outstanding funds. It’s common for the fund to get rid of everyone save the founders and the bare minimum in the way of support roles so they can keep as much of the management fees for themselves as possible. And since they no longer have to worry about staying in the good graces of the limited partners, they are even more tempted to steal than most general partner are (recall that the SEC’s Andrew Bowden stated last May that more than half the firms they had examined thus far were engaged in serious misconduct).

While this news report does indicate that the SEC is starting to deliver on its repeated public statements that more private equity enforcement actions are in the pipeline, the Fenway case, like the earlier Lincolnshire settlement that we discussed at length, is troublingly consistent with the idea that the agency is primarily pursing smaller targets that won’t mount much in the way of a defense. Fenway, for instance, never raised particularly large funds. A zombie firm has no franchise to protect, and less in the way of ongoing cash flow to contest an SEC civil action, if things were to go that far. Thus for them, settling is a straight up economic calculation of the cost of paying the SEC what it wants versus incurring the legal costs of fighting back and the expected value of what the court would visit on them if they were to lose.

And keep in mind that going after zombies does not threaten the vaunted reputation of the industry. These funds were losers performance-wise; the incumbents can take the position that the desperate actions of these losers has nothing to do with them. So this effort allows the SEC to burnish its image without getting major figures in the industry to pressure the SEC for alleged undue zealousness.

In fairness, the Journal story does point to evidence that the agency is also arm-wrestling with industry giant KKR, which was fingered by the Wall Street Journal for dubious billing practices by its captive consulting arm KKR Capstone, and by the New York Times for not sharing other types of fees as investors expected. But so far, KKR is the only major firm were there has been any public evidence of SEC action, when the agency was telling people privately that in private equity, unlike other areas it supervised, it was finding greater levels of misconduct among the larger players). Thus, we see no change from what we’ve expected: a few token actions against the big players, just as we saw one CDO case per major bank when they sold far more in the way of toxic CDOs, and far more concerted efforts against the small fry.

Update 2:00 PM: Chris Witowsky at Reuters’ PEHub has more detail:

New York-based Fenway Partners, which has raised more than $2 billion across three core funds since its founding in 1994, received a Wells Notice from the SEC in early March, the sources said…

The SEC informed Fenway about various issues it has been looking at, including payments made by portfolio companies to Fenway Consulting Partners LLC, sources said. The exact relationship between Fenway Consulting Partners and the firm is not clear.

The regulator is also looking into how the firm has handled disclosing to limited partners information related to fund financial statements and a GP clawback. A clawback obligation arises when a fund manager takes distributions early in the life of a fund that eventually have to be returned to investors because they turn out to have exceeded the agreed-to profit share….

However, Fenway does shed light in its latest Form ADV filing, current as of March 31, 2015, both how it charges portfolio companies fees and expenses and how much of that activity it reveals to investors. For example, the firm charges portfolio companies expenses in connection with services performed. Such expenses can include limousine service, first-class travel and late-night meals in the office.

Portfolio companies reimburse the firm for those expenses, but the amount of the reimbursement “often will not…be disclosed to investors in the funds,” the firm said in the filing.

Fenway almost certainly owes clawbacks on all its funds. It’s best IRR was a pathetic 1.4% Most funds are subject to an 8% hurdle rate but also have a deal-by-deal carried interest payout structure. This is perverse, since early deals typically have the best returns, and Fenway likely had some transactions that produced better than 8% returns. It would thus be on the hook to make good when the fund was wound up. However, the overwhelming majority of investors finesse that. Rather than paying money back, they instead offer a fee reduction on the next fund. However, with a GP that produced serial dogs like Fenway and then went zombie, this gambit clearly would not have worked for the last fund, and likely did not get much uptake for its immediate predecessor, raising the question of whether clawback payments were made properly.

It also seems pretty dubious to try to clear up what appears to be years of inadequate disclosure by tidying up the current Form ADV. We’ll hopefully see how well that goes over with the SEC in due course.

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  1. PEInvestor

    Where is Mr. I want my son to work in PE on this? Seems to be a mixed message coming from the SEC.

  2. Jay M

    Fenway Partners in NYC–my head is about to explode.
    NYC is adequately supplied with swamps.

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