Marc Wyatt, the acting director of examinations at the SEC, was asked to give a speech at the same annual conference where his predecessor, Andrew Bowden, gave his now-famed Spreading Sunshine in Private Equity speech. As we said at the time:
In the years that I’ve been reading speeches from regulators, I’ve never seen anything remotely like Bowden’s talk….
Despite the at times disconcertingly polite tone, the SEC has now announced that more than 50 percent of private equity firms it has audited have engaged in serious infractions of securities laws. These abuses were detected thanks to to Dodd Frank. Private equity general partners had been unregulated until early 2012, when they were required to SEC regulation as investment advisers.
The Bowden speech also highlighted the degree to which private equity investors, aka “limited partners,” were derelict in their duties, since most are fiduciaries. He described how they have entered into agreements that are vague on many key issues, provide for inadequate oversight, and thus allow private equity general partners to take advantage of their investors. The general partners control the cash flows of the companies their funds owned while not having to provide investors with any information about what fees and expenses they extract from them. This is a license to steal.
As regular readers may recall, after this bold speech, Bowden went quiet and then walked back much of what he had said, at least as reported in interviews with industry publications and summaries of his remarks at industry conferences. Bowden attributed his softened posture to a change in industry attitude, but that seemed implausible in light of the deep-seated sense of entitlement in that industry.
Bowden resigned after we published a video of an appearance he made on a panel at a Stanford Law School conference where he said he’d like to see his son work in private equity and made other fawning remarks. Wyatt, who has gotten a battlefield promotion, is thus in an awkward position, in that he now has to clarify the agency’s position on private equity. The SEC needs to be seen as taking a firmer posture towards private equity. The choice of Wyatt, who came out of the private equity exam unit, is no doubt meant to signal that the agency is still committed to cracking down on private equity (it remains to be seen whether the SEC’s idea of being serious corresponds to what the public wants to see). Moreover, even if, contrary to the SEC’s history, the agency had decided to go full bore against private equity misconduct, it could not say much about pending enforcement actions.
So what to make of this talk? Wyatt gave a cautious speech, and seemed to be saying the bare minimum that he thought was necessary. Nevertheless, three parts stood out.
First was that Wyatt effectively thanked the media for supporting the SEC’s efforts. If you know the history of the major press stories in the last year, all the changes in conduct that Wyatt describes look to be the direct result of Grecthen Morgenson of the New York Times and Mark Maremont of the Wall Street Journal documenting specific types of private equity grifting and the industry being embarrassed into restraining itself a tad. Here’s the relevant section of the speech:
…. there have been many press articles detailing the breadth and depth of some of the practices contained in the Sunshine Speech. Investors are more focused on fee and expense topics, and the industry is reviewing and often changing the practices highlighted a year ago….
In our exams we see that some advisers are changing fee and expense practices. For example, the practice of accelerating monitoring fees when a portfolio company is sold or taken public appears to be falling out of favor and the use of evergreen provisions in monitoring agreements, which often enable advisers to take large monitoring agreement termination payments, appears to be declining. Additionally, the collection of revenues from portfolio companies’ use of group purchasing organizations is being better disclosed and contained.
Morgenson wrote major stories on accelerated monitoring fees (also called “termination fees”) and so-called evergreen fees; Maremont exposed group purchasing abuses. Blackstone announced it was ceasing the practice of charging termination fees, making it hard for other general partners to continue the practice. KKR also admitted it had rebated some ill-gotten fees and expenses, albeit only directly to limited partners when asked, and not the public at large.
The second noteworthy element was that Wyatt also told the industry that telling investors that they were being charged fees after they had signed investment documents, via their required annual investor disclosure form, didn’t remedy bad conduct as far as the SEC was concerned.
However a third aspect was that the SEC appeared to be giving limited partners way too much credit for getting tougher with general partners:
We have also seen changes in the limited partner community. Institutional investors have long taken due diligence seriously. Nonetheless many were surprised by some of the practices we discovered. The private equity business is complex with many moving pieces with the adviser frequently controlling operating companies and other entities. At the same time, private equity operations are not always transparent to investors. This, combined with the fact that many LPs do not have the staff or access to delve as deeply into manager operations as our examiners, may create an environment where bad conduct can occur.
While some of these dynamics are structural and therefore not likely to change significantly, OCIE believes that our examinations have enabled limited partners to better focus their resources and priorities. Some of this focus takes the form of new due diligence procedures. For instance, from OCIE’s discussions with institutional limited partners we have observed that operational due diligence, once thought to be unnecessary in private equity, is now taking a greater role at many organizations. And, while access to the top managers and economic terms are still critical factors in private equity manager selection, according to those institutional limited partners, transparency, governance, and access to information have all grown in importance.
This lip service to limited partner efforts is particularly depressing if the agency actually believes it. As we’ve described at some length, private equity due diligence is an exercise in form over substance, since the limited partners are afraid to rock the boat with general partners by getting tough in due diligence and in asserting their rights generally. Moreover, the hired guns on which the limited partners rely are generally far more loyal to the private equity firms than their nominal clients. In some cases, as in with law firms, it’s well nigh impossible to hire an unconflicted firm that is competent, and given how much private equity firms spend in legal fees, law firms are clearly keener about watching out for their better meal tickets. The shoddy state of private equity limited partnership agreements alone is proof; see our post on Ropes & Gray for a specific example of this syndrome.
As far as specialized consultants are concerned, private equity firms can easily put them out of business by telling cowed limited partners that their advisor is too aggressive or poking into minutae. That’s partly because limited partners believe the industry myth that the private equity firms might stop begging them for money if they get too uppity.
And worse, Wyatt propagates another industry fable. Note this remark; “And, while access to the top managers and economic terms are still critical factors in private equity manager selection…” First, as we detailed, the belief that outperformance of top managers persists is no longer valid, so the strategy of tying to get into top quartile funds no longer works. Second, trying to find the “best” managers was always a flawed concept. As we explained:
Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity. The investment consultants go through the shooting-fish-in-a-barrel exercise of convincing their institutional clients that each of them is prettier, smarter, and more charming than average, and therefore capable of achieving sparking results….
Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.
So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
Wyatt also parrots the limited partners’ belief that they are doing an effective job of negotiating fees. But if you look at the reports prepared by industry consultants, they are embarrassingly superficial in how they review fees. Oxford professor Ludovic Phalippou explained in a 2009 paper that this sort of simple-minded comparison is misleading. For instance, a supposedly standard terms like a 20% upside fees subject to an 8% hurdle rate, using a representative set of fund cash flows, could lead to success fees being as as low as $7.5 million or as high as $19 million depending on the definition of key terms. The lack of attention to detailed contractual provisions means these consultants are being paid for liability avoidance, not bona fide due dilingence. The proof is that, as David Sirota and Gretchen Morgenson both publicized recently, private equity benchmarking firm CEM recently publicized that private equity firms have no idea, and worse, given the inadequate disclosure and oversight, can have no idea what they are paying in total fees and costs to private equity general partners. So with that abject level of ignorance, how can the SEC believe that limited partners are doing anything other than a failed job of due diligence and oversight?
So it is more than a bit alarming to see signs that the SEC does not know the industry as well as it thinks it does and thus is too willing to accept limited partners’ view that they are getting tougher with general partners, when we’ve seen evidence of the reverse: that limited partners have circled the wagons with the private equity firms, and have not asked the sort of pointed questions they should be asking in light of Bowden’s disclosures of embezzlement and other serious misconduct last year.
The nod to the press shows that Bowden was on the right track. The private equity industry will continue to get away with its impressive level of abuses as long as it can keep its activities under wraps. Even with the diligent efforts of able reporters, most of the information that the media and broader public needs to oversee the industry, most important, its legal agreements and company-level cash flows, are still treated as state secrets. Much greater transparency is a necessary condition for cleaning up this deeply corrupt industry.
Disclosure: We have made a private equity whistleblower filing to the SEC