Another day, yet another private equity exposé, this one on an atypically simple-minded scam.
Gretchen Morgenson at the New York Times describes how private equity firms arbitrage legal fees. They dispense so much in the way of legal fees, between buying and selling companies, arranging for financing, and raising funds, that they are the most sought-after clients of big law firms and accounting firms. That means they are in a position to obtain discounts.
But guess what? The only beneficiary of the private equity firms’ buying power in too many cases is the private equity firm itself. The general partners get a break for themselves, on the back of the vastly greater dollar value of fees generated at the portfolio company and limited partnership level. The investors pay the rack rate or even a premium.
Let’s use an analogy. Let’s say you inherit a large office building. You’ve got no interest in running it and don’t trust the people your rich relative had running it. You have a good buddy who is a semi-retired real estate maven who owns a couple of small buildings. You ask him to manage it. He arranges to do all the normal things, like bill tenants and deposit their funds, supervise capital investment projects (like upgrading elevators), and handle routine maintenance. As part of what his job, he’s engaged outside companies to handle building cleaning and security.
You learn that he’s arranged with these companies to have them charge you their regular price even though you are such a big customer that you’d normally get a discount. Worse, he’s using the same companies at his buildings and getting the services for nearly free, even though on his own, he’d not get much of a price break.
The Times story is a little leisurely in getting to the the real dirt. At the seventh paragraph provides a crisp statement of the abuse:
Wealthy private equity funds receive discounts on legal, accounting and other outside work while pension fund investors, like retired bus drivers, librarians and teachers, pay full freight or, in some cases, a premium.
And the next bit juicy detail starts at the 21st paragraph:
Consider a filing by Apollo Global Management, the private equity behemoth overseen by Leon Black. It states that Apollo and its funds receive discounts on plain vanilla legal work such as employment contracts and regulatory filings. Apollo and its investors also receive discounts, its filings show, on charges known as broken-deal fees, which arise when a proposed acquisition or sale of a portfolio company is not completed.
No discounts are given on investment transactions, including those charged to investor-owned funds managed by Apollo, however. In fact, Apollo says that for these transactions, outside service providers often receive a premium beyond the level of customary rates.
“Legal services rendered for investment transactions,” the filing states, “are typically charged to the Apollo Private Equity Managers, their affiliates and clients on a ‘full freight’ basis or at a premium.” Because investment transactions typically occur in investor-owned funds, they end up paying the bulk of the premium prices.
Keep in mind that the actual abuse may be greater than what is presented here. Rate breaks aren’t the only way that law firms make price concessions to keep clients happy. Keep in mind that over the last 30 years, the hourly billing model has been under attack. Large corporations often complain that invoices are too high. Many professional firms discount their bills when asked to out of fear of losing the client. Partners can and often do discount bills by writing off hours or never entering them at all. If PE getting any of those indulgences because big clients with investors proportionately, which means bulk of bennines should to go investors.
Mind you, these are all common quid pro quos, but given the pattern Morgenson has exposed with billing rates, it’s not hard to imagine that only the general partners would receive the other forms of preferential treatment. It’s a certainty that requests for advice on small matters, the sort of thing that would be treated as a freebie for a good client would be on the meter for the portfolio companies. Moreover, the beauty is that because there’s no paper trail of written-off or unbilled hours at the general partner, there would be no need for disclosure.
And this issue exposes a corporate governance fiction. The private equity-owned companies have their own officers, such as presidents and corporate secretaries, who owe a duty of loyalty and care to the corporation. Yet the private equity overlords foist lawyers on the portfolio companies, and in the case of Apollo, require them to agree to pay premium rates. The lawyers entering into these arrangements know full well that the executives at the investee companies should challenge these billing schemes, but no one is about to buck a big-ticket paymaster.
It appears that this story got to Morgenson by virtue of a former CalPERS board member turned private equity researcher presenting evidence of this practice to some CalPERS board members, and potentially to other pension funds as well. Board member JJ Jelincic, who has almost become a regular here by virtue of taking the rare role at CalPERS of digging into questionable private equity practices, gave the only sensible reaction of any of the investors quoted in the Times story:
“It puts the lie to the fact that we are partners with the private equity firms,” Mr. Jelincic said. “We are simply a source of income to the general partners; we are not partners.
By contrast, consider the misdirection in the official CalPERS comment:
Joe DeAnda, a Calpers spokesman, said in a statement: “Calpers has long been a leader in advocating for fee economies and transparency, including in private equity. We have been actively engaging with some of our private equity partners to help improve the disclosure and data available, and have been closely monitoring the regulatory announcements and attention around this subject.”
First, DeAnda exhibits precisely the sort of cognitive capture that Jelincic highlighted, that of thinking that someone who sees (and treats) you as a meal ticket should be thought of as a partner. But confusing legal structures with the actual economic relationship is pervasive among investors. Second, the fee issue is not a transparency problem. It’s an abuse of fiduciary duty. And it’s not remedied by ex post facto disclosure in Dodd Frank mandated SEC filings after the investment was made (Form ADV).
The New York City Comptroller, Scott Stringer, gives an even more lame response:
Asked how he views the potential conflicts relating to vendor discounts, Mr. Stringer said: “The S.E.C. has raised serious concerns, and we support them taking a hard look at this issue. It’s clear that we still don’t have enough transparency from our private equity partners.”
“We support the SEC taking a hard look.” How about doing your job for city retirees and asking some questions yourself? Aren’t you the one ultimately responsible for the handling of these funds? Not only does he want the toothless SEC to do his work for him, but he makes it clear he’s not interested in rocking the boat. All he wants is a “hard look”. It looks like Stringer is an ambitious enough pol that he does not want to alienate future campaign donors. And again, we have the “transparency” dodge and the mischaracterization of firms as partners when they are actually taking advantage of his dereliction of duty.
Another ugly bit here is that the law firms are complicit in this behavior, and many of them work both sides of the street. For instance, we wrote early on about how Boston’s blue-chippiest firm, Ropes & Grey, using it to warn the candidate we hoped would win the New York City comptroller’s race, Eliot Spitzer, was not only working on every side imaginable of private equity transactions, but was also taking advantage of a loophole in standard conflicts of interest waivers for its partners to take an economic position in deals ahead of and in clear conflict with that of its longest-standing client, Harvard. We didn’t bother addressing this post to Stringer too because it was clear he was too unsophisticated and spineless to take on private equity kingpins. So why aren’t investors at a minimum also asking law firms that represent them, if they also represent private equity firms, what their discount and other billing practices are?
And as readers are seeing, Stringer, who oversees a pension system that is one of the largest private equity investors in the US, typifies the complacency that makes pension funds such easy prey for private equity firms. It’s time that fund beneficiaries, meaning retirees, as well as taxpayers who are ultimately on the hook, start raising hell with state and local politicians who have a role in pension fund supervision.
Disclosure: We have made a private equity whistleblower filing to the SEC