The SEC has taken action against a major private equity firm, KKR, slapping it with close to $30 million in charges, consisting of $10 million in penalties and nearly $19 million in disgorgement and interest. We’ve embedded the SEC order at the end of the post.
The agency had described widespread lawbreaking in the industry over a year ago, in a surprisingly forceful speech by its now former head of examinations, Andrew Bowden. Critics had pointed to the disconnect between the fact that Bowden said that more than half the firms examined had engaged in what amounted to stealing or other serious compliance violations, yet the agency was entering into only penny ante settlements and orders against small players.
The settlement with KKR is not as much of a departure from this practice as it might appear. While it’s a step in the right direction to see the agency take on one most powerful firms in this industry, these fines are nuisance level to a player as large and profitable as KKR. The scam is straightforward: KKR incurred what are called “broken deal expenses” for transactions that were not completed. For the funds in question, these charges totaled $338 million from 2006 to 2011. KKR had so-called “flagship” funds, which were marquee funds, and co-investments in these funds, where preferred parties invested in particular companies in these funds without paying the same fees the limited partners pay. Co-investors are in a preferred position, effectively investing alongside the general partner. The co-investors here included KKR executives and consultants (almost certainly from its captive consulting firm, KKR Capstone).
The SEC found that KKR had been making the preferred status of the co-investors and KKR itself too preferred, by virtue of allocating virtually all the broken deal expenses to the chump limited partners when 20% should have been allotted to the co-investors. The amount of the misallocation was $17.4 million. Amusingly, the order describes how KKR tried to get out in front of the SEC by refunding investors $3.26 million in broken deal expenses for 2009 to 2011 while the SEC was examining KKR’s expense allocations. In other words, KKR looks to have been making remedies only as a result of the SEC showing up, and then presumably to forestall fines and other penalties. The basis for the fines and disgorgement was that KKR had breached its fiduciary duties and had failed to implement written policies on this matter until 2011, when it was obligated to do so when it became a registered investment adviser in 2008.
It’s hard to tell if the fines are adequate since we can’t tell how egregious the conduct was (the fact that KKR suddenly tried to shape up when the SEC started its exam suggests they were plenty aware). But more important, we have no idea if the SEC is being as serious about going after private equity misconduct as the Bowden speech last year says they ought to be or whether the agency will revert to its practice with CDOs, of hitting each major market participant with a case on one particular deal to get the headline value, when all of the big CDO sponsors pumped out lots of toxic product.
As troubling as far as reading the SEC’s actions to date is that expense-shifting is one of the simplest forms of grifting that general partners engage in. That means it is also comparatively easy for the agency to pursue. There is no evidence so far that the SEC has the competence to take on more complex abuses, which would work out to be a huge boon to the industry, since its sharp practices are typically tough to ferret out. Thus while this order is a step in the right direction, it’s way short of what is needed. We’ll see soon enough if the agency is capable of making a real dent in private equity misconduct.