Nothing like elected officials using letter-writing to a weak agency and asking it to exceed its powers to hide the fact that they aren’t willing to do their jobs. And this shirking of duties is particularly grating since these officials, most important of all John Chiang, the State Treasurer of California, Thomas DiNapoli, the New York State Comptroller, and Scott Stringer, the New York City Comptroller, are powerfully positioned to propose legislation to solve the problem they are trying to fob off on the SEC.
The only good news in this pathetic case of responsibility three-cared monte by state and city officials is that it shows that they feel the need to be perceived to be Doing Something about private equity abuses.
Why the State Officials’ Letter to the SEC is a Joke
If you didn’t know better, and the tacit assumption is that the dumb chump public does in fact not know better, you might easily think a letter by state officials to SEC chairman Mary Jo White amounted to meaningful action. Here’s the overview from the Wall Street Journal; we’ve embedded a copy of the letter at the end of the post:
A group of states and cities said it intends to send a letter to the Securities and Exchange Commission late Tuesday asking for greater transparency and more frequent disclosures by private-equity funds.
Around a dozen comptrollers and treasurers from New York to California want the SEC to demand private-equity funds make disclosures of fees and expenses more frequently than they do now…
This is patently ridiculous.
The SEC does not have the authority to order more frequent fee and expense disclosures. The information that the investors receive now is what they have obtained in their negotiations at the time they invest. They can calculate management fees from one of the documents they sign, the subscription agreement; they should be able to derive the so-called carry fees from annual audited fund financial statements. Those audited financial statements also contain fund-level expense information.
These limited partners have chosen, for decades, to give private equity general partners a blank check by allowing them to use the portfolio companies purchased with the limited partners’ monies as piggy banks, with virtually no checks or oversight. Critically, the limited partners have no right to see the financial statements of the portfolio companies, nor do they get information about transactions or business arrangements between the portfolio companies and parties related to the general partner and its owners, employees, and affiliates.
Sure, the officers of these portfolio companies nominally have a duty of loyalty and care to these entities. But what do you think happens when the private equity overlords, who can fire anyone at the portfolio companies, tell their employees to engage in indefensible arrangements, like contracts that provide for handsome fee payments but do not require that any services be provided, or agree to the use accounting systems that allow the general partners to tamper with the data?
The elected officials who are asking the SEC to intervene on their behalf are all board members or trustees of pension funds that have agreed to sign remarkably one-sided agreements with private equity general partners. So why, pray tell, have they sat pat and allowed this sort of thing to go on?
The SEC has been able to get at fee and expense abuses as part of regulatory examinations that were mandated under Dodd Frank. The additional information they obtain above and beyond what the limited partners receive is considered confidential supervisory information. The SEC can’t disclose that, even assuming it would like to. Nor can it promulgate rules in a vacuum. In layperson terns, SEC rules are more detailed provisions that set forth how they implement their authority under law. The SEC can’t go about creating rules to implement powers unless it has been granted by statute.
And this particular SEC is one of the last parties you’d expect to take a more aggressive posture against powerful financial firms. As we’ve pointed out, despite the SEC having found widespread pilfering and serious compliance abuses in private equity, the agency’s fines and settlements have ranged from underwhelming to pathetic. For instance, Mark Maremont of the Wall Street Journal reported extensively on large-scale abuses by KKR involving its captive consulting firm, KKR Capstone. KKR’s limited partners (and pretty much anyone who encountered KKR Capstone) regarded it as an affiliate of KKR. That meant that any fees KKR Capstone charged would be rebated (the term of art is “offset) at a typical level of 80% against the management fee. KKR takes the eyepopping position that KKR Capstone is no affiliate even though it controls its economics. But rather than take on this significant abuse, the SEC has just settled with KKR for a comparatively penny-ante and easy to attack violation. As we noted:
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.
While the SEC could still be pursuing KKR Capstone, its pattern during the crisis with a much more high profile abuse, CDOs, was to settle on one CDO per major firm. And KKR’s modest reserving for regulatory charges says they aren’t expecting more SEC actions.
Similarly, even if the SEC actually had the statutory authority to demand more private equity disclosure, dream if you’d see rules any time soon. The SEC has been taking its sweet time on promulgating rules on high-frequency trading, CEO pay relative to worker pay, and disclosure of campaign contributions by public companies, to the point where Elizabeth Warren included rule delays in her recent sharply critical letter to Mary Jo White. The CEO to worker pay ratio disclosure was mandated as part of Dodd Frank. Dodd Frank became law on July 21, 2010. It’s more than five years and we have yet to see a proposed rule out of the SEC. And remember, any proposed rule then has to go through a comments process before it becomes final.
What State Officials Should Be, But Aren’t Doing: Propose Legislation Mandating More Disclsoure
First, with the noteworthy exception of Curtis Loftis of South Carolina, who has made a major, serious and successful push for more capture of fee and expense information by his state’s pension funds, none of the officials who have signed this letter have used the authority they already have to press their in-state pension funds to be more thorough in gathering fee and expense information.
And the intelligence-insluting part of this letter is that these state and city treasurers have the power among them to solve this problem. They could all propose state-level legislation based on language they all agreed to that would bar investment by any state or local government pension fund in alternative investments that did not make stipulated fee and expense disclosures. For private equity funds, that could include:
All fees and expenses paid to private equity general partners, any employees, affiliates or agents of the general partners as well as by agents, affiliates and investees of any owners or carry pool participants of the general partner legal entities. The language would need to be drafted as broadly as possible so as not to allow for KKR Capstone or similarly crafty efforts to create affiliates that arguably fall outside the definition.
Annual disclosure of audited financial statements of the portfolio companies to the limited partners. The limited partners should also have audit rights into fund and portfolio company level fees and expenses, with the cost to be borne by the general partner if any improper charges exceed a certain level (some thought would need to go into how to define the threshold, say having it be set as a percentage of portfolio company revenues).
Disclosure of all related-party transactions, with related parties defined again defined broadly so as to forestall circumvention
Having these state officials table this type of legislation, given their status as board members and trustees of important pension funds, would make it difficult for the legislature to fail to pass it. Nevertheless, one argument might be that any state that made such a bill law before others did would run the risk of being redlined by private equity funds, and thus could deprive retirees of attractive opportunities (given the peak of cycle multiple being paid for mid-sized companies, being out of the market is likely to prove to be a blessing in disguise). That’s solved by having the bill contain a provision that it does not become effective until states that have a stipulated percentage of total public pension fund investments in private equity have passed with certain minimum disclosures mandated.
In practice, with California having the high profile, industry leaders CalPERS and CalSTRS, which are the #1 and #2 public pension fund investors in private equity, and LACERA at #20, per the authoritative study Private Equity at Work) and New York pension funds in the #4, #10,, #13, #19, and #26 rank, it’s game over for private equity when California and New York sign up. But Oregon, whose Treasurer Ted Wheeler also signed the SEC missive, has the #5 and #6 funds, so Oregon’s participation would also be important in terms of both the amount of assets at issue as well as the message sent (Oregon was an early to start investing in private equity).
There is one way that this letter to Mary Jo White is a plus: the private equity industry has been trying to assert that the SEC exams are intrusive and that the limited partners see them as disruptive and unproductive. These state officials are saying loudly and clearly that they want the SEC doing more, not less. That fatally undermines the private equity propaganda campaign to depict the limited partners as supporting their efforts to curtail or end the SEC oversight. Private equity investors have gotten the message that they are being fleeced and they need a lot more information to stop these abuses.
So I hope readers will send this post to any current public employees or public pension fund beneficiaries you know in any of the jurisdictions whose officials signed the SEC letter (California, the District of Columbia, Missouri, New York, Nebraska, North Carolina, Oregon, South Carolina, Rhode Island, Vermont, Virginia, Wyoming). Please encourage them to contact state officials and tell them to stop asking the toothless and overburdened SEC to do their job. They’ve come to recognize that private equity grifting and sharp practices need to stop. They have the power to make that happen. It’s time they use it.