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I suspect that reporters who’ve been digging into private equity have similar reactions to mine: every time you turn over a rock, more creepy-crawlies emerge.
Gretchen Morgenson, in her Sunday New York Times column, returns to the lack of transparency in private equity fees and costs and provides some troubling new examples of how investors are kept in the dark, or just as bad, have information presented to them in such as way as to well-nigh insure that they won’t appreciate the significance of what they are saying. This is important because, as is widely recognized in the investment management industry, fees and costs eat into investment returns. That’s the rationale behind passive strategies, aka index funds, because it’s well-nigh impossible to find an “active” manager who can consistently produce enough in excess returns (alpha) to justify his higher fees. In keeping, a recent study by the Maryland Policy Institute confirmed its earlier findings, that high-fee strategies like private equity cost public pension funds billions of dollars compared to cheaper options.
And the overarching issue is that investors in private equity like public pension funds have no idea how much they are paying in total costs and fees. The lack of transparency not only means they are ignorant of the total drag, but it also means they can’t negotiate effectively to reduce costs, particularly since many private equity charges are cleverly structured so that if you squeeze the balloon one place, the private equity managers can recoup much or all of the apparent fee reduction somewhere else.
And as we’ll discuss shortly, Morgenson catches out KKR making a misrepresentation to her, and possibly to investors, since one assumes that what a flack would say to her would typically be consistent with how it responds to limited partners. I’ve had private equity press people say things to me that are contradicted by their SEC filings, so the KKR misdirection appears to be typical industry conduct.
Morgenson starts by describing California state treasurer John Chiang’s proposed legislation for full disclosure of private equity fees and costs, as well as SEC enforcement actions against private equity firms.
But many charges, which are shifted from the private equity fund legal vehicle onto the portfolio companies that the funds own, remain hidden. For instance, the most recent $39 million Blackstone settlement involved fees paid mainly or entirely by the portfolio companies. One involved abuse involved monitoring fees paid by portfolio companies, and the second involved the law firm discounts, where Blackstone was using the same firm for its own legal work as well as for its private equity funds and their investee companies. Blackstone itself was getting the discounts when the overwhelming majority of the legal work was done on behalf of the investors. And given that the really big ticket legal items in private equity result from buying and selling companies (which includes taking them public), those charges are billed to the portfolio companies, and are thus hidden from investors.
Morgenson points out that some dubious practices that have been exposed by the media have yet to be corrected by the SEC. The agency apparently thinks it’s OK to cheat investor if you’ve sorta told them. One type of misconduct, which we’ve discussed at length, is the misrepresentation during the marketing period of who exactly is paying for the “team” that will be making and overseeing the investments. The limited partners were stunned to learn in the Wall Street Journal that the staff of KKR’s captive consulting firm KKR Capstone are not part of KKR’s overhead but are billed to portfolio companies as if they were an independent operation. This practice is mirrored across the industry, as professionals shown on private equity firm websites as “senior advisers” are, much to investors’ surprise, typically hired guns.
Despite all the media scrutiny, the SEC has not forced the private equity general partners to make sufficient disclosures so that investors can ascertain where the use of advisers is consistent with what they were told during the marketing period and what is permitted by the limited partnership agreements. As Morgenson reports:
Some private equity firms acknowledge that their fee disclosures are incomplete. A recent regulatory filing by the industry giant Silver Lake Partners states that fees paid to “engage and retain senior advisers, advisers, consultants, and other similar professionals who are not employees or affiliates” will often not be disclosed to investors.
A Silver Lake spokeswoman declined to comment.
This matters because, as we have discussed, the SEC is woefully understaffed and seems to regard (at best) selective enforcement as adequate to stop bad practices. But it has yet to bring an enforcement case on this particular type of grifting. The Silver Lake disclosure troublingly suggests that the SEC will treat acknowledgement of the adviser issue as adequate, when limited partners have arguably been ripped off for decades, and continue to be deprived of the information they need to determine how much has been taken from them via this device.
Morgenson describes a new nasty: that charges are masked by deducting them from the proceeds of the sale of companies. She reports on one sneaky case, that of when KKR was on the hook for the settlement of a an anti-trust case that alleged collusion to suppress the price in the bidding on a public company.
KKR was able to pass the cost of the legal settlement on to investors because its limited partnership agreements have very broad indemnification language. We happen to have a copy of the very KKR limited partnership agreement at issue in our Document Trove.You can search for “indemnification” and find the section 6.6.3 on p. 40-41. We’ve written before on how private equity general partners seek to escape their fiduciary duties through various contractual terms.
One of the mechanisms is the aggressive indemnification language, which strongly resembles the indemnification language used when companies hire merger and acquisition advisors. But the relationship is completely different: M&A firms are advising principals who are very actively involved, and have to have board and sometimes shareholder approval to consummate a meaningfully-sized deal. By contrast, the very structure of a limited partnership requires that the investors be passive. Allowing the general partners to reduce their liability as fiduciaries is utterly inappropriate, yet that is precisely what limited partners have accepted.
So with this knowledge, what KKR has done it to try to hide the cost of this limited partner negotiating lapse. As Morgenson explains:
As is typical among private equity deals, K.K.R.’s 2006 fund agreement required its investors to cover the costs of such legal settlements. K.K.R. settled the collusion matter in 2014.
Rather than show the $38.6 million charge to investors as an expense in the financial statements, K.K.R. noted it on Page 35 of the 37-page report. The obligation would be paid to K.K.R. out of “realization proceeds allocable to the fund” upon the sale of fund investments, it said. The charge had been deducted from the portfolio companies’ values as presented to investors, the report said…
Because the K.K.R. report is confidential, few beneficiaries of pensions invested in the 2006 fund knew that they were paying toward $38.6 million in settlement costs. These beneficiaries include schoolteachers in California, Kentucky, Louisiana and Texas, and public employees in Idaho, Illinois and Iowa.
And Morgenson closes with a discussion of what KKR tells private equity investors about the companies they own in its periodic reports (and note that even when they are audited, the standards are lover than for public company audits; for instance the auditors do not opine on the adequacy of financial controls) does not square with the information given to investors to KKR’s financial reports to KKR shareholders:
Materials sent this year to investors in the K.K.R. 2006 fund contained a Dec. 31, 2014, table listing transaction and monitoring fees paid to K.K.R. by 14 portfolio companies. A portion of these fees, totaling $7.2 million, offset or reduced K.K.R.’s management fees.
But some of the figures in the table are far lower than the fee amounts reported in regulatory filings issued by the same portfolio companies. An example is Samson Resources, a troubled oil and gas company. The K.K.R. 2006 fund report showed Samson paid transaction and monitoring fees of almost $1.1 million for the quarter that ended on Dec. 31, 2014. But public filings state that Samson is contracted to pay K.K.R. at least $2.8 million each quarter.
And we see the KKR spokesman making a misrepresenation:
Ms. Huller said that the 2006 fund document reflected only the expenses that were allocated to investors in that particular fund and that the additional money paid by Samson was allocated to investors in other K.K.R. vehicles…
But K.K.R.’s investment advisory filings state that the firm may not use the expenses allocated to other vehicles to offset management fees. So if investors think the figures in the 2006 fund table reflect all the monitoring and transaction fees received by K.K.R. from their portfolio companies, they are most likely wrong.
To unpack this: the documents that KKR provided to investors in its 2006 fund says they paid just shy of $1.1 million in transaction and monitoring fees for the last quarter of 2014. But the audited statements to KKR show that Samson is obligated to pay a minimum of $2.8 million a quarter. The KKR spokesperson tried to fob that off by saying investors in other investment vehicles bore those costs. But that is contradicted by SEC form ADV filings that say KKR can’t do that. So basically, either the flack lied to Morgenson or KKR lied in its SEC filings.
One suspects that the divergence could result from KKR choosing defer some of the fees it is owed, and it plans to recover then in a restructuring or sale. But irrespective of what machinations are underway, the investors in Samson aren’t getting an accurate picture from KKR.
One of Morgenson’s sources underscores how utterly irresponsible limited partners have been:
“In any other investment context, it would be uncontroversial that investment managers should disclose all the fees they extract from the corpus of their clients’ assets,” said Michael Flaherman, a former Calpers board member who researches private equity practices as a visiting scholar at the University of California, Berkeley.
This is being charitable. The fact that it has taken more than 18 months of major media stories on private equity limited partner fecklessness to stir embarrassed elected officials to act shows how badly the limited investors are captured as well as how outmatched they are. While California treasurer John Chinag has taken a bold step forward in proposing long-overdue legislation, this is only the opening battle in what is certain to be a protracted struggle to bring private equity general partners to heel.