New Study Blasts Private Equity Fee Abuses, SEC and IRS Enforcement Failures, Limited Partner Capture

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Eileen Appelbaum and Rosemary Batt have released a new report, Fees, Fees and More Fees: How Private Equity Abuses Its Limited Partners and U.S. Taxpayers, which we have embedded at the end of this post. The study covers the major developments in private equity since the publication of their landmark book, Private Equity at Works, namely, the SEC’s and media’s exposure of widespread misconduct in the private equity industry. Even though Appelbaum and Batt use a judicious academic writing style, the information they marshall is damning. Even though much of the terrain will be familiar to NC regulars, I encourage you to read it in full, since it recaps a wide range of abuses in a compact form, It also discusses the weak enforcement efforts of the SEC, the IRS’ tardy moves to target loopholes and abuses, and limited partner complacency and capture.

A partial list of important issues:

IRS Failure to Crack Down on Monitoring Fee Tax Dodge

As Lee Sheppard wrote in Tax Notes, “Private equity often seems like a tax reduction plan with an acquisition attached.” We’ve repeatedly criticized monitoring fees, based on the work of Oxford professor Ludovic Phalippou and other experts, as “fees for nothing”.

Portfolio companies enter into monitoring fee agreements with their new private equity overlords, supposedly because the general partners will be doing work on behalf of the companies. In fact, these are not arm’s length agreements, and the monitoring agreement are set up so that almost without exception, fees are to be paid whether or not the general partner gets out of bed on behalf of its investee company. We wrote about the tax aspects of that abuse, based on a paper by University of North Carolina law professor Gregg Polsky in 2014:

The monitoring fee abuse is so crass that unlike pretty much anything related to tax, it is easy to explain. You may recall that once a private equity firm buys a company, it typically makes the company sign an agreement to hire the private equity firm or an affiliate* to provide various services to it for a flat fee per year for a long period of time, typically ten to twelve years. That means that the payment to the private equity firm is tax deductible to the portfolio company.

Well, you might say, what’s wrong with that? The wee problem is that when you look at these agreements, it’s clear no business would enter into this arrangement. While the portfolio company has an unambiguous obligation to make payments to the private equity firm, the private equity firm is under no obligation to do anything to justify getting these fees. I’m not making this up, as this highly engaging video called “Money for Nothing” by Professor Ludovic Phalippou of Oxford attests. The entire video is worth watching, and the critical section starts at 8:00

Here is his translation of the services agreement:

I may do some work from time to time
I do some work, only if I feel like it. Subjective translation: I won’t do anything.
I’ll get [in this case] at least $30 million a year irrespective of how much I decide to work. Subjective translation: I won’t do anything and get $30 million a year for it.
If I do decide to do something, I’ll charge you extra
I can stop charging when I get out (or not), but if I do I get all the money I was supposed to receive from that point up until 2018.

This payment for non-services doesn’t wash with the IRS. For an expense to be deductible, the payment must have compensatory intent, as it is supposed to pay for something and that payment has to be reasonable in terms of what was received. The “Money for Nothing” scheme that Phalippou describes should be a non-starter, yet it’s widespread and the IRS has failed to intervene.

Appelbaum and Batt take up the fact that these monitoring fee payments are in fact disguised dividends, and should not be tax deductible to the portfolio company. They also point out that the worst of the “money for doing nothing” abuses, termination of monitoring fees and evergreen fees, are egregious tax abuses.

Three major unions, the AFL-CIO, AFSCME, and the American Federation of Teachers, as well as five other public interest groups, including Americans for Financial Reform and Public Citizen, sent a letter to the Treasury Department and IRS, in parallel with the publication of the Applebaum and Batt study. It points out that the media has reported on this abuse for over two years, yet the agency has failed to act. Moreover, a tally that was inherently incomplete identified close to $4 billion of dubious monitoring fee payments in five years. The letter also pointed out the broader effects, that these payments deprive companies of cash flow they could use to invest in operations. Please forward the letter at the very end of the post to your Representative and Congressman and express your opposition to this abuse.

Failure to Regulate Private Equity Firms as Broker-Dealers

This is another topic we’ve written about that has not gotten as much attention as other forms of private equity chicanery. Many take transaction fees that clearly require them to register as broker-dealers. Not only are almost no private equity firms complying, but the few that do are not taking the private equity transaction fees through their broker-dealer units. From the report:

Because transactions of this type create potential conflicts of interest, they are typically covered by securities laws designed to protect investors. Securities laws require that anyone engaged in the business of affecting transactions in securities for the account of others must register as a broker and be subject to increased oversight by the SEC to ensure fair behavior. The SEC requires that the advice that is provided is “suitable” and imposes penalties on broker-dealers for violating this standard…A whistleblower case filed in 2013 by a former PE executive identified 200 cases of unregistered broker-dealer activities related to private equity LBOs over the prior decade, including 57 cases worth $3.5 billion in fees.

As we’ve stressed, the SEC’s failure to address abuse is troubling on two fronts. First, this is a long-standing, clear-cut violation and there’s no rationale for letting sophisticated players who are advised by highly paid securities lawyers to get away with it. There’s no rationale to support the SEC’s “do nothing” posture. As Appelbaum and Batt point out, requiring that private equity firms adhere to broker-dealer standards would increase oversight and force improvements in conduct.

Second, the sanctions for acting as an unlicensed broker-dealer are serious: dollar-for-dollar for the transaction value. The size of potential fines is a powerful lever for requiring more serious settlement payments on other fronts.

Third is that, astonishingly, the SEC has been giving miscreant private equity firms “eligible issuer” waivers despite their flagrant, ongoing violation of broker-dealer rules.

Debunking General Partner Propaganda That SEC Settlements Come Out of Limited Partners’ Pockets

Limited partners have been grumbling about multi-million dollar private equity fines out of the mistaken belief that the sweeping indemnification agreements that they sign means they are on the hook for those charges. And reading the language in the limited partnership agreements we’ve obtained from KKR, Blackstone, Carlyle, Apollo, and TPG, as well as other players, that would seem to be a reasonable conclusion. The SEC orders, which it publishes on its website, do not contain any prohibition that the general partners not hit the limited partners up for these bills.

However, it turns out that the SEC order does not disclose the full terms of the deals with the miscreants. From the section of the report on indemnification provisions:

In the context of possible SEC enforcement actions related to abusive fee practices of general partners, however, it is important to note that the SEC’s Letter of Acceptance, Waiver and Consent that accompanies settlements in administrative proceeding and enforcement actions prohibits GPs from activating the indemnification clause in the LPA. The GP must make restitution and pay any fines. Unlike the SEC’s enforcement order, which is published, letters of acceptance, waiver and consent are not public documents; many LPs mistakenly believe they will bear some or all of the legal expenses and penalty the SEC imposes. This would be true in cases of civil lawsuits or collusion or price fixing, but not in SEC settlements.

Chastising Weak SEC Enforcement

The study comes down hard on not just how few actions the SEC has taken to date, but also how paltry the fines have been relative to the magnitude and scope of abuses:

With only six cases brought by the SEC in the three and a half years since general partners of PE funds have had to register as fund advisors, results are not reassuring. No matter how egregious the PE firm’s behavior or how inconsequential the firm, the SEC has not insisted on an admission of guilt. Financial penalties have been trifling in relation to the size of the PE firm, and other remedies available to the SEC have been waived. Self-dealing appears to be widespread among PE firms. TPG and other PE firms continue to flaunt the fact that they will waive their fiduciary responsibility to their investors whenever it is in their own best interest to do so. The SEC’s enforcement actions appear too timid to have the effect of putting the industry on notice that it will have to change deep-seated behaviors that enrich PE firm partners at the expense of other stakeholders

In a speech yesterday in San Francisco, SEC enforcement chief Andrew Ceresney, in a speech that almost entirely recited old SEC bromides, did say that more enforcement actions were coming. But the SEC’s posture on private equity at best looks likely to parallel the one it took on financial-crisis related misconduct: to slap big players with one settlement, even if they had clearly engaged in numerous abuses. And the SEC is also showing a predisposition to hit big firms with relatively easy-to-prove misconduct, rather than more fundamental, widespread forms of grifting. For instance, the KKR settled with the SEC over the misallocation of broken deal expenses.

Yet the agency failed to sanction the private equity kingpin for the much larger abuse of its misleading investors about the status of its captive consulting firm, KKR Capstone. The Wall Street Journal’s Mark Maremont reported that KKR was billing its in-house consulting firm to portfolio companies as if it were an independent entity, contrary to the understanding of limited partners.

The SEC’s failure to act not only seemed unjustifiable at the time (we debunked the KKR assertion that KKR Capstone was not an affiliate here); it is even more difficult to fathom in light of the fact that the Ceresney made clear that the SEC’s standard was the representations made by the firm when it was marketing its fund. By all accounts, investors were surprised to learn that KKR Capstone was being billed to portfolio companies, and not included in KKR’s hefty management fees.

So while it is encouraging to see unions and public interest groups taking the work of experts like Appelbaum, Batt, and Polsky seriously and demanding regulatory action, it will clearly take a good deal more pressure to embarrass the SEC into doing its job.



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  1. readerOfTeaLeaves

    That video is mind-bending.

    If I understand correctly, Private Equity is scamming the scale effects of very large accumulations of money.
    And the feckless government types are credulous and solicitous of the scamming, rather than unpacking this nonsense for the vast buffoonery that it is.

    And people wonder why the economy is limping along.

  2. flora

    As you point out this damning information has been reported for over 2 years now.
    The IRS still turns a blind eye.
    The SEC still doesn’t enforce.
    It will take political pressure to force them to do their jobs. I don’t see Obama or Clinton appointing SEC chiefs that will regulate. Maddening.
    In the meantime, I’m glad to read that unions and public interest groups are reading and demanding action. Maybe the only way to shut down PE abuses is to stop giving PE money to invest.

    Thanks for this post and for your continued reporting.

    1. Yves Smith Post author

      We’ve written about them:

      We’ve written more about CalPERS because they are perceived to be the best and most sophisticated public pension fund, so if they are doing a poor job in private equity, it’s pretty much a given no public pension fund is. And pressuring CalPERS to up its game tends to raise standards in the industry.

      Are you a beneficiary of LACERA or do you have specific issues or concerns about them?

  3. Citizen

    There are several employment opportunities in the Los Angeles County. I am doing some preliminary inquiries regarding the way their retirement system is administered. I had read an article you had written several years ago regarding LACERA regarding transparency in the fees being paid.

  4. Matthew Cunningham-Cook

    To paraphrase Alex Cockburn, private equity is like the implacable noise of a running generator under the neighboring table at a restaurant.

    The only sensible thing to do is leave, or in this case, divest.

  5. TheCatSaid

    Another tour de force post, Yves. Thanks for including the full report and also the monitoring fee letter. If we want to take action by sending the letter, should it go to each of my Senators &
    also my Representative? Are there certain people who are more likely to be able to make a difference, or who are particularly vulnerable to public pressure?

    Thank you for this series. That Phalippou video is a superb explanation of what PE is all about, and how it works.Telling it like it is.

  6. Robert Coutinho

    I have been following a website ( that has been showing this kind of chicanery for over a decade! Pat Burns (founder of has been detailing all sorts of mind-bogglingly horrendous actions by corporate criminals (and underworld criminals). The SEC is a revolving door of lawyers who spend some time in SEC–are told by previous employees of SEC (now in fancy law firms) that if they do as the industry wants, then they too will have a seven-figure-salary job waiting for them. Even those who don’t want to play that game can get nowhere with enforcement. The entire agency has been captured by the financial industry.

    As for a comment from flora above: no, Obama and Clinton are not likely to change the system. They hired/are hiring the actors who enabled much of this in the past fifteen to twenty years.

    I recommend those who have strong stomachs to go read what DeepCapture has on its site. The detail (and the attempts to stop investigation) that the various authors have shown is breathtaking–and very, very disturbing.

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