Even though California was first to have a state official propose path-breaking private equity transparency legislation, as we’ve written, that effort was already falling short of its promise due to the lack of definition of key terms in the bill. That lapse allows crafty private equity general partners and their captured investors wriggle room to circumvent a key aim of the bill: to report fees and expenses paid by the portfolio companies to the general partner and any related parties, since those monies do not flow through the limited partnership and are thus not subject to disclosure and oversight.
The California initiative, led by California Treasurer John Chiang, who also sits on the boards of CalPERS and CalSTRS, has been seriously outclassed by a bill that was introduced via amendment yesterday in the Illinois Senate. Sponsor Daniel Biss, a mathematics professor turned legislator, has proven to be an extremely quick study of the private equity industry.
We’ve embedded the text of HB6292 at the end of the post. You can also read it here. It is a vastly more ambitious and painstakingly drafted bill than its California counterpart, AB 2833.
A key difference is that Biss’ bill opens new terrain by requiring disclosure of some of the most troubling terms of private equity limited partnership agreements, specifically, the indemnification provisions, the clawback language and management fee waivers.
As we’ve discussed, typical private equity indemnification provisions are tantamount to a waiver of fiduciary duty. It’s incomprehensible how fiduciaries like public pension funds, which insist on strict adherence to fiduciary duty by contractors who exercise discretion or provide important advice, deviate from this practice so radically with the managers of one of their highest-risk investment strategies.
And the indemnification language is often unconscionable. For instance, we discussed how the terms of the Apollo VIII fund indemnify the operators for criminal acts if they can muster a case that they didn’t know their conduct was against the law. In other words, the new “dog ate my homework” is “I didn’t understand what my lawyer told me.”
Similarly, we have been advised that the limited partnership agreement for one of the Bain flagship funds (and presumably others) indemnifies Bain even in the event of SEC violations, meaning investors are explicitly on the hook for SEC fines.
The Illinois measure also requires disclosure of any indemnification payments, indemnification-related deductions made against monies owed to the limited partners, as well as documents “justifying the demand” for payment.
Clawbacks, another target of HB6292 disclosure, are problematic because they are designed not to work as popularly understood. The high concept is that a clawback provision is supposed to remedy for a defect in how carry fees are paid. In US-style deals, the carry fee, which is what tax mavens call a profits interest and is a share of the gain, typically 20%, once a hurdle rate is met, is calculated and paid on the sale of each portfolio company. Since investors have incentives to realize profits on at least some well-performing deals early in the fund’s life, this raises the possibility that early stars can be offset by later dogs, with the result that the carry fees withheld were excessive in light of the fund’s eventual performance.
There are several problems with clawback language. The first is that the limited partners will not recoup the full amount of over-payment. Typical terms provide get back the amount after deducting the general partners tax liabilities, calculated at the highest applicable rate. Since when is a vendor’s tax problem made a customer tax problem? Only in the “heads I win, tails you lose” world of private equity.
Second, as we observed yesterday, clawbacks are pretty much never paid. General partners will simply not sell the last dog asset in a fund so as to avoid triggering the clawback, or alternatively, will offer the limited partners a “special deal” in the next fund in lieu of a cash payment. Third, limited partners seldom, if ever, keep tabs on what if any clawbacks they are owed. For instance, SEC examiners have warned that private equity “waterfalls,” which among other things, determine how carry fees are computed, need further scrutiny.
HB6292 also lifts the veil on management fee waivers. This is an abuse that the IRS is in the process of ending via recent guidance. Hence it is fair game in current agreements. HB6292 requires both that the management fee waiver provisions in limited partnership agreements (including all definitions necessary to understand how the provision operates) be among other things, published material on its website, and “the amount of all management fee waivers made” be disclosed annually.
The bill also provides for disclosure of the signature block of the executed limited partnership agreement.
On the fee transparency front, while the Illinois bill focuses on issues similar to Chiang’s legislation, the approach is dramatically different. HB6292 has an exacting set of definitions. I spoke to Senator Biss about his approach and whether he had conferred with Chiang’s office. Biss said that he’d not known about the shortcomings with private equity disclosure until Chiang announced his intention to sponsor legislation last fall:
I thought I should learn more about it. I spoke to as many people as I could. The more I learned, the more troubling I found it. I didn’t think it was sustainable in the long run. I thought there was an opportunity and I wanted to play a role in this change.
The bill’s terms are precise and detailed; you can see a great deal of thought has been given to cutting off general partner escape routes. I encourage you give the language a look. Here’s an example:
(d) “External manager group” means (1) the external manager, (2) its affiliates, (3) any other parties described in the external manager’s marketing materials for the relevant alternative investment fund as providing services to or on behalf of portfolio holdings, and (4) any other parties described in the external manager’s affiliated adviser’s SEC Form ADV filing as receiving portfolio holding fees or portfolio holding other compensation. “External manager group” does not include the affiliated alternative investment fund in which the public retirement system is an investor, nor does it include an alternative investment fund used to effectuate investments of the affiliated fund in which the public retirement system is an investor.
If you’ve been following media coverage of private equity abuses, you’ll recall that one of them was that the general partner would present a “team” when marketing its fund. Investors would naively assume all were employees of the entity that was acting as the manager to the limited partnership and therefore their compensation (ex participation in the carry pool) came out of the management fee. That matters because many investors look at the size and composition of the team and compare it to the management fees to assess the reasonableness of that charge.
As we and others have discussed, in fact, it’s commonplace for many of these “team” members to be contractors, which means they are instead billed as expenses to the portfolio companies. The net effect is to enable the general partner to treat the management fee, which was intended only to cover overheads, as a source of profit.
Biss explained his approach: “Vagueness has been an opportunity for the industry.” He volunteered that he “didn’t pretend to be able to write a bill that would put a fence” around all misconduct. But this is a very impressive effort.
Because Illinois has a shorter legislative calendar that California, if this bill stays on track, it will pass both houses before its West Coast cousin. That could pressure California legislators to up their game.
One has to wonder if California and Illinois are blazing trails for the rest of the nation because their public pensioners have much better legal protection of their benefits than in the vast majority of states. That means that any pension fund shortfalls hit taxpayers, rather than being subject to renegotiation, as in cuts. The taxpayer risk is turning out to have the upside of giving state legislators strong incentives to ride herd on cognitively captured public pension fund employees and trustees.
HB6292 is due to come up for hearings this month. If you are in Illinois, I hope you’ll e-mail, call, or write your state Senator and Representative and urge them to back HB6292. If you have family, friends, or colleagues in that state, please send them this post and encourage them to voice their support. It would also be helpful to cc or call Biss as well. You can find contact information for the Illinois Senate here and the House, here.
And again, thanks for your interest and help! You can see how the efforts of Naked Capitalism readers, which were a major impetus to Chiang proposing his bill in California, are having even broader effects. So keep up the good work!