Listen up, because you are about to get another object lesson in how brazen the private equity industry is in defending its dubious looting, um, fee extraction practices. We will also see captured public pension funds, in this case CalSTRS, stand shoulder-to-shoulder with the private equity industry and against the interests of its beneficiaries and California taxpayers.
Background: How Private Equity General Partners Have Been Violating Broker-Dealer Registration Rules for Decades
The private equity industry is up in arms over the idea that the SEC might finally address a long-standing abuse, that of the failure of private equity firms to register as broker-dealers. We alerted readers to this misconduct in 2013:
The violations result from the long-established practice of PE firms charging “transaction fees” to investors in their funds when the PE firms, as managers of various funds, buy and sell of portfolio companies. They also levy transaction fees when portfolio companies issue debt or equity securities. Bear in mind that these fees are not in lieu of fees paid to investment bankers and brokers; they are additional charges, on top of both those third party fees and the private equity firm’s management fee, the famed “2 and 20” (2% annual management fee, 20% of the gains, although the management fee is lower for the very large funds). And these transaction fees are typically comparable in size to the fees paid to investment bankers.
This controversial practice has been going on for decades, and it is no secret. The PE firms collectively have reaped billions of dollars through this ruse. Dozens, if not hundreds, of articles have been written about it. Typically, these stories depict these transaction fees as an abuse of both the portfolio companies and the private equity fund investors, since portfolio company revenues are diverted into the pockets of private equity managers. For instance, a account about the whistleblower published last week by the usually pro-industry CNBC, where the headline itself described transaction fees as “private equity’s ‘crack cocaine.’”
But as scandalous as this ongoing looting ought to be, the whistleblower focuses on another glaring problem with the private equity firm transaction fees: the private equity firms are not registered broker-dealers.
Anyone who has been in the securities industry will know how big a deal being a broker-dealer is. Even as a small firm consultant, I’d take care with how my engagements were defined so that there was no way they’d be considered to be securities dealing and hence oblige me to register my firm as a broker-dealer. Being a broker-dealer involves not just registering with the SEC but complying with a long list of requirements to make sure you are dealing with customers fairly, including:
Becoming a member of a self-regulatory organization (usually FINRA)
Training and licensing principals and staff
Obeying state securities laws
Being subject to SEC inspections and disciplinary actions
Complying with customer protection and commission disclosure rules, recordkeeping, financial reporting requirements, and Treasury anti-money laundering requirements
See this Davis Polk discussion for more detail.
As we indicated then, this misconduct goes back at major players like KKR to at least the 1980s, and has been widespread since the 1990s* Virtually all the big firms charge transaction fees and financing fees; the only noteworthy exceptions are Hellman & Friedman and Warburg Pincus.** It isn’t as clear if the practice is as universal among smaller general partners, since pulling the same level of fees out of their portfolio companies as the big boys charge would be a bigger drag on returns.
Note that the SEC warned in a 2013 speech that it was looking into the issue. The general partners were apparently so confident of their protected position as to ignore the head’s up.
Why Are General Partners Outraged About Being Required to Register?
Astonishingly, what the general partners are screeching about is the prospect of having to register as broker-dealers. They aren’t even contemplating the idea that the most of the entire industry should be required to disgorge the impermissible fees (which lucky for them are subject to a statute of limitations). If the SEC got out of bed to sanction the private equity industry, it would be hit with billions of dollars in fines.
Bear in mind that the SEC has issued a fine for broker-dealer violations….a mere $3 million for a firm no one ever heard of, Blackstreet Capital Management. Admittedly, Carlyle has also warned in recent SEC filing that it might be charged for broker-dealer violations.
But the noise from the industry is mainly over registering going forward. Why is this anything more than an inconvenience? As Eileen Appelbaum, co-author of the landmark book Private Equity at Work, explained via e-mail:
The purpose of SEC oversight of broker-dealer activities is to rule out a situation in which a PE firm that needs cash can have one of its portfolio companies acquire an add-on business, even when this does not make economic sense for the portfolio company, and charge very high, undisclosed fees for providing this ‘service.’ The transaction may enrich the PE firm while impairing the value of the portfolio company and reducing the ultimate returns paid to PE fund investors. SEC oversight guards against self-dealing by PE firms, and against PE firms’ charging excessively high transaction fees for providing broker-dealer services.
Transaction fees related to the acquisition of a portfolio company or to an add-on to an existing company are paid directly to the PE firm. Investors in the portfolio company have no say over the acquisition and receive no information about the size of the transaction fee the PE firm has pocketed. Institutional investors turn a blind eye to this because the PE firm uses these fees to rebate as much as 80 to 100% of the management fee they pay to the PE firm. The LPs then advertise the low management fees they pay to private equity, without counting up all the ways in which this transaction may reduce the fund’s earnings and the profit they will ultimately earn from their PE investments.
The PE firm, meanwhile, gets to collect and pocket a bonanza in transaction fees.
If anything, Appelbaum is too charitable. The fundamental approach that most general partners take to transaction charges is arguably self-dealing, even before getting to cases where the general partner makes questionable acquisitions merely for the purpose of generating fees. Recall what we described earlier: that in most cases, the fees being charged are in addition to charges made by third parties, like investment banks or specialized boutiques, for executing the transaction. In other words, these “fees” are at best grotesque overcharges for hiring firms that do the actual work.
If you look at the first embedded document at the end of this post, a monitoring agreement for Samson Resources with KKR, you’ll see the typical “money for nothing” arrangement, as described by Oxford professor Ludovic Phalippou. Section 1 says, “The Advisory Fee shall be payable regardless of the level of services actually provided during any fiscal quarter and shall not be refundable under any circumstances.”
In addition, in section 3 on page 2, the agreement provides that
…the Managers may charge the Company a customary fee for services rendered in connection with securing, structuring and negotiating equity and debt financing,….
Mind you, this is not “providing” these services. This is a fee for arranging for other parties to supply them. Moreover, the balance of the section contemplates that the Managers (as in KKR and friends) may decide they want to do the heavy lifting and be paid for that too:
….the Group may, from time to time after the Effective Date, engage one or more of the Managers or their affiliates to provide additional investment banking or other financial advisory services in connection with any acquisition, divestiture or similar transaction by the Group, in respect of which (i) separate agreements may be entered into and (ii) such Managers or their affiliates may be entitled to receive additional compensation in respect thereof pursuant to such separate agreements.
Let us look at a second, more explicit example, the “EP Energy Transaction Fee Agreement” embedded at the end of this post among EP Energy Global and a related entity, Apollo, and other investors. To keep your eye on the ball, Apollo is the “Initial Service Provider”. In the Section 3 (a), Apollo gets a fee for arranging the deal. Mere mortals would think all that work would be covered by the management fee, since private equity firms are in the business of buying companies and all the things described in that section are typical activities. But lo and behold, Section 4 shows they are subject to additional fees.
Even better, in Section 6, the first part states that if there are any future investment banking services (meaning actual work), EP Energy agrees to negotiate with Apollo and its co-conspirators (who divided the closing fee very much in favor of Apollo and presumably that type of split would apply) for those transaction fees. Notice that that is in addition to the the one percent investment banking fee or $100 million (sporting of them to cap it on this deal) that Apollo and friends gets automatically that Apollo get irrespective of whether they do any work (see the part starting with “In the absence of an express agreement to the contrary” though the end of that section).
The Astonishingly Dishonest Defenses of Broker-Dealer Abuses
With that background, you can now understand the snow job the private equity industry is trying to pull on the unwashed public and interested policy makers. Consider a recent story in Pensions & Investments by Arleen Jacobius, Private equity firms fear broker-dealer registration. The brazen misrepresentations start at the top of the article:
Once a loosely regulated bunch, private equity firms might have to register as broker-dealers or find their ability to charge transaction fees or provide bank-like services impaired. These are the very services that help them attract portfolio companies.
This is ludicrous. First, private equity firms do not “attract” portfolio companies. Portfolio companies have no agency. They are sold, most often in auctions, to the highest bidder. Some mid-sized and smaller firms work hard at trying to source companies on a non-competitive basis, most often by persuading an owners of private companies that the general partners are nice guys who will respect whatever is important to them (preserving brand name, keeping a ne’er do well son-in-law employed for at least a few years, maintaining operations in the local community) and giving them a juicy price. In other words, providing services that private equity firms rent all the time from financial firms has nothing to do with being successful at buying companies.
There’s also an statement that will give readers who are not up on this beat the wrong impression:
In 2014, the SEC released a no-action letter on the issue, which provided limited relief only for brokers that solely worked on mergers and acquisitions, making relief generally unavailable to most private equity firms….
While this is technically accurate, it’s irrelevant to private equity. Its inclusion in this article appears intended to create the impression that private equity firms are being treated unfairly. “Gee, the really big fees that private equity firms charge are M&A fees. Why are M&A boutiques exempt but not private equity firms?”
In reality, the no-action letter established a safe harbor, where registration is not necessary for parties meeting all of a set of requirements. The most important of them, as far as private equity firms are concerned, is that the party never touch the money funding the transaction. Obviously, any type of asset manager could never meet that standard.
Moreover, the article offers a bogus claim that the industry thought it had a loophole:
In order to avoid broker-dealer registration, many private equity firms have been offsetting as much as 100% of transaction fees against the management fees and/or carried interest…..executives at private equity firms believed they could avoid registering as a broker-dealer if they refund 100% of transaction fees to investors.
This is utterly misleading. First, notice the “as much as”. The management fee offsets are negotiated as the same percentage level across all specified fees subject to offsets. In recent years, on large funds, private equity funds have created size buckets, so limited partners making larger commitments get bigger fee offsets. Investors committing early may also get a better deal on offsets. And since limited partners have many older commitments at lower fee offset levels, it is a virtual certainty that no limited partner has a contractual management fee offset of 100% across all his fund investments.
And that’s before you get to the fact that the realized fee offsets are routinely below the nominal fee offsets. A few of many reasons:
* General partners can time when they impose their fees, which in a year when they are engaging in a lot of transactions in a particular funds, can allow them to charge more fees in a particular quarter than the management fee due. That allows them to keep the excess (note some limited partnership agreements requires that excess fees in any period be offset against future management fees, but this is far from universal).
• General partners set up their agreements so they can deduct “out of pocket” expenses and broken deal expenses for other deals that didn’t happen from the fees subject to offsets.
• Late in a fund’s life, investors will be subject to “stranded offsets,” because the particular fund vehicle will never again charge a management fee. This occurs when the fund is no longer earning management fees (e.g., an exit fee is earned on sale of a company in year 14 of a fund, when the management fee sunset at the end of year 12)
* Co-investments are popular with limited partners because they avoid management fees. The result is no fee offset, which in turn means those investors bear the full effect their share of any fees charged to the portfolio companies, including transaction fees.
And the article includes CalSTRS either playing dumb or revealing how ignorant it is:
“While CalSTRS is following the SEC settlements, we … don’t yet have enough information to comment on the impact to our partners or portfolio,” said Ricardo Duran, spokesman for the $188.8 billion California State Teachers’ Retirement System, West Sacramento.
Ahem. As mentioned earlier, a registered broker-dealer would be held to the standard that the transaction and fee be “appropriate.” Even though this protection would clearly be a benefit to them, CalSTRS professes ignorance.
Finally, the article closes by noting: “KKR, Apollo Global Management LLC, TPG and The Blackstone Group all have registered as broker-dealers.” While it does not say so explicitly, the implication is that these firms are complying with the broker-dealer requirements as far as private-equity related transactions are concerned.
There’s good reason to think that’s not the case. TPG’s broker-dealer filings with thee SEC show transaction fees far below the transaction fees they reported taking in SEC filings for the subset of companies that are public registrants.
It’s not hard to envision what is at stake and why the private equity industry is so upset. The Dodd Frank requirement that private equity firms register as investment advisers has exposed widespread misconduct, including what in other walks of life would be called embezzlement. But the SEC investment adviser exams cover only a portion of private equity firms’ activities. Broker-dealer registration would subject more of their activities to supervision and disclosure, as well as basic protection, like not overcharging customers.
In 2015, eleven state treasurers, plus the New York state and New York City comptrollers, asked the SEC to assist them in getting better disclosure of private equity fees. To further this aim, they should demand that private equity firms register as broker-dealers, and call for fines for past abuses to make sure the general partners take these responsibilities seriously.
* You might very reasonably ask, why was the SEC not all over this abuse long ago? The short version is that the SEC has a “show up and be registered” policy toward broker-dealer licensing, as in it does not actively look for violations. And the fact that its deterrence is large, as in dollar for dollar fines for the amount of fees charged, would seem to provide plenty of incentive to register. The way the SEC normally finds out about broker-dealer violations is much the same way that state medical boards find out about doctors practicing medicine without a license: a customer who has been abused makes a complaint.
But private equity industry though it had set up the perfect crime. The “customers” for its broker-dealer services were companies it owned and controlled. Its investors were captured and would never complain. And when they finally woke up to the fact that broker-dealer and other fees that the private equity firms were hoovering out of the portfolio companies were significant in aggregate, rather than insist the general partners cut it out, they allowed themselves to be appeased by getting partial rebates (the percentage of the rebate has a lot to do with how much money is chasing private equity at various points in time, and how “hot” a particular manager is perceived to be).
And why haven’t former portfolio company employees turned in any general partners? The short answer is the code of omerta is astonishingly strong because the perceived cost of not having access to the private equity gravy train is very high.
** Warburg and Hellman do not charge transactions fees when they own a company through funds they control but they will take them in a group deal when others are also taking fees.