At a recent Wall Street Journal conference, one of Blackstone’s top private equity executives tried depicting the firm at on board with SEC oversight and gave a high level sketch of a new private equity fee structure, which was presented as a change from the old regime of charges that were invisible to investors but imposed large costs on portfolio companies.
However, as we’ll show, the commitment to change is purely optical.
Even though Blackstone is eliminating its largest fees charged to portfolio companies – transaction fees and monitoring fees, and it uses this sacrifice to justify increasing its largest source of income, management fees. But how much sacrifice is really going on here? there’s every reason to believe Blackstone is leaving other mechanisms in place for extracting funds from portfolio companies. And even better from Blackstone’s perspective: these tricky fees are not offset against management fees as the old transaction and monitoring fees were, making the new scheme potentially even more lucrative than its predecessor.
Laura Kreutzer, Wall Street Journal: You know, we’ve seen a lot of enforcement actions by the SEC and a lot of settlements, with probably close to a dozen firms in the past two years, including Blackstone. Um, particularly over fee disclosure and a lot of it around disclosure, how has all of this SEC scrutiny affected the way you operate your firm, particularly when it comes to disclosure?
Joseph Barratta, Senior Managing Director and Global Head, Private Equity, Blackstone: Well, I think, to start I’d say the SEC was right to be, ah, scrutinizing the industry. It’s grown in importance. We manage, Blackstone manages money on behalf of 37 million retirees in this country and around the world. And that’s an important obligation. And so for the SEC not to be engaged in monitoring people who manage that kind of money would be inappropriate.
So that they’re looking I think is a good thing, shedding transparency and changing business practices, I’d say the business practices questioned were struck thirty years ago in the first generation of funds, where you had a buyout practitioner negotiating with sophisticated pension plans negotiating documents that weren’t meant to look like S-1 public company disclosures. And so, there was a lack of specificity in those agreements, and then operating practices cropped up over time that were well understood by buyer and seller, meaning LP and GP, which the SEC has come to question: Did you disclose this? Did they know about it? And those things are all fine.
So yes, the buyout industry, writ large, big firm, small firm, everybody acting in good faith, is changing its practices, which is right. How have we specifically changed our practices? In our recent funds, we’ve tried to radically simplify the relationship, the fee relationship, between ourselves and our limited partners. So get rid of all of the historical practices that were understood but weren’t explicitly disclosed, um, and increase disclosure of all sorts…
Kreutzer: What are some of those historical practices, like accelerated management [sic, she means monitoring] fees?
Barratta: Yes, the active transaction fees, monitoring fees, that were common industry practices. You know, that in our recent fund, we’ve eliminated those altogether in exchange for a higher base management fee.
In the bulk of this short segment Barratta gives a big dose of revisionist history: that the standards for private equity were set in the 1980s via “good faith” negotiations between pension funds, when the contracts then and now are “take it or leave it” arrangements with only some inconsequential modifications granted for appearances’ sake.1
Similarly, the weak effort to pretend that Blackstone is doesn’t mind being supervised at all may result of the fact that Blackstone CEO Tony James is on the short list of Treasury Secretary candidates in a Clinton administration.2
However, Barratta’s pious patter sets up the important part of his remarks, which come as if they were a mere afterthought, as if to suggest that they were a natural and easily-made concession.
But any change in an established, widely-used fee structure is actually a curious response to the SEC’s wrist slaps. Rather than clean up its definitions of terms and make fuller disclosures, Blackstone has foresworn all those long-standing, supposedly well-understood fees that the SEC exposed as tricky and not understood at all. The posture is that Blackstone is merely achieving a similar economic result to what it had before by raising its management fees and giving up the other levies.
But Blackstone is not in fact renouncing the ability to charge other fees. The only fees it has said it is giving up are ones like transaction fees and monitoring fees that have been the subject of SEC fines. That also happens to include most of the types of fee that are subject to management fee offsets.
That creates the real possibility that limited partners will wind up worse of, in terms of the total amount of charges extracted from the businesses acquired on their behalf. This would be a perverse outcome given that general partners, including Blackstone, have warned investors to expect lower returns in the future. If one were to believe the notion that that the general partners love to promote, that limited partners are “partners,” as opposed to users of a legal structure, the general partners should take a hit as well.
If you look at the second part of the Blackstone VI limited partnership agreement from our Document Trove on p. 56 (numbered page A-4)3, you’ll see it states that Blackstone can recover from portfolio companies as much as it wants in expenses incurred by its “portfolio operations group.” If you are familiar with monitoring fees, one of the types that Blackstone says it is eliminating, they are presented to limited partners as paying for overseeing the portfolio companies. In fact, as we’ve written, the monitoring fee agreements are pure rent extraction. They provide for fees to be paid irrespective of whether any services whatsoever are rendered. Professor Ludovic Phalippou of Oxford has called them “money for nothing“.
Monitoring fees can be reconstituted as “portfolio operations group” charges. While there is a $5 million per annum cap on expenses from this so-labeled group in what it can bill to the fund directly, there’s no limit on what it can charge portfolio companies, which is how general partners have managed to evade oversight and disclosure. And bear in mind that the portfolio operations group language was new in the Blackstone VI agreement. It may have been a toe-hold carve-out that has been in broadened in later funds (for instance, the $5 million limit on direct expensing to the funds could now be higher).
Also, keep in mind that the definition of fees to be offset against the management fee is net of out-of-pocket expenses. That is a major exclusion. It has almost certainly been preserved in the new Blackstone agreements that supposedly do away with monitoring and transaction fees.
Finally, and critically, despite Barretta trying to depict lack of clarity about terms in limited partnership agreements as an unfortunate historical accident, the term “portfolio operations group” is nowhere defined in the limited partnership agreement4. This suggests that Blackstone can designate every single one of its employees, up to and including Steve Schwarzman, as being included in this category. Likewise, “reasonable out-of-pocket expenses” is nowhere defined.
So you can see that discontinuing transaction and monitoring fees is meaningless, since Blackstone has other fee extraction mechanisms. And even better, none of these other channels for syphoning money out of the portfolio companies are subject to management fee offsets, which in Blackstone VI were 65%.4
So even when a Blackstone executive, in a very short remark at a conference, tries to depict the firm as turning over a new leaf with private equity, you can see it’s more of the same ole chicanery in familiar professional packaging. Nicely played.
1 Barratta misrepresents the history of private equity norms. While Blackstone started in the mid-1980s the firm was a latecomer.I met Pete Peterson and Steve Schwarzman when they were having a tough slog raising their first fund), The industry had started in the 1970s and Henry Kravis had already become so rich by then that Peterson and Schwarzman were openly jealous.
Simialarly, contrary to what Barratta would have you believe, the early investors in private equity funds were wealth individuals, not pension funds. They couldn’t even contemplate investing until the Department of Labor issued a new interpretation of its rules in 1978 to allow risks to be judged on a portfolio basis, rather than investment by investment. Leveraged buyouts and venture capital would never have passed muster under the old standard.
Needless to say, wealthy individuals had neither the clout nor the lawyers of the same caliber as the early players in “bootstrapping” game, who came out of mergers & acquisitions, as Peterson and Schwarzman did. Public pension funds didn’t begin investing until the mid 1980s, when Washington State not only invested in KKR’s funds but promoted KKR to other public pension funds. And in the mid 1980s, private equity was coining money. No one was fussy about fund terms given how much money it was making.
And as for the insinuation that pension funds then or now understood the deals, the fact that Barratta acknowledges that some definitions were unclear or absent says otherwise. We’ve demonstrated at length how CalPERS, a long-standing and supposedly savvy investor in private equity, does not understand many of its basic features. And in its private equity workshop last November, CalPERS confirmed what outside experts have said: private equity agreements are “take it or leave it” contracts, where the general partners allow a show of negotiating by accepting limited partner changes on some inconsequential terms.
2 Two of many examples as to why it’s hard to see Blackstone as a supporter of more transparency and oversight:
Even though Blackstone has registered a broker-dealer with the SEC, which means that unit is subject to SEC oversight, there is good reason to believe that like its peers, it is not providing transaction services to its private equity portfolio companies through that entity. We’ve explained at length in earlier posts why this is a flagrant, long-standing violation of SEC regulations.
Blackstone has not endorsed the ILPA template which provides for extensive disclosure of private equity fees and costs.
3 The relevant section:
Such [portfolio company] fees (including fees received in respect of guaranties as contemplated by paragraph 5 .1.2 of the Partnership Agreement) shall be net of (x) reasonable out-of-pocket expenses incurred by the Advisor or its Affiliates (and not otherwise reimbursed) in connection with the transaction out of which such fees arose and (y) to the extent not reimbursed or paid as provided in clause (2) below, internal compensation (i.e., salary and bonus) costs specifically allocated to portfolio companies associated with employees in Blackstone’s portfolio operations group (which shall in no event include investment professionals or legal/accounting professionals), not to exceed $5 million in the aggregate in any Fiscal Year; provided, that such costs in each case shall be no greater than would be obtained in an arm’s length transaction for similar overall services as determined by the General Partner in good faith (but, in each case of (x) and (y), shall not be net of all other direct or administrative costs allocable to such fees); it is understood that the Advisor or its Affiliates (1) may seek to have all such reasonable out-of-pocket expenses reimbursed or paid by the company in respect of which such expenses are generated and (2) shall seek to have such internal compensation costs associated with employees in Blackstone’s portfolio operations group (as described above) reimbursed or paid by the company in respect of which such costs are generated (which in each case of (1) and (2) shall not be considered a fee described in any of the foregoing clauses (i) through (iii) above).
4 Even though the section above states “employees in Blackstone’s portfolio operations group (which shall in no event include investment professionals or legal/accounting professionals),” since none of “investment professionals” “legal professionals” or “accounting professionals” are defined terms, the parenthetical is meaningless.
4 According to p. A-4, “(iii) 65% of net monitoring,
transaction, directors’ and organizational fees received by the Advisor and its Affiliates” must be rebated to investors.