Wednesday, April 9, 2014

Bogus Private Equity Fees?

Alan Katz of Bloomberg reports, Bogus Private-Equity Fees Said Found at 200 Firms by SEC:
A majority of private-equity firms inflate fees and expenses charged to companies in which they hold stakes, according to an internal review by the U.S. Securities and Exchange Commission, raising the prospect of a wave of sanctions by the agency.

More than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors, according to a person with knowledge of the SEC’s findings who asked not to be named because the results aren’t public. While some of the problems appear to have resulted from error, some may have been deliberate, the person said.

The SEC’s review of the $3.5 trillion private-equity industry began after the 2010 Dodd-Frank Act authorized greater oversight of money managers, putting many firms under the agency’s scrutiny for the first time. By December 2012, examiners had found that some advisers were miscalculating fees, improperly collecting money from companies in their portfolio and using the fund’s assets to cover their own expenses.

“A lot of the practices, in the eyes of the SEC, raise conflicts,” said Barry Barbash, co-head of the asset-management group at Willkie Farr & Gallagher LLP in Washington. “The SEC wants those conflicts aired out and wants certain practices ultimately changed, and I’m sure we’re going to see it.”

John Nester, an SEC spokesman, declined to comment on the exams.
Opaque Model

Private-equity firms buy companies using a combination of investor capital and debt, with the goal of selling them or taking them public for a profit. They typically charge annual management fees of 1.5 percent to 2 percent of committed funds and keep 15 percent to 20 percent of profit from investments, known as carried interest. Most buyout firms also charge fees to the companies they acquire to help cover costs related to the deals or restructuring, often sharing some of the proceeds with their investors.

“These organizations, though, are opaque, and that’s the problem. We’re basically taking them at their word,” said William Atwood, executive director of the Illinois State Board of Investment, which oversees three state retirement systems. “The role of the regulator in this situation can’t be overstated.”

The private-equity model lends itself to potential abuse because it’s so opaque, according to Daniel Greenwood, a law professor at Hofstra University in New York and author of a 2008 paper entitled “Looting: The Puzzle of Private Equity.” The attraction of the funds is that the managers have broad discretion, which also means that investors have a hard time knowing what the managers are doing, he said.

“The SEC and SEC enforcement can now see problems that probably existed all along and probably were actionable all along, but there was nobody to bring the action,” Greenwood said. “The big change has got to be the disclosure.”
More Enforcement

Last month, the agency filed a civil case against Clean Energy Capital LLC and its founder Scott Brittenham, accusing them of misusing more than $3 million in funds to pay for office rent, tuition costs, bottled water and group photo sessions. The money should have gone to investors, the SEC said.

“We believe that all of the expenses the SEC was complaining of were permitted by the limited partnership agreements and Delaware law,” said Aegis Frumento, a partner at Stern Tannenbaum & Bell LLP in New York, who represents Brittenham and the firm. “We have every confidence at the end of the day that these charges will not be found to have been fraudulent under the Investors Advisers Act.”

The SEC’s action against Clean Energy Capital is probably just the first of several enforcement cases that will draw the boundaries of what’s allowed, according to Barbash, a former director of the SEC’s investment-management division.

“The industry is going to be forced into change because, frankly, when your big investors are public plans and other money that’s run by fiduciaries, you can’t afford as a business matter to be deemed to be engaging in fraud,” Barbash said. “Fraud doesn’t sell very well.”
It's high time regulators shine the spotlight on private equity fees. You can read the SEC's press release here. I also urge you to read Daniel Greenwood's 2008 paper, “Looting: The Puzzle of Private Equity.”

Charging investors bogus fees is basically legalized theft. It's the same thing that goes on with large hedge funds managing billions and raping clients on fees for beta or sub-beta performance. They quickly forget about performance and focus on sales and marketing. That's the problem with the 2 & 20 model, it incentivizes hedge funds to become large and lazy asset gatherers. Why focus on performance when you can clip hundreds of millions or even billions on a 2% management fee?

In private equity, the management fee is initially based on the total investor commitments to the fund as investments are made. After the end of the commitment period, ordinarily 4–6 years, the basis for calculating the fee will change to the cost basis of the fund, less any investments that have been realized or written-off. But unlike hedge funds, private equity and real estate funds have a hurdle rate to clear before they can charge performance fees.

The Bloomberg clip below discusses the other hidden fees private equity funds charge, like their "consulting fees" to the companies they acquire using investors' capital. This is a joke but it goes on all the time.

The SEC's review focuses on whether private equity funds are abusing the terms of their limited partnership agreements with investors. To be clear, it's up to limited partners (ie. institutional investors) to scrutinize all the fees and expenses their private equity funds and hedge funds charge them. If their funds are violating an LP agreement, it's their fiduciary duty to uncover it and tell their managers to reimburse them.

But institutional investors also need to wake up and start scrutinizing all fees they pay out to hedge funds and private equity funds. I discussed this in my comment on the hedge fund curse:
I also met up with one of Canada's sharpest hedge fund talent in Toronto. This is a guy who I would seed in a heartbeat and unlike all of Quebec's hedge funds, which I foolishly keep promoting, he would have no problem obtaining money from Julian Robertson if the Tiger fund was a true seed fund, not an accelerator fund. HR Strategies is currently looking at him for their SARA Fund but I put him in touch with a few U.S. funds of funds and raised concerns with HR Strategies and their SARA Fund (will they survive in the next three years??).

Anyways, we talked about markets and the entire culture of hedge funds. He told me flat out that he's happy to benefit from the 2 & 20 model (it's more like 1.5 and 15 now) but he thinks it's nuts to pay an established hedge fund manager managing billions a 2% management fee. I agreed and even wrote about how some smart managers are now chopping their fees in half. As I told him: "Why should Ray Dalio or any mega hedge fund 'guru' collect billions in management fees for turning on the lights? It's absolutely nuts!!" (if the ILPA had any balls and clout, they would pressure their established managers to only get paid on performance! I talked about this ten years ago at an ILPA meeting in Chicago but people looked at me like I was from Mars)

We also talked about culture at hedge funds. I told him I liked to meet with senior managers and then randomly meet with a junior analyst when doing due diligence. If the senior managers asked me why, I'd tell them flat out "because they carry the weight of your hedge fund" so I want to gauge their level of engagement and happiness and see how well they are treated.  (He told me Dan Loeb has a terrible reputation for not paying his senior analysts and managers the terms of their contract, something which if true, would make me pull out of his fund pronto, no matter how good he is)

In terms of compensation, he told me analysts and managers at hedge funds should be paid "a direct share of the total P&L with their swing factor determined by 1) quality and quantity of their research and 2) making other analysts better at their jobs." Right on!
I stick by these comments and if Ray Dalio or any other elite hedge fund or private equity manager managing multi billions has a problem, I welcome them to email me with their concerns and I will publish them (

Go back to read Ron Mock's strategy on hedge funds and why OTPP's sweet spot lies with funds managing between $500M and $2B. OTPP got slammed hard in 2008 investing in all sorts of illiquid and funky hedge fund strategies. That experience taught them the importance of managing liquidity risk. Ron recently told me that since 2008, they shifted their hedge funds mostly into managed accounts to "manage liquidity risk, have more transparency and control." But he added that they still invest some of their sizable hedge fund portfolio in "unique alpha funds that are not as liquid."

I can guarantee you, however, that Ontario Teachers scrutinizes all fees and expenses their hedge funds and private equity funds charge them down to the penny. The same goes for all other large Canadian public pension funds investing in private equity and/or hedge funds.

The biggest abuses happen in the United States where you still have far too many incompetent public pension fund managers that aren't properly compensated and staffed to understand whether the fees and expenses their alternatives funds charge them are respecting the limited partnership agreement.

Even CalPERS, the largest U.S. public pension fund, is in the process of revamping their PE portfolio and striking fear into PE firms but Real Desrochers and his team have a lot more work to clean up the mess they inherited. They recently got embroiled in a legal feud with Yves Smith of Naked Capitalism because they refuse to provide her private equity data she requested (Yves replied to my comment -- see my postscript -- but I told her she will never see that data because it will show how grossly incompetent CalPERS was in paying PE funds all these hidden fees).

Once again, I welcome all intelligent feedback from institutional investors and private equity fund managers and will gladly post your thoughts anonymously or I can attribute it to you.

Below, a majority of private-equity firms inflate fees and expenses charged to companies in which they hold stakes, according to an internal review by the U.S. Securities and Exchange Commission, raising the prospect of a wave of sanctions by the agency. Cristina Alesci reports on Bloomberg Television's “In The Loop.”