Behind Private Equity's Iron Curtain?

Gretchen Morgenson of the New York Times reports, Behind Private Equity's Curtain:
From New York to California, Wisconsin to Texas, hundreds of thousands of teachers, firefighters, police officers and other public employees are relying on their pensions for financial security.

Private equity firms are relying on their pensions, too. Over the last 10 years, pension funds have piled into private equity buyout funds. But in exchange for what they hope will be hefty returns, many pension funds have signed onto a kind of omerta, or code of silence, about the terms of the funds’ investments.

Consider a recent legal battle involving the Carlyle Group.

In August, Carlyle settled a lawsuit contending that it and other large buyout firms had colluded to suppress the share prices of companies they were acquiring. The lawsuit ensnared some big names in private equity — Bain Capital, Kohlberg Kravis Roberts and TPG, as well as Carlyle — but one by one the firms settled, without admitting wrongdoing. Carlyle agreed to pay $115 million in the settlement. But the firm didn’t shoulder those costs. Nor did Carlyle executives or shareholders.

Instead, investors in Carlyle Partners IV, a $7.8 billion buyout fund started in 2004, will bear the settlement costs that are not covered by insurance. Those investors include retired state and city employees in California, Illinois, Louisiana, Ohio, Texas and 10 other states. Five New York City and state pensions are among them.

The retirees — and people who are currently working but have accrued benefits in those pension funds — probably don’t know that they are responsible for these costs. It would be very hard for them to find out: Their legal obligations are detailed in private equity documents that are confidential and off limits to pensioners and others interested in seeing them.

Maintaining confidentiality in private equity agreements is imperative, said Christopher W. Ullman, a Carlyle spokesman. In a statement, he said disclosure “would cause substantial competitive harm.” He added: “These are voluntarily negotiated agreements between sophisticated investors advised by skilled legal counsel. The agreements and other relevant information about the funds are available to federal regulators and auditors.”

Mr. Ullman declined to discuss why Carlyle’s fund investors were being charged for the settlement. But at least one pension fund supervisor is unhappy about the requirement that municipal employees and retirees pay part of that settlement cost.

“This is an overreach on Carlyle’s part, and frankly it violates the spirit of the indemnification clause of our contract,” said Scott M. Stringer, the New York City comptroller, who oversees the three city pension funds involved in the Carlyle deal. Mr. Stringer was not comptroller when the Carlyle investment was made.

Private equity firms now manage $3.5 trillion in assets. The firms overseeing these funds borrow money or raise it from investors to buy troubled or inefficient companies. Then they try to turn the companies around and sell at a profit.

For much of the last decade, private equity funds have been a great investment. For the 10 years ended in March 2014, private equity generated returns of 17.3 percent, annualized, according to Preqin, an alternative-investment research firm. That compares with 7.4 percent for the Standard & Poor’s 500-stock index.

More recently, however, a simple investment in the broad stock market trounced private equity. For the five years through March, for example, private equity funds returned 14.7 percent, annualized, compared with 21.2 percent for the S.&.P. 500. One-year and three-year returns in private equity have also lagged.

Nonetheless, pension funds have jumped into these investments. Last year, 10 percent of public pension fund assets, or $260 billion, was invested in private equity, according to Cliffwater, a research firm. That was up from $241 billion in 2012.

But the terms of these deals — including what investors pay to participate in them — are hidden from view despite open-records laws requiring transparency from state governments, including the agencies that supervise public pensions.

Private equity giants like the Blackstone Group, TPG and Carlyle say that divulging the details of their agreements with investors would reveal trade secrets. Pension funds also refuse to disclose these documents, saying that if they were to release them, private equity firms would bar them from future investment opportunities.

The California Public Employees’ Retirement System, known as Calpers, is the nation’s largest pension fund, with $300 billion in assets. In a statement, Calpers said it “accepts the confidentiality requirements of limited partnership agreements to facilitate investments with private equity general partners, who otherwise may not be willing to do business with Calpers.”

But critics say that without full disclosure, it’s impossible to know the true costs and risks of the investments.

“Hundreds of billions of public pension dollars have essentially been moved into secrecy accounts,” said Edward A.H. Siedle, a former lawyer for the Securities and Exchange Commission who, through his Benchmark Financial Services firm in Ocean Ridge, Fla., investigates money managers. “These documents are basically legal boilerplate, but it’s very damning legal boilerplate that sums up the fact that they are the highest-risk, highest-fee products ever devised by Wall Street.”

Retirees whose pension funds invest in private equity funds are being harmed by this secrecy, Mr. Siedle said. By keeping these agreements under wraps, pensioners cannot know some important facts — for example, that a private equity firm may not always operate as a fiduciary on their behalf. Also hidden is the full panoply of fees that investors are actually paying as well as the terms dictating how much they are to receive after a fund closes down.

A full airing of private equity agreements and their effects on pensioners is past due, some state officials contend. The urgency increased this year, these officials say, after the S.E.C. began speaking out about improper practices and fees it had uncovered at many private equity firms.

One state official who has called for more transparency in private equity arrangements is Nathan A. Baskerville, a Democratic state representative from Vance County, N.C., in the north-central part of the state. In the spring, he supported a bipartisan bill that would have required Janet Cowell, the North Carolina state treasurer, to disclose all fees and relevant documents involving the state’s private equity investments. The $90 billion Teachers’ and State Employees’ Retirement System pension has almost 6 percent of its funds in private equity deals.

The transparency bill did not pass the General Assembly before it adjourned for the summer. Mr. Baskerville says he intends to revive the bill early next year.

“Fees are not trade secrets,” he said. “It’s entirely reasonable for us to know what we’re paying.”

Reams of Redactions

It might help investors to know the fees they are paying, but when it comes to private equity, it’s hard to find out.

Consider the Teachers’ Retirement System of Louisiana, which holds the retirement savings of 160,000 teachers and retirees. It invested in a buyout fund called Carlyle Partners V, which was Carlyle’s biggest domestic offering ever, raising $13.7 billion in 2007. Companies acquired by its managers included HCR ManorCare, a nursing home operator; Beats Electronics, the headphone maker that was recently sold to Apple for $3 billion; and Getty Images, a photo and video archive.

Earlier this year, The New York Times made an open-records request to that pension system for a copy of the limited partnership agreement with the Carlyle fund. In response, the pension sent a heavily redacted document — 108 of its 141 pages were either entirely or mostly blacked out. Carlyle ordered the redactions, according to Lisa Honore, the pension’s public information director.

The Times also obtained an unredacted version of the Carlyle V partnership agreement. Comparing the two documents brings into focus what private equity firms are keeping from public view.

Many of the blacked-out sections cover banalities that could hardly be considered trade secrets. The document redacted the dates of the fund’s fiscal year (the calendar year starting when the deal closed), when investors must pay the management fee to the fund’s operators (each Jan. 1 and July 1), and the name of the fund’s counsel (Simpson Thacher & Bartlett).

But other redactions go to the heart of the fund’s economics. They include all the fees investors pay to participate in the fund, as well as how much they will receive over all from the investment. The terms of that second provision, known as a clawback, determine how much money investors will get after the fund is wound down.

In the Louisiana pension fund’s version of the partnership agreement, that section was blacked out. But the clean copy discloses an important provision reducing the amount to be paid to investors.

In order to calculate their total investment returns generated by private equity deals, outside investors must wait until all the companies held in these portfolios have been sold. Any profits above and beyond the 20 percent taken by the general partners overseeing the private equity firms are considered excess gains and are supposed to be returned to investors.

But the Carlyle agreement includes language stating that general partners must return to investors only the after-tax amount of any excess gains. Assuming a 40 percent tax rate, this means that if general partners in the fund each received $2 million in excess distributions, they would have to repay the investors only $1.2 million each. That’s bad news for the funds’ investors: They would lose out on $800,000 in repayments for each partner.

Mr. Ullman of Carlyle declined to comment on this provision.

Also blacked out in the Carlyle V agreement is a section on who will pay legal costs associated with fund operations. First on the hook are companies bought by the fund and held in its portfolio, the unredacted agreement says. That essentially makes investors pay, because money taken from portfolio companies is ultimately extracted from the funds’ investors.

But if for some reason those portfolio companies cannot pay, the Carlyle V document says, investors will be asked to cover the remaining expenses. This may require an investor to return money already received — such as excess returns — after a fund has closed, the agreement explains. One way or another, the general partners are protected — and the fund investors, who included tens of thousands of retirees, are responsible for paying the bill. (By contrast, in mutual funds, which are required to make public disclosures and have independent directors, investors are far less likely to be stuck with such costs.)

The Ohio Public Employees Retirement System holds $150 million in investments in each of the Carlyle IV and V funds. Asked about the requirement to pay the legal settlement costs, a spokesman, Michael Pramik, said he understood why such a question would be raised, but declined to comment.

Another blacked-out section in the Carlyle V agreement dictates how an investor, like a pension fund, also known as a limited partner, should respond to open-records requests about the fund. The clean version of the agreement strongly encourages fund investors to oppose such requests unless approved by the general partner.

Some pension funds have followed these instructions from private equity funds, even in states like Texas, which have sunshine laws that say “all government information is presumed to be available to the public.”

In mid-September, after receiving an information request about a private equity investment, the Fort Worth Employees’ Retirement Fund denied the request. Doreen McGookey, its general counsel, also sent a letter to the buyout firm, Wynnchurch Capital, based near Chicago, notifying it of the request and instructing Wynnchurch how to deny it by writing to the Texas attorney general, according to a document obtained by The Times.

“If you wish to claim that the requested information is protected proprietary or trade secret information, then your private equity fund must send a brief to the A.G. explaining why the information constitutes proprietary information,” Ms. McGookey’s letter states, adding that the pension “cannot argue this exception on your behalf.” Then the letter warned the private equity firm that if it decided not to submit a brief to the attorney general, that office “will presume that you have no proprietary interest or trade secret information” at stake.

In an email, Ms. McGookey said Texas law required her to notify the private equity firm of the information request.

The Fort Worth pension is not alone in opposing open-records requests for private equity documents. Calpers has also done so. A big investor in private equity, with more than 10 percent of its assets held in such deals, it has put $300 million into the Carlyle IV fund — the fund that is levying investors for the $115 million legal settlement reached by Carlyle executives.

Earlier this year, Susan Webber, who publishes the Naked Capitalism financial website under the pseudonym Yves Smith, asked Calpers for data on the fund’s private equity returns. After a legal skirmish, Calpers said last week that it had fulfilled her request. But on Friday, Ms. Webber said Calpers had provided only a small fraction of the data.

Karl Olson is a partner at Ram Olson Cereghino & Kopczynski and the leading lawyer handling Freedom of Information Act litigation in California. He has sued Calpers several times, including a successful suit for the California First Amendment Coalition, in 2009, forcing Calpers to disclose fees paid to hedge fund, venture capital and private equity managers.

“I think it is unseemly and counterintuitive that these state officials who have billions of dollars to invest don’t drive a harder bargain with the private equity folks,” he said. “A lot of pension funds have the attitude that they are lucky to be able to give their money to these folks, which strikes me as bizarre and certainly not acting as prudent stewards of the public’s money.”

‘Not Open and Transparent’

Regulations require that registered investment advisers put their clients’ interests ahead of their own and that they operate under what is also known as a fiduciary duty. This protects investors from potential conflicts of interest and self-dealing by those managers. This is true of mutual funds, which are also required to make public disclosures detailing their practices.

But, as a lawsuit against Kohlberg Kravis Roberts shows, private equity managers can try to exempt themselves from operating as a fiduciary.

The case involves Christ Church Cathedral of Indianapolis, which contends that it lost $13 million, or 37 percent, of its endowment because of inappropriate and risky investments, including holdings in hedge funds and private equity deals. The church sued JPMorgan Chase, its former financial adviser, for recommending those investments.

JPMorgan Chase said in a statement that despite market turmoil, “Christ Church’s overall portfolio had a positive return for 2008-2013, the time period covered by the complaint.”

Christ Church’s private equity foray included a small interest in K.K.R. North America Fund XI, a 2012 offering that raised around $6 billion. K.K.R., the fund’s general partner, can “reduce or eliminate the duties, including fiduciary duties to the fund and the limited partners to which the general partner would otherwise be subject,” the fund’s limited partnership agreement says. Eliminating the general partner’s fiduciary duty to investors in the private equity fund limits remedies available to the church if a breach of fiduciary duty should occur, the church’s lawsuit said.

Kristi Huller, a spokeswoman for K.K.R., initially denied that it could reduce or eliminate its fiduciary duties. But after being presented with an excerpt from the agreement, she acknowledged that its language allowed “a modification of our fiduciary duties.”

Linda L. Pence, a partner at Pence Hensel, a law firm in Indianapolis, represents the church’s endowment in the suit. She said she had been shocked by the secrecy surrounding some of her clients’ investments. “On one hand they say they don’t owe you the duty,” she said, “but everything is so confidential with these investments that without a court order, you don’t have any idea what they’re doing. It’s not open and transparent, and that’s the kind of structure to me that’s ripe for abuse.”

Some investors who are privy to the confidential agreements have walked away from these deals. A recent survey of institutional investors by Preqin, the research firm, found that 61 percent indicated that they had turned down a private equity investment because of unfavorable terms.

“It is apparent that private equity fund managers are not doing enough to appease their institutional backers with regards to the fees they charge,” Preqin said.
This is an excellent article which shows you there is still way too much secrecy in the private equity industry, and much of this is deliberate so that PE kingpins can profit off dumb public pension funds that hand over billions without demanding more transparency and lower fees. This is why I played on the title and called it an "iron curtain."

Go back to read my comment on the dark side of private equity where I discussed some of these issues. I'm not against private equity but think it's high time that these guys realize who their big clients are -- public pension funds! That means they should provide full transparency on fees, clawbacks and other terms. They can do so with a sufficient lag as to not hurt their "trade secrets" but there has to be laws passed that require them to do so.

And what about the Institutional Limited Partners Association (ILPA)? This organization is made up of the leading private equity investors and it has stayed mum on all these transparency issues. If they got together and demanded more transparency, I guarantee you all the big PE funds would bend over backwards to provide them with the information they require.

Interestingly, all the major private equity funds have publicly listed stocks, many of which have sold off recently during the market rout (and some offer very juicy dividends!). Go check out the charts and dividends of Apollo Global Management (APO), Blackstone (BX), Carlyle Group (CG), and Kohlberg Kravis Roberts & Co. (KKR).

On its Q3 conference call, Blackstone's management pointed out that during the past four years, its growth had been limited only by how much capital it can manage efficiently, not by how much capital investors have been willing to provide.

But as valuations keep inflating, it will be even more difficult for these alternative investment managers to find deals that are priced reasonably. And if deflation settles in, I foresee very difficult days ahead for all asset managers, including alternative investment managers.

Below, David Woo, head of global rates and currency research at Bank of America Merrill Lynch, Monica Dicenso, U.S. head of equity strategy at JPMorgan Private Bank, and Bloomberg’s Michael McKee discuss how global economic concerns are impacting equity markets. They speak on “Street Smart.”

And Westwood Capital's Dan Alpert, author of The Age of Oversupply, talks with Yahoo's Aaron Task. Alpert argues the global economy is suffering an oversupply of labor, capital and productive capacity relative to demand. He called it a "reverse supply shock." I'm afraid he's absolutely right.