SEC Probing PE Performance Figures?

Greg Roumeliotis of Reuters reports, SEC probing private equity performance figures (h/t, Yves Smith, naked capitalism):
The U.S. Securities and Exchange Commission is examining how private equity firms report a key metric of their past performance when they market new funds to investors, as the regulator boosts its scrutiny of the industry, according to people familiar with the matter.

At issue is how private equity firms report how they calculate average net returns in past funds in their marketing materials, the sources said.

Net returns, also known as the net internal rate of return (IRR) and an indicator of investors' actual profits, deduct private equity fund investors' fees and expenses from a fund's gross profits. Private equity fees are not standard and different investors in the same fund can pay different fees.

Fund investors such as pension funds, insurance companies and wealthy individuals – known as limited partners - pay the fees to the private equity firm. The private equity firm and its managers, called general partners, also typically invest some of their own money into the funds, but don't pay any fees.

Including the general partner's money in the average net returns can inflate the fund's average net performance figure, and the SEC is investigating whether private equity fund managers properly disclose whether they are doing that or not, the sources said.

A SEC spokeswoman declined to comment.

The SEC's focus on the average net IRR disclosures, which has not been previously reported, marks a new phase in the agency's efforts to regulate private equity and comes at a time when the industry is already under pressure from investors to simplify its fees and expenses structure.

The emphasis on performance figures is likely to cause many buyout firms to review their regulatory compliance measures and force them to increase disclosures and make their numbers more intelligible to investors.There is no standard practice for calculating average net IRRs among the roughly 3,300 private equity firms headquartered in the United States.

A Reuters review of regulatory filings and interviews with people familiar with different firms' practices show the calculation varies widely even among the top private equity firms.

Blackstone Group LP, Carlyle Group LP and Bain Capital LLC, for example, do not include money that comes from general partners in average net IRR calculations, while Apollo Global Management LLC does, the review shows.

Fund marketing documents are not public, but the sources said all these firms disclose to investors whether they include general partner capital in the calculation or not.

The SEC's review comes after the agency put together a dedicated group earlier this year to examine private equity and hedge funds that had to register with it as part of the 2010 Dodd-Frank financial reform law, Reuters first reported in April.

Much of the SEC's focus so far had been on fees that private equity funds charge. In a May 6 speech, Andrew J. Bowden, director of the SEC's Office of Compliance Inspections and Examinations, said more than half of the private equity funds the agency examined had inappropriately allocated expenses and collected fees.


The average net IRR figure is crucial to investors' understanding of their actual profits from private equity funds. That's because not all investors in a fund pay the same amount of fees to the private equity firm for managing their money.

Typically, fund managers charge a management fee of about 1.5 percent of committed capital and take 20 percent of the fund's profits assuming performance meets a returns hurdle agreed with investors.

Investors, however, are usually offered fee breaks if, for example, they commit money early during the fundraising process or if they make a larger allocation to the fund.

The SEC expects private equity firms to report average net IRRs alongside gross IRRs with equal prominence in marketing materials when they are seeking to raise a new fund.

Industry sources said including general partner capital in the average net IRR calculation can make a material difference if that commitment is sizeable.

"Over the past five years, some general partners have started to invest more of their personal capital into their vehicles on a non-fee basis and that obviously can create some IRR distortion," said David Fann, chief executive officer of TorreyCove Capital Partners LLC, a private equity advisory firm.
I'm glad the SEC is finally scrutinizing the performance figures of the private equity industry to shine some light on whether these figures are exaggerating net returns.

Admittedly, the inclusion of a general partner's money is not a big deal in the smaller funds but large public pension funds and sovereign wealth funds typically invest in large well-known buyout funds, and they invest big sums alongside their investors.

As the article states, including the general partner's money in the average net returns can inflate the fund's average net performance figure, and the SEC is investigating whether private equity fund managers properly disclose whether they are doing that or not.

In her comment, Yves Smith (aka Susan Webber) notes the following:
We’ll put aside an issue that we’ve discussed at some length in past posts, that IRR is a terrible way to measure returns. As McKinsey put it,”…typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great.”
As far as the SEC investigation is concerned, there are actually two issues here, and the SEC is focusing on the worst of the two. One is, as the article notes, is that the some funds are basing their return calculations with general partner capital included, and since the general partners don’t pay any fees, including their funds in the return calculation has the effect of increasing it.

There’s a second issue, and it’s surprising the SEC hasn’t taken interest in it (or maybe it is but hasn’t figured out what to do about it) is that even the use of an “average net returns” will exaggerate prospective returns for many investors, meaning pretty much all the smaller ones. For instance, investors have succeeded in negotiating reductions in fees many general partners charge, the so-called monitoring fees (annual consulting fees charged to portfolio companies) and transaction fees (which are basically double-dipping, since these general partners hire investment bankers who charge merger & acquisition and financing fees of their own). These reductions come in the form of rebates credited against the annual management fees. These rebates typically range from 60% to 100%, with 80% considered to be a representative level. Industry leader CalPERS generally gets a 100% rebate.

The question is whether a small or newbie investor, who is likely to get only a 60% rebate, has the acumen to adjust the “average net IRR” he is presented in his marketing materials to a level to what someone like him would get on a net basis. Note that the magnitude of these fee differentials, and the lack of transparency surrounding fee differences, has turned into a full-blown row in the UK, where limited partners are less captured than in the US.
Indeed, in the UK, private equity investors are lukewarm on the asset class and they're much more vigilant on monitoring hidden fees and ensuring a level playing field for all investors, big and small.

It's worth noting, however, most of the large well-known funds do not include the general partner's money in their calculations of average net returns, but some do. The article specifically mentions Apollo Global Management (APO), which ironically has CalPERS as a huge equity owner (close to a 15% stake) and a big investor in their funds too.

As you can see below, the common shares of Apollo Global Management (APO) have had a miserable 2014, down over 30% (click on image):

The shares of other alternative investment funds have been hit too, but not to the extent of Apollo, which makes me wonder how CalPERS is fairing with this investment.

I mention CalPERS here because they had a board meeting recently where they grilled their consultants on hidden PE fees and got some surprising answers (h/t, naked capitalism).

Below, I leave you with the last Board and Committee meeting at CalPERS. You can view all Board meeting agendas here. The start and stop times for the consultants are at 34:30 to 38:30 for Albourne America, 1:04:35 to 1:08:30 for Meketa Investment Group, and 1:37:30 to 1:40 for Pension Consulting Alliance. Or you can click to each at the start of each segment here: Albourne America, Meketa Investment Group, Pension Consulting Alliance.

CalPERS' board member Jelincic describes how the fees are shared only if the fund has not fully exited its investment in the portfolio company and asks if that’s an example of an evergreen fee, and if so, what CalPERS should do about it.

Listen carefully to the response from all three consultants to Jelincic's question, it's a real eye-opener, especially in the case of Albourne which conducted an extensive back office audit and knew about hidden fees but failed to share it with their limited partners, claiming  a lot of the fees were disclosed in footnotes.

Really? Wow! More evidence of how useless investment consultants have become (and I consider Albourne to be among the best investment consultants). Also, listen carefully to how all the consultants think private equity deals are pricey now but limited partners are best to keep on investing steadily in all vintage years (so the consultants can keep collecting their fees). 

Finally, go back to read my comment looking behind private equity's iron curtain. As these private equity funds manage increasingly more money from public pension funds, we need to start looking more closely at their operations and whether the information they're providing is accurate and reflects the risks and costs of their investments.