Are 2 & 20 just not enough?
Are private equity types any different from hedge funders?
The SEC apparently doesn’t think so and, after excoriating the latter for flagrant securities law violations, the regulators are now training their sights on the former.
In private equity, it’s not insider trading that’s the rub. What has caught the SEC’s attention are the juicy transaction fees PE fund managers have been charging their portfolio companies for arranging their LBOs, interim restructurings and eventual sales.
PE is a $3.3 trillion industry. Leveraged buy-outs can run into the tens of $billions. When the deals close, the PE firms take tens of $millions out of the proceeds for their investment banking services. Some PE firms also charge $millions in ongoing “monitoring fees” for overseeing portfolio company operations.
Both transaction and monitoring fees are over and above the 2% annual management fees and 20% carried interests that PE firms typically receive.
The additional fees also constitute a substantial percentage of PE fund operations. KKR, for example, earned nearly $100 million in transaction fees last year — more than a sixth of its PE revenues — and a total of $360 million over the past three years. Blackstone also generated $100 million in transaction fees last year — an eighth of its PE gross — and collected over $300 million during the past three years. Overall, PE firms have amassed more than $2 billion in transaction fees over the past 10 years.
Conflict of Interest
The SEC now wants to know why a PE firm’s management fees and carried interests don’t cover these investment banking services and to what extent, if any, the extra fees are being shared with fund investors. The regulators also want to know whether shareholders of the portfolio companies have been advised of these fees before deals are closed. PE investors are already on the case and have been pressuring their fund managers to give up more of their IB fees to their limited partners.
A case in point is Caesars Entertainment, the casino company1. Caesars was taken private by TPG Capital and Apollo in a $30.7 billion LBO in 2008. At the closing, the two PE firms collected a $200 million transaction fee and, since then, have been charging around $30 million a year in monitoring fees. The PE firms have kept a third of those fees and passed on the balance to their investors.
Earlier this year, two of those investors — the state pension plans of Rhode Island and Oregon — pressed TPG and Apollo to retroactively give up their transaction and monitoring fees in light of the facts that Caesars is now saddled with debt and has been losing more than $1.4 billion a year since the buy-out.
According to RI Treasurer Gina Raimondo, the $6 billion in equity that the PE firms invested in Caesars is now worth only $2.2 billion. She called the fees retained by the two PE firms “a clear misalignment of interest” in light of the fact that fund investors had seen no profits: “[w]hile I understand investing entails risk and not every investment will work, I expect us to sink or swim together.”
She called the fees retained by the two PE firms “a clear misalignment of interest” in light of the fact that fund investors had seen no profits: “[w]hile I understand investing entails risk and not every investment will work, I expect us to sink or swim together.”
PE firms argue that their transaction fees are negotiated with sophisticated counterparties and no one is being exploited. They also point out that, in cases where they don’t own all of the equity in a portfolio company, their investment banking services would effectively be subsidizing the other investors in the company if they were not paid separate transaction fees. What’s more, most of such fees nowadays are being offset against management fees. According to Preqin, a PE data tracker, LBO funds launched in 2012 and 2013 rebate an average of 87% of transaction fees to their investors and about 63% of PE funds now rebate all of their transaction fees to investors. Rebates were at 51% in 2010 and 2011.
Monitoring fees are encountering the same resistance. PE fund managers have historically justified these fees by claiming that they relieve portfolio companies from having to pay management consultants for the same services. Nevertheless, according to Pitchbook Data, such fees have fallen precipitously across the entire PE industry since the fourth quarter of last year, thanks largely to the efforts of activist limited partners. Apollo, for example, recently offered 100% rebates on monitoring fees in its newest PE fund.
The PE industry also stands by its returns to investors. “Private equity is the highest returning asset class for investors—net of fees—over long time horizons,” according to a recent study by the Private Equity Growth Capital Council, a PE trade group. The study shows that PE delivered a 10% median annualized return to 146 public pension plans managing more than $1 billion over the last 10 years. By comparison, the surveyed pension plans earned only a 6.5% median annualized return on their total investments during the same period (comprised of stocks @ 5.8%, bonds @ 6.6% and real estate @ 6.7%).
The SEC also thinks that PE transaction fees are transaction-based compensation that may require PE fund managers to register as securities brokers. PE firms are currently regulated by the SEC only as investment advisers2 and broker registration – which is a far more onerous regulatory regime than IA registration — would undoubtedly be anathema to them.
Under US law, a securities broker is any person engaged in the business of effecting transactions in securities for the accounts of others. One earmark of being a broker is receiving fees in connection with a securities transaction that are either conditioned on its success or calculated in proportion to its size. According to David Glass, a senior SEC attorney, the receipt of any such fees causes an adviser “to take on a salesman’s stake” which, according to Glass, could be avoided in PE by offsetting such advisory fees against fund management fees.
Other SEC Concerns
PE transaction fees are not the only SEC target. The industry is facing scrutiny from Congress over why its carried interests in portfolio companies should be taxed at capital gains rates rather than as ordinary income. Also, regulators are concerned about inconsistencies in the valuation of illiquid PE assets and the offloading of regular PE management company expenses onto investors through the outsourcing of administrative and other services to independent vendors. Lastly, a number of the most prominent PE firms have been confronted with a class action from erstwhile shareholders in their portfolio companies alleging collusion in club deals designed to depress acquisition prices.
All in all, the PE industry offers a potentially rich vein of enforcement opportunity for a revitalized regulator like the SEC which is determined to root out any financial chicanery that, once again, puts even sophisticated investors at the mercy of Wall Street.
1 Another good example is TXU, a Texas utility, which, in 2007, was taken private in the largest LBO ever ($48 billion) by KKR, TPG and Goldman Sachs which collectively pocketed almost $300 million in transaction fees at the closing. TXU (renamed Energy Future Holdings) is now overloaded with debt and facing bankruptcy.
2 Ironically, the House of Representatives just passed a bill actually exempting PE fund managers from SEC registration in an effort to facilitate the flow of capital to new and growing businesses. The bill, however, is not expected to survive in the Senate or, even if it did, a likely Obama veto.