Lifting the Lid on Private Equity

Who knew what PE managers were hiding from their investors?

Are private equity documents so opaque that even sophisticated investors couldn’t possibly figure out how much PE firms actually earn (or save) from their portfolio companies?

The SEC thinks so.

Following Dodd-Frank, the agency has been examining hundreds of new PE registrants and has found serious disclosure violations regarding fund fees and expenses in more than half of the firms examined.

Businessman in big problem(special photo f/x)One surprising discovery is the employment by PE managers of so-called “operating partners”.  These are industry experts touted by PE firms during fundraising as part of their management teams who are then installed on portfolio company payrolls once the PE funds are up and running.

Apparently, numerous PE firms don’t even tell their investors about transaction fees they earn from the recapitalizations and eventual sales of their portfolio companies.  In addition, those PE firms that charge their portfolio companies so-called monitoring fees for providing ongoing advisory services (like board members) don’t disclose their receipt of early termination payments when their monitoring contracts are closed out upon exit.  Some of those contracts run for as long as 10 years, despite the fact that PE holding periods are typically half that long.

“In some instances, investors’ pockets are being picked,” according to Andrew  Bowden, who heads the SEC’s examination efforts. 

The list of indiscretions goes on.  PE firms commonly charge their funds for administrative and back-office services – such as legal, accounting and reporting — that investors would reasonably expect to be included in their management fees.  Moreover, some of the outsourced providers are actually affiliates of the PE managers.  “In some instances, investors’ pockets are being picked,” according to Andrew  Bowden, who heads the SEC’s examination efforts. 

In cases where PE managers have established separate accounts or co-investment vehicles for clients, the SEC found that broken deal expenses or other costs associated with generating deal flow were frequently allocated solely to the PE funds and not to the side-by-side accounts that would have benefitted from the investments.

Because PE firms typically obtain controlling interests in private companies, they are faced with temptations and conflicts that don’t affect asset managers who traffic only in publicly-traded securities according to the SEC.  PE managers actually have the power to hire and pay themselves to perform needed services for their portfolio companies and they apparently do so on a much wider basis than the regulators expected.

On the other side of the ledger, PE fund investors have their work cut out for them.  Try reading PE private placement memoranda and limited partnership agreements and see if you can ferret out anything that would clearly prohibit the self-serving, financial shenanigans described above.  Generally speaking, the disclosures in those documents are purposely broad and give PE managers lots of leeway.  In other words, caveat emptor.