Is the PE industry any more ethical than the universal banks?
Ever since Mitt Romney failed to make the economic case for private equity during the last presidential campaign, PE’s public image has been battered even further.
Last year, seven of the leading PE firms in the U.S. paid almost $600 million to settle a class action lawsuit claiming they had rigged the bids in 19 leveraged buyouts between 2003 and 2007 and cheated target company shareholders out of fair market prices for their stockholdings. The evidence in the case apparently showed that the defendants1 — Bain, Blackstone, Carlyle, Goldman Sachs, KKR, Silver Lake and TPG – had for years been honoring an unwritten code not to “jump” each other’s take-over bids in club deals. The allegations constituted anti-competitive price-fixing under the Sherman Antitrust Act and could have resulted in criminal prosecutions.
Since 2012, when Dodd-Frank required PE firms managing more than $150 million to register with the SEC, routine SEC examinations have turned up what appears to be a standard industry practice among PE fund managers to extract enormous fees from their portfolio companies for investment banking, information technology, public relations, property management and other services of which their investors (and seemingly everyone else) were unaware.2 The SEC has also uncovered PE fund managers shifting their own operating expenses onto their PE funds without investor consent or favoring certain PE funds over others in the allocation of expenses. KKR, for example, just had to refund millions of dollars of misallocated expenses to its LPs.
Now we are hearing of two other disturbing developments in the $3.8 trillion PE industry.
Inflated portfolio company valuations
PE fund valuations of portfolio companies – which are typically determined by the PE fund managers themselves — tend to rise when PE firms are fund-raising or being audited and tend to drop — by a whopping 35% on average — when portfolio companies are exited.
Academic studies are showing that PE fund valuations of portfolio companies – which are typically determined by the PE fund managers themselves — tend to rise when PE firms are fund-raising or being audited and tend to drop — by a whopping 35% on average — when portfolio companies are exited.3 Is it possible that PE fund managers have been massaging their portfolio valuations as a marketing tool? An upcoming study on the “smoothing” of PE valuations also suggests that PE fund managers have been overstating portfolio valuations in times of market stress. In 2008, for example, PE portfolio valuations reportedly dropped by only 20% when the equity market as a whole was off by almost twice that amount. The authors argue that, since PE portfolio companies are typically much more leveraged than their listed counterparts, they should in theory have fared much worse than the broad market in a precipitous meltdown.4
Most recently, the SEC reported that it is investigating PE firms for allegedly bribing sovereign wealth funds to invest with them. Since SWFs are government entities, any such payment would constitute a violation of the U.S. Foreign Corrupt Practices Act which forbids U.S. persons from paying foreign officials to acquire or retain business. Many of the largest PE firms, such as Apollo and KKR, have raised substantial sums from SWFs.5 The Nigerian Sovereign Investment Authority alone contributed 10% of the capital raised by global PE firms from 2011 through 2013, according to Preqin.
If the SWF bribery allegations pan out and PE firms have actually been inflating their self-reported valuations to market their funds, PE will be giving the big banks a run for their money in the financial scandal department. Moreover, since both bribing sovereign officials and intentionally defrauding LPs are criminal offenses, this time some Wall Street ‘fat cat’ may actually end up in the slammer.
1 Three other PE defendants in the original lawsuit — Apollo, Providence Equity and Thomas H. Lee – secured dismissals of the conspiracy charges against them prior to the final settlement.
2 These fees also present a conflict of interest for PE fund managers since they are not negotiated at arm’s-length and could easily exceed the fees charged by independent firms for the same advice or services. The conflict can be mitigated by offsetting such fees against PE management fees and thereby sharing them with LPs.
3 See, e.g., Do Private Equity Funds Game Returns? and How Fair Are the Valuations of Private Equity Funds?. The SEC is also looking into whether PE fund managers inflate their internal rates of return by including their general partner investments, which pay no fees, in their net IRR calculations.
4 Comments taken from an interview with corporate valuation expert Jeff Hooke, co-author of the not-yet-published “smoothing” study and author of Security Analysis and Business Valuation on Wall Street (Wiley 2010).
5 As has hedge fund Och-Ziff Capital, which is currently being investigated by the Justice Department and SEC for allegedly bribing the Libyan SWF to win a $300 million investment mandate.