Thursday, October 8, 2015

Blackstone’s SEC Settlement Highlights the Failure of Institutional Investors

Blackstone’s SEC Settlement Highlights the Failure of Institutional Investors[1]

Once again I’m compelled to put down my pens and brushes to comment on a troubling development in money management. Over the past several years I’ve written repeatedly about the monitoring fees imposed by private equity on portfolio companies and the conflicts of interest authorized in limited partnership agreements.[2] Yesterday the SEC reached a settlement with Blackstone concerning its failure to properly disclose to LP the terms and conditions of its monitoring fees and its retention of outside counsel to advise both Blackstone and its PE funds.[3]  The SEC also found that Blackstone received a bigger discount than the funds on the legal fees charged by the law firm.

This settlement isn’t a victory for investors.  Rather, it points out the failure of sophisticated investors to protect their own interests.    The SEC doesn’t have substantive authority over money management firms, so it can’t do much more than pursue PE firms that fail to make proper disclosure or lack adequate policies and procedures.   Presumably the SEC will bring similar proceedings against other PE firms, but it won’t change the dynamics or nature of the industry.  There are simply too many firms, too many funds, and too few resources at the SEC.  Furthermore, a financial penalty is merely a small additional cost for doing business.   Blackstone will pay $28.9 million in disgorgements and $10 million in fines, which is a tiny price for a firm that collects billions of dollars in management, transaction, and carried interest fees.[4]   

The failure of LPs to protect their interests is highlighted in the text of the SEC’s order.    The SEC reveals that Blackstone notified all of its LPs about its legal arrangements and the disparate fee structure without receiving any complaints from the investors.  CalPERS, CalSTRS, Oregon, and Washington are major investors with Blackstone because they disclose the performance of their PE managers.  However, none of them complained about Blackstone’s legal arrangements.

As “sophisticated investors” the public pensions and other LPs ought to have been apoplectic over the legal arrangements and fee discounts.  No LP should be comfortable, let alone permit, a General Partner to use the same law firm as the firm representing the fund.  And if the legal arrangement didn’t bother the LPs, the discount afforded Blackstone, but not the funds, should have concerned them.  Investing with a private equity firm requires a high level of trust.  The GP (in this case Blackstone) has all sorts of discretion in buying and selling companies and retaining bankers, accountants, and lawyers.  When the GP cuts corners on hiring an attorney to represent the investors, it should raise concerns about the entire relationship with the GP. 

As a result of the SEC’s action, Blackstone has curtailed its monitoring fees and ended its practice of charging large termination fees when the monitoring contract is terminated prematurely.  I’m left to wonder why large, sophisticated investors tolerated these practices in the first place.    Blackstone and other GPs have been charging all sorts of unjustified fees for years.  Even if the disclosure was poor and procedures were deficient, major investors like CalPERS, CalSTRS, Oregon, and Washington knew about these practices.  Incredibly they’ve tolerated them.

Addendum:  Once again Naked Capitalism had provided the clearest and most detailed analysis of the violations committed by Blackstone.

[2] See for example,  Private Equity Tentacles: Blackstone Files to Take SeaWorld Entertainment Public, 1/5/13; Shuffling Paper to Generate Fees: The Case of Bain and Bright Horizon, 1/28/13; Quintiles Files to Go Public: The Details Matter, 2/20/13; Quintiles Update: Company Will Pay a $25 Million Termination Fee, 4/8/13.  I also wrote a column for the News and Observer,

[4] As per usual, Blackstone didn’t admit or deny any of the SEC’s findings.  Curiously, the fines were all related to the improper disclosure and procedures regarding monitoring/termination fees.  The hiring of a single firm to represent Blackstone and the funds, as well as the discount, did not appear to incur any particular fine.