Tuesday, April 8, 2014

There is No Closing Statement in Private Equity Revisited

There is No Closing Statement in Private Equity Revisited

Last February, I wrote the following:

If you’ve ever bought a home, you’ve probably received a HUD-1 form at the closing.  The form has two columns of tiny print that detail all the buyer’s and seller’s fees and expenses in the transaction.  Unfortunately, private equity firms don’t present their investors with itemized statements.  It’s nearly impossible to account for all of the fees because some of them are deducted at the fund level and others are deducted at the company level.  The success of the private equity model depends on the lack of accounting of the fees incurred.  If investors realized that 40% of their equity was paid out in fees in a successful fund, and even 25% in an unsuccessful one, they’d never show up for a closing.  There is No Closing Statement in Private Equity” (January 29, 2013)

The post was the last of three that attempted to tease out the underlying fees and expenses incurred by investors in Bright Horizon, a deal structured by Bain Capital.[1]  According to BusinessWeek the SEC has been conducting an internal investigation of 400 hundred private equity firms.[2]  According to Alan Katz’s reporting, the SEC believes that some private equity firms have inflated the fees and expenses charged to private equity funds.  The SEC’s examination is a by-product of the Dodd-Frank legislation. 
Taiwan Investment (1999)

Most of us are familiar with the management fee and carried interest charge by the general partner of a private equity firm.   However, as I’ve written before, PE firms have many opportunities to impose all sorts of additional fees and expenses on their investors.  While the partnership agreement often provides a general description of these fees and how they should be handled, the document almost always leaves the GP with a great deal of discretion.  Moreover, it is next too impossible for LPs to track these fees.

In any area where money managers have discretion, a big profit motive, and the benefit of opacity, we should fully expect to find problems.  Thus, the SEC’s conclusions should come as no surprise.  The management fee almost certainly already covers all the relevant expenses of a PE firm.  However, if the manager can charge additional fees for monitoring portfolio companies, he’s going to generate a huge profit even if he credits some of the fee back to the LPs. Imposing expenses on the fund or the portfolio companies can only be good for the money manager’s bottom line.  Typically, deal costs are charged to the fund, including the cost of deals that fail to materialize (known as “dead deal costs).  If the manager expands the definition of deal costs, there are a wide variety of expenses that can be charged to investors instead of being absorbed by the manager.  Since virtually every fund involves a series of sub-funds and feeder funds, and every portfolio company consists of a collection of corporate entities, there’s plenty of opportunity for the manager to impose fees and expenses that are difficult to trace.

Years ago when the SEC examined soft dollar brokerage practices, they found plenty of money managers using their clients’ commissions for items that weren’t research related.  It took the better part of two decades for the SEC to narrow down the use of those practices.  The agency’s inquiry into private equity will also take a long time to complete.

In a separate article, Reuters reports that the SEC has creating a new examination unit focused on private equity firms.[3]  According to the reporters, Greg Roumeliotis and Sarah Lynch, the SEC is seeking increased budget authority to staff the unit.  I’m sure an army of lobbyists will go to work to undermine this request. If the SEC is going to threaten private equity’s most important function, generating profits for itself, the regulators should be prepared for a vicious battle.

[1] See, “A Nice Little Pay Day for Bain and Goldman” (January 26, 2013), “Shuffling Paper to Generate Fees: The Case of Bain and Bright Horizon” (January 28, 2013) and “There is No Closing Statement in Private Equity” (January 29, 2013)
[2] http://www.businessweek.com/news/2014-04-07/bogus-private-equity-fees-said-found-at-200-firms-in-sec-review
[3] http://www.reuters.com/article/2014/04/07/us-sec-privatefunds-idUSBREA360M420140407

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