No escape from red tape: regulation is coming

Last fall, the folksy and occasionally obstreperous Louisiana Senator John Kennedy needled the state treasurer of Illinois on a question that captured the sometimes confusing relationship between institutional investors and private equity managers. Kennedy, at a Senate banking committee hearing that focused on private equity reforms, demanded to know why the treasurer would invest in a private equity fund without understanding the fees being charged. His question was spurred by the treasurer’s advocacy for legislation to force private equity to be more transparent.

“Are you telling me that you make private equity investments as a fiduciary without understanding the fees and, if so, whose fault is that?” Kennedy asked.

He compared the situation to buying a car: “If I go to buy a car, and the car salesman doesn’t explain the details of the financing to me, I just walk away. I don’t call for the federal government to take over every car salesman in America. What am I missing here?”

The treasurer, Michael Frerichs, said Illinois’s state pension system, one of the largest investors in private equity funds, is forced to spend money analyzing and monitoring its private equity portfolio simply to make sure that it is paying proper fees and expenses.

“Given that fees charged by private equity managers are among the highest shouldered by institutional investors, lack of transparency represents a meaningful risk factor,” Frerichs said. “As private equity continues to evolve, there is a growing need for improved disclosures around direct and indirect fees, expenses and performance-based fees such as carried interest.”

So why back managers with opaque fees and expenses? It’s a reasonable question, and one that gets to the heart of the idiosyncrasies of private equity investing, especially considering the transparency that exists in the public markets.

“This is coming. I feel like [SEC] chairman Gary Gensler has been walking around with a sign over his head saying, ‘regulation is coming.’ He’s been making it clear, every time he speaks, that private funds [should] watch out, regulations are coming, and it’ll probably be coming next year.” Amy Lynch, FrontLine Compliance

Limited partners, for better or worse, have tolerated certain practices that in other types of investing would be quickly squashed. But this toleration seems to be an anachronism of a formerly obscure business strategy that is evolving into a mainstream and pervasive industry.

Kennedy hammered home his main point – that both parties in the relationship are sophisticated investors, and that big public systems such as Illinois’s can simply walk away from bad deals. “Have you ever invested in private equity when you didn’t understand the fees?” he asked.

After some qualifying, Frerichs was forced to concede: “No.” He then added: “Private equity has done well for us, but it would be beneficial to see new rules and sensible reforms. For example, standard reporting would ensure transparency for all investors and ensure investors can validate all fees charged by private equity so they conform with their negotiated agreements.”

Rising pressure

The charged discussion is a reflection of broader tensions in the financial markets and Washington, DC regarding private equity, which has grown into a major part of the economy. The sector generated around $1.4 trillion in gross domestic product in 2020, according to information from industry lobby group the American Investment Council.

Because of its size and reach – especially when considering that private equity-backed companies employed an estimated 11.7 million Americans in 2020, according to AIC – regulators and politicians are clamoring to tighten controls over the once-freewheeling, little-noticed asset class.

The debate is expected to result in stricter regulations over private equity operations, especially when it comes to fee and expense reporting.

Pressure on the industry is coming both from Congress and the SEC. The commission may be the most direct challenge as it can craft rules that only need to go through a public comment process before they can be enacted.

New legislation, like that put forth by Senator Elizabeth Warren that would fundamentally change the way private equity operates, is less likely to make it through the bitterly divided Congress. The balance of power in Washington could very well change this year, taking some of the pressure off the industry, at least from legislators.

Private equity has long withstood criticism from the mainstream and has rarely seen any big changes. The biggest came after the global financial crisis, when the Dodd-Frank financial reform act forced most private equity firms to register as investment advisers with the SEC. This exposed them to SEC scrutiny, including regulatory exams and has led, in the years since, to numerous enforcement actions against firms such as KKR, Thomas H Lee Partners, Blackstone, Apollo and TPG, among many others.

But since Dodd-Frank, regulators have come up with little else with which to control private equity. With Democrats (barely) controlling Congress (for now), could this be the moment when private equity faces more regulation? Most sources believe change is coming, and the question is only how intense the rules will be.

“Why should it cost more? Yes, the fund may be larger, and maybe there are marginally more LPs in the fund, but why should those organizational expenses grow so much along with the fund size? It doesn’t necessarily make sense and indicates a lack of cost control for fund counsel.” Chris Hayes, ILPA

“This is coming,” says Amy Lynch, founder and president of FrontLine Compliance. “I feel like [SEC] chairman Gary Gensler has been walking around with a sign over his head saying, ‘regulation is coming.’ He’s been making it clear, every time he speaks, that private funds [should] watch out, regulations are coming, and it’ll probably be coming next year.

“[This] tells me there are rules being written as we speak… and changes are coming and we should be looking for those proposals in the first half of 2022.”

Kennedy made a good point – why invest in something if you don’t have a full understanding of how much it will cost? But here’s the reality – LPs agree to hard terms when they commit to a fund, and then they have to struggle to track those costs through the fund life and make sure they aren’t overpaying.

Why is that such a hard task? For one, an issue that has plagued the industry for years is the lack of standardized reporting of financial information. Industry trade group the Institutional Limited Partners Association in recent years created templates to try to standardize financial reporting, but those templates are not mandated and have not been universally adopted.

Instead, GPs will present reams of information to LPs in different ways, trying to customize as much as possible to meet each investors’ needs. But it doesn’t always happen, and sometimes it doesn’t happen at all, usually depending on the size of the LP.

“We had a third-party adviser come in and check the fee and carry calculations that the sponsors gave us, and some looked pretty bad. You can’t look at the financials and actually figure out, am I being charged the correct fees and carry?” An LP who runs a large PE portfolio

Some larger institutions have the money to hire outside firms to audit their books and help track private equity costs, but smaller LPs likely aren’t able to do that.

“We had a third-party adviser come in and check the fee and carry calculations that the sponsors gave us, and some looked pretty bad,” says an LP who runs a large PE portfolio. “You can’t look at the financials and actually figure out, am I being charged the correct fees and carry? It’s frustrating, and it’s pretty basic: are you charging me the right fees and carry? But many managers don’t give you enough information to answer that question.”

A state law in California, passed in 2016, forced GPs that collect capital from state organizations such as pensions to disclose annual fee, expense and performance data to investors. The reports also have to show each fund’s net and gross returns, reflecting the spread between what an investment returns and what investors ultimately receive, Buyouts previously reported.

Systems for systems

To implement the rule, pensions such as the California Public Employees’ Retirement System use that information to produce annual reports detailing specific fees and expenses charged by each of the firms to their private equity portfolios. CalPERS established a system called Private Equity Accounting Reporting System (PEARS).

The system enables CalPERS to segregate the individual costs associated with each of its private equity funds, separating management fees from fund expenses – such as the cost of legal and auditing services – while also accounting for carried interest collected by the manager.

“If done right, if it’s a strong rule, then the investor with the most negotiating leverage now sets the price for every single investor and that could create some massive fee compression.” Igor Rozenblit, Iron Road Partners

This is an example of the kind of technology that has become available in recent years allowing LP organizations to collect scattered financial data into one system and thereby help them organize, and better monitor, the costs of their programs.

“Ten years ago this was onerous and hard to do, but not today,” says the LP who runs a large PE portfolio. “GPs complain they have to do 100 different reports, and every LP wants something presented differently. That’s the beauty of standardization, that’s not true anymore. And [if the SEC says], ‘You give this report to everybody the same way,’ you can’t tell me you’re doing 100 reports anymore. You’re doing one report, and it’s ILPA approved.”

LPs also need to track expenses – minor costs that add up over time and that LPs want to make sure they actually owe. Expenses are usually capped in funds. They are generally categorized as operational, organizational, extraordinary and tax-related, according to a summary from law firm Duane Morris.

Operational expenses could include things like management of the fund, acquisition and holding expenses, broken deal and finder’s fees and costs of service providers. Organizational expenses include costs related to fund formation, printing, travel, accounting and legal work. Extraordinary fees involve things such as paying out legal settlements, which often fall to the fund.

GPs have been shifting more of the burden of paying for fund operations away from the management fee and directly on to fund investors in the form of expenses, according to an ILPA survey last fall. This shift is happening as organizational expenses in private funds have exploded, increasing 123 percent since 2011, the survey found.

Although expenses are generally capped, Chris Hayes, senior policy counsel for ILPA, told Buyouts in October that LPs said they were seeing more limitations on what those caps cover. “Why should it cost more?” asked Hayes. “Yes, the fund may be larger, and maybe there are marginally more LPs in the fund, but why should those organizational expenses grow so much along with the fund size? It doesn’t necessarily make sense and indicates a lack of cost control for fund counsel.”

“I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions.” Gary Gensler, quoted at the 2021 ILPA summit

In some cases, regulatory action also forced GPs to move certain costs off the management fee and into the expense category as regulators sought greater clarity about who pays for what.

“This resulted in increased point-by-point [breakdowns] on what fees are being charged, but also more direction about shifting those fees and costs to the funds,” a source tells Buyouts.

At ILPA’s annual summit last year, Gensler laid out a potential agenda for more regulation of private equity. This included disclosure of the various levels of fees GPs collect, including management and performance fees, as well as fees charged by portfolio companies.

“I wonder whether limited partners have the consistent, comparable information they need to make informed investment decisions,” Gensler said at the time. It was possible, he added, that more competition and disclosure of fees and expenses would “bring greater efficiencies.”

A perhaps surprising area of focus for the SEC, as described by Gensler last year, is side letters. These spell out terms and conditions specific to the investor that go above and beyond, or complement, what’s in the limited partner agreement.

According to a summary by Igor Rozenblit, managing partner with compliance consultancy Iron Road Partners, Gensler signaled potential prohibitions of certain provisions in side letters, such as those involving economics, liquidity options, informational or co-investments. Rozenblit was a top regulator at the SEC focusing on the examination program.

“This could be the most impactful one of all because, if done right, if it’s a strong rule, then the investor with the most negotiating leverage now sets the price for every single investor and that could create some massive fee compression,” Rozenblit says. “Especially at the largest firms, which tend to have those kinds of arrangements.”

Wants and needs

Side letters have grown into an unwieldy, and expensive, part of the fund negotiations. Side letters involve both necessities and nice-to-haves. Necessities might involve carving out an LP’s capital from a deal in a vice-related company that is tied with guns or tobacco, or for an institution that is barred from investing in those things. For that LP, that exemption must be there for it to commit to the fund.

Nice-to-haves might involve economic terms, certain reporting requirements or even co-investment preference for certain LPs. Scott Reed, co-head of private equity USA with Aberdeen, says: “If the GP promises to show me… some amount of coinvestment or guarantee me my pro rata share, that’s often codified in a side letter agreement.”

“The GP would rather everyone just sign up to the LPA and have no side letters because if they have 40 LPs and each LP has a different side letter with different provisions, the burden is on them to remember what’s in all those provisions to make sure they’re adhering to it.” Scott Reed, Aberdeen

Other necessities might involve confidentiality agreements, sources say.

Furthermore, LPs are granted provisions called ‘most-favored nation’ which give them the right to view, and opt in to, all the side letter exceptions given to LPs of their commitment size and smaller. “The GP would rather everyone just sign up to the LPA and have no side letters because if they have 40 LPs and each LP has a different side letter with different provisions, the burden is on them to remember what’s in all those provisions to make sure they’re adhering to it,” Reed says.

“They try to minimize all the bells and whistles that go into side letters and, like economic terms, GPs that are highly oversubscribed and highly in-demand usually get away with having relatively limited, if any, side letters. Whereas if a manager is more desperate to raise capital they’re willing to give some stuff away.”

Lynch of FrontLine Compliance says that private equity firms should be tightening up language in regulatory documents like Form ADVs on big topics on the SEC’s radar, such as use of side letters, fees and expenses, and conflicts of interest.

She believes the concern among regulators is whether certain investors are being “given special treatment in order for these managers to have access to their dollars. How are these private equity managers then showing, perhaps, favoritism among their investors when you have investors with different terms and conditions regarding their interests in the fund?”

Some large investors may be able to negotiate fees down or achieve special liquidity rights. “There are various ways they might get better economics… regarding their investments than another investor,” Lynch says. “And that could be deemed a conflict of interest as well as showing favoritism among investors, which is exactly what creates that conflict.”

Legislation? No worries…

One area that does not appear to be of major concern to the industry is new legislation restricting various processes. Although Senator Elizabeth Warren introduced legislation that would fundamentally change the way private equity operates, turning that proposal into law appears increasingly unlikely.

The Democrats have a razor-thin margin of control in Congress and have been focusing their energies on major spending and tax programs, rather than on new private equity rules.

Even something as controversial as the tax treatment of carried interest as capital gains rather than ordinary income does not seem like it’s going to change anytime soon. And if Republicans win back control of Congress this year, PE can probably breathe a sigh of relief on the legislative front.

For now, the real action is likely to come from the SEC, and Gensler appears poised to make some changes. Time will tell just how intense those controls will be.