When it comes to private equity, I’d have to agree with many sources I’ve talked to over recent months that their biggest shock this year was delivered by the SEC.
“If you asked me a year ago what I would be thinking about this year, it wouldn’t be whether an operating partner is actually an employee of the firm,” one GP told me recently.
The SEC announced in May that, based on preliminary findings from its newly instituted examinations of private equity firms (about 150 in all at the time), the agency had found material weaknesses and violations of law around GP treatment of fees and expenses in more than half.
Andrew Bowden, director in the SEC’s Office of Compliance Inspections and Examinations, made the now-infamous speech in which he laid out some of the problems the SEC had found. One example was GPs paying operating partners by charging the fund or portfolio companies, rather than through management fees. This charge is unexpected because operating partners are usually presented as employees of the firm.
Bowden also talked about the monitoring fees firms charge their portfolio companies that at times extend beyond 10 years, some of which accelerate to full payment of the monitoring contract at the time of exit.
Months later, we’ve seen one private equity firm that I would consider of any significance, Lincolnshire Management, settle with the SEC, agreeing to pay $2.3 million without admitting or denying the agency’s finding. The SEC accused Lincolnshire of integrating two portfolio companies and charging more expenses to one of the companies.
A lot of what the SEC has discovered in its examinations appears to be small-potato kind of stuff that can be easily fixed. Sources told me they do not expect to see any major heads on platters as a result of the increased SEC scrutiny.
I’m not so sure. I don’t believe there are a lot of GPs out there maliciously defrauding investors. But over the years some GPs have been able to get away with some activities that, while not technically illegal, hover on the line between right and wrong. It’s plausible a GP out there who has been operating on the line for a long time stepped over at some point.
One LP told me at a conference over the summer that LPs know who the firms are that stretch the line, which kind of reminded me of that scene in the movie “The Untouchables” when Sean Connery tells Kevin Costner, “Everyone knows where the booze is.”
In private equity’s case, everyone may know where the bad behavior is, but they’ll continue committing to those managers as long as they are top performers.
In recent months, GPs appear to have hardened their opinions against the SEC’s public pronouncements. I’ve found an interesting pattern: The GP will say heightened regulatory scrutiny is a good thing because some practices needed to end, but later in the conversation the GP will talk about how the SEC’s intense probing of the industry is nothing more than a political witch hunt.
One GP told me that if the industry doesn’t present systemic risk to the economy (and it doesn’t), you have to question what we’re spending our money on.
The GP made a good point, but I tend to come down on the side of the LP. More transparency, more disclosure and more standardization is a good thing. Because as Bowden pointed out in his speech, investors like CalPERS and CalSTRS may be some of the most sophisticated in the world, but they are managing the retirement funds of teachers, cops and firefighters.
And while I don’t believe the industry presents systemic risk, the ultimate beneficiaries of private equity’s prowess or failure deserve a well-regulated and transparent asset class.
We here at Buyouts will be watching and doing some probing of our own into this ongoing issue, so stay tuned for an exciting 2015.