Andrew Palmer, CIO of the $45.8 billion Maryland State Retirement and Pension System, knows how tough it can be for investors to figure out how much they’re paying private equity firms in fees and expenses. “You start the process with ‘These are the things that are important to us as a pension system,’ and then you work your way down the list to indifference,” Baltimore-based Palmer says, describing the efforts involved in defining fees before allocating to a private equity fund. “You have to prioritize because there are only so many dollars you want to spend on legal fees within the bigger picture.”
Private equity remains popular with investors because in a low-yield world, it’s one of the few asset classes that delivers consistently high returns. But those returns come at a price, and they aren’t enough to silence criticism of the industry’s murky fee structures. What can investors do to strengthen their hand? A combination of guidance, legal maneuvers and fear of enforcement action is converging to give them more control.
There’s big money at stake. Private equity firms charged investors as much as $20 billion in so-called hidden fees between 1981 and 2013, according to a recent academic study, “Private Equity Portfolio Company Fees.” Ludovic Phalippou, an associate professor of finance at the University of Oxford’s Saïd Business School, co-authored the paper with Christian Rauch, a fellow in entrepreneurial finance at Saïd, and Marc Umber, assistant professor of corporate finance at the Frankfurt School of Finance & Management.
Phalippou and his colleagues argue that the hidden fees crop up in transaction and monitoring expenses levied through master services agreements that are intentionally vague. After Texas-based utility Energy Future Holdings Corp. filed for bankruptcy in 2014, they write, U.S. private equity giant KKR & Co. and other firms working on the deal still made $666 million in portfolio company fees. That number dwarfs any distribution check an individual investor is likely to see from a general partner like KKR.
Such claims hark back to the now-infamous “Spreading Sunshine in Private Equity” speech. In that May 2014 address, Andrew Bowden, former director of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE), jolted private equity firms by alleging that advisers to the industry inappropriately handle fees and expenses more than half of the time.
The SEC has been scrutinizing private equity firms since 2012, when they had to start registering with it under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Each year the commission releases examination priorities — a bit of guidance that is closely watched because the examination process can often lead to enforcement actions. From 2012 through 2015 these priorities have touched on areas specific to the private equity industry.
As a result, the commission has assembled data on how private equity firms operate. Their business practices have prompted several settlements with the SEC, according to Igor Rozenblit, co-head of the OCIE’s private funds unit in New York.
“The incidence of issues in private equity is still surprisingly high; however, private equity is not legalized gambling,” Rozenblit says. “Private equity is a legitimate asset class, but it is complex, opaque and has relatively poor governance.”
The private equity business model can be a strength because it allows managers to operate freely, Rozenblit observes, but it also creates a disconnect between what general partners think limited partners know about certain issues and what the latter group actually knows.
When hammering out deals with private equity general partners, investors must pony up the legal fees necessary to agree on a meaning for “consulting costs” and other vague terminology found in master services agreements. Historically, general partners have relied on these so-called terms of art to give them plenty of wiggle room when it comes to charging expenses on top of performance fees.
“The LP agreement process is very granular; we spend a lot of time on business terms,” Maryland State Retirement CIO Palmer says. “But where it’s less granular is that we use terms of art in the documents that may not be uniformly applied, so it’s important to be clear in the docs about what a fee offset means for each GP, for example.”
On Friday the Institutional Limited Partners Association, an industry group made up of private equity investors and general partners, released a new set of templates that investors can use in negotiations with general partners to push for more consistency. The ILPA drafted its templates after a public comment period that included feedback from private equity firms, investors, regulators and other stakeholders. “What we are aiming to do with the templates is create standardization around the data points that are reported by GPs and where they are reported,” says Jennifer Choi, the association’s Boston-based director of industry affairs.
“You can’t underestimate the role of standardization in this process,” Choi adds. “It can be interesting to ask where certain information is in mixed company, because different GPs will have the same data points in all sorts of different documents. So it becomes incredibly labor-intensive to be able to compare data on the LP side.”
ILPA guidelines are typically used in side letters or as reference material during the initial due diligence process before an investor comes into a fund. But these standards aren’t much more than a conversation starter, warns Michael Belsley, a Chicago-based partner in the private equity practice at law firm Kirkland & Ellis. “From our work with LPs, they are using the ILPA standards on a selective basis,” Belsley says. “It really depends on the relationship between the LP and the GP.”
Legally speaking, the SEC agrees. “From our perspective, there’s nothing under the law that makes these reporting guidelines binding,” the OCIE’s Rozenblit says.
Belsley says ILPA standards are best used when considering the total picture of fees and expenses, so investors have a clear list of points they might negotiate on. “If you look at ILPA standards, they call for a 100 percent fee offset for transaction fees,” he notes. “But an investor may look at that and decide they’ll trade away some of those fees if they end up paying a lower management fee on the other side.”
In negotiations, investors are also becoming savvier about using tools like carve-outs to get even more specific on fees, Belsley adds. Carve-outs typically list partnership expenses that the investor won’t pay for, such as SEC examination costs.
Rozenblit, who points out that the agency is just getting started on the enforcement front, says the “Sunshine” speech wasn’t meant as an opening of the floodgates. “The speech just happened to come in the middle of our examination process, when we were comfortable sharing some of our more significant findings,” he explains. “People mistook the speech as a signal of upcoming enforcement actions, when in fact it was our attempt to reach out and work with the industry and improve compliance.”
Because cases take time to build, it may be a few years before investors see a rash of enforcement actions. “One of the former co-chiefs of enforcement’s asset management unit used to say that in private equity enforcement, we’re about five years behind what we are in hedge fund enforcement,” Rozenblit says. “So if you want to see where we are headed in private equity, you can use our historical hedge fund activity as a benchmark.”
