When the SEC got a bunch of private equity execs in a room earlier this month, Special Inspector Andrew J. Bowden did not have good news. His discussion was basically a warning that the SEC was going to start looking deeper into the industry.
And one of the things the agency would be looking into, per his comments, is the very basis of the PE industry's dealmaking — the agreement between PE firms and their portfolio companies, or limited partnership agreements (LPAs), which are considered trade secrets.
"Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies (as opposed to being borne by the adviser)," said Bowden. "This has created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors. Poor disclosure in this area is a frequent source of exam findings. We’ve also seen limited partnership agreements lacking clearly defined valuation procedures, investment strategies, and protocols for mitigating certain conflicts of interest, including investment and co-investment allocation."
In other words, some of these agreements are written so that firms make a bundle at everyone else's expense. Moreover, they're considered trade secrets so not a lot of people get to see them. Over the holiday weekend, though, blog Naked Capitalism managed to get their hands on 12 LPAs from the Pennsylvania Treasury's public e-contracts library and published them. (Via Fortune's Dan Primack)
This is complex stuff so we'll give you two big ideas people are taking from the documents.
- In a few instances firms elect to waive their management fee and collect only fees that could be considered capital gains. Some might call this a tax dodge since management fees are taxed at a much higher (35%) rate than capital gains income (15%).
- The LPAs don't seem to contain any trade secrets at all, just vague language about the firm's fee structure that can, as Bowden suggested, could work against the firms' PE buy. Bowden specifically called out "monitoring fees" in his speech. Those are fees that PE firms collect for advising a company that it owns. Usually the firms collect those fees for as long as a company is in their custody, but in some cases the fee collection extends beyond that time. The SEC hates this, and, as Primack pointed out, Gretchen Morgenson wrote a big piece about it in the NYT this weekend. Expect to hear more about this.
"By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time," said Bowden last month.
If that doesn't get some people in Congress angry, what can?