I hope readers forgive me for going a bit heavy on private equity coverage this week, but with markets complacent and Congress out of session (the House is back from recess as of today), the timing is fortuitous for pursuing this topic more intensely than usual.
We’ve had a surprising run of stories showing that the private equity industry, which heretofore has been treated with considerable deference, isn’t all its cracked up to be. Following hard on the heels of an astonishingly direct SEC speech in early May setting forth a bill of particulars of industry abuses, the Wall Street Journal published an important article by senior reporter Mark Maremont questioning industry leader KKR’s dealings with its house consulting firm KKR Capstone violated its agreements with investors. If KKR gets away with it, it will only be by virtue of an opinion letter from Linklaters, the same firm that blessed Lehman’s Repo 105 ruse.
A mere two days after that, over Memorial Day weekend, Gretchen Morgenson of the New York Times reported on fee abuses that are common, if not widespread in the private equity industry, including getting fees for services never rendered. And as most readers know, we released 12 private equity limited partnership agreements Monday evening. While our document publication is unlikely to register as significant to the broader public, it is a seismic event for the private equity industry, since it demonstrates conclusively that their claim that theses heretofore super-secret agreements be kept confidential to preserve critical trade secrets is an utter sham.
Curiously, the private equity firms do not appear to be reacting to these stories. One indicator is that the documents we revealed, which were made public by the Pennsylvania Treasury, are still up on its e-contracts website. The limited partners would clearly be in their rights to demand that they be taken down pronto. Even if these horses have left the barn and are now in the next county, failure to act promptly in this instance could send the wrong message to industry incumbents. However, Lambert pointed out that the mechanics for Pennsylvania to take the contracts down could be more cumbersome that outsiders might anticipate.
Admittedly, the clustering of breaking news around a weekend where anyone who is anyone in New York City decamps to the Hamptons may have caught the private equity general partners flatfooted. And they may also hope that the holiday timing blunts the impact of these stories, so if they lay low, this will blow over.
But while one robin does not make a spring, one reporter’s reaction indicates that the sudden exposure of new information about the private equity industry is leading to some serious reassessment.
Dan Primack is a seasoned reporter on the private equity beat, having launched the peHUB publications for Thomson Reuters before he joined Fortune in 2010. Primack now has a broader reporting ambit than before, but he still covers private equity.
One of the cliches of journalism is that reporters are only as good as their sources. Over the last decade, both business and government officials have used that to their advantage to play the access journalism game. Any reporter on a comparatively narrow beat can easily become hostage to his sources, and Primack’s recent articles on private equity gave reason to think he fell into that camp.
David Sirota at Pando has been all over a private equity pay to play scandal in New Jersey which has broader political ramifications, since it involves both Chris Christie and Massachusetts gubernatorial candidate Charlie Baker. Sirota and Primack have had some Twitter dust ups as well as running articles with diverging viewpoints (without directly acknowledging them as dueling perspectives).
For instance, Primack ran a reasonable-seeming piece on a critical element of the story, whether Charlie Baker was guilty of violating SEC and New Jersey rules on exactly what constituted pay to play. The account was useful in delineating the Federal v. state regulatory differences. However, the Primack story was also based heavily on input from Charlie Baker, and the subhead to the story seemed a tad generous: “It’s not really his fault, but now he has only himself to blame,” based in large measure on Baker’s claim that he was not an employee of the private equity firm in question, General Catalyst, but an “executive in residence”. If you read the piece, Primack was careful to delineate that it appeared Baker was not an employee, but he also stressed that he had asked Baker and General Catalyst for proof in the form of a copy of Baker’s contract with General Catalyst. Both Baker and General Catalyst refused, invoking the tired trade secret excuse (which Primack parenthetically pooh-poohed).
Sirota hit back with a piece showing that he had located 33 documents in the relevant time frame that listed Baker as an employee of the firm in question, General Catalyst. As you can see, the “was he or wasn’t he” issue will be subject to as much tortured legal wrangling as the question of whether KKR Capstone is or isn’t an affiliate.
Mind you, I’m not trying to arbitrate this dispute. And in fairness, Primack broke a straight-up-the-center piece after this exchange, that the New Jersey pension system was seeking an independent legal opinion on whether General Catalyst had broken pay-to-play rules (Primack’s earlier reading was that it probably had). But it’s not hard to surmise that Primack, if nothing else than by virtue of covering this industry for a long time, has become predisposed to its way of thinking but actually does try to get his hands on evidence.
I was gratified last night to see him take early notice of our limited partnership agreement release on Twitter and recognize it as significant. At the same time, he seemed to fall in with probable industry defenses, namely, that the language in the actual KKR documents related to KKR Capstone wasn’t a big deal, but an investor tax violation looked serious. In other words, his initial tweets suggested he regarded the documents as more of a problem for the limited partners than the general partners! I gave a bit of pushback on Twitter, but I’m not one for protracted conversations via that medium.
So I was surprised and gratified to see the next morning that Primack had given the my post and the underlying documents a serious read and had revised his views in a big way, starting with his headline: Will private equity investors keep getting their pockets picked?. Mind you, this is more significant than you might realize, since most people are attached to their existing beliefs. He provided solid summaries of our post and the Morgenson article, including her money quote from an SEC official, “In some instances, investors’ pockets are being picked.”.
Primack’s observations:
My understanding is that the SEC thinks the following is happening, broadly speaking: LPs and their attorneys negotiate the LPA, and include all sorts of fee rebates. And then the LPs let their (outside?) accountants handle the incoming checks from the GP. What doesn’t apparently happen is any reconciliation between what the LP is owed from the GP (per the LPA) and what actually gets paid. Perhaps because the LPAs are written in such tortured language that the average accountant would likely give up. Thus the massive potential for pocket-picking….
It remains entirely unclear if the SEC will or won’t act on the alleged abuses that it has found (and I can almost assure you that even more of these will leak within the next few weeks). But if LPs believe they’ve been dupes, then they do have the power to collectively stand up and demand LPA amendments and/or reparations… After all, fiduciary responsibility should outweigh embarrassed ego
Primack has thrown down a guantlet: either limited partners should insist on much more stringent protections as a condition of future investment, or tell the public that they are really on board with how general partners (mis)treat them. The problem is the latter position exposes them to considerable reputation loss if (as we anticipate) more disclosures of abuses become public.
Why am I focusing on this from a media perspective? There are two reasons. One is to confirm that these revelations really are shocking. For an industry reporter like Primack to call out this behavior is confirmation that it really does look poor. But there’s a second layer, which is that heretofore in private equity, industry incumbents have controlled the news flow almost completely. The scandals and hot stories are ones that tend to involve scandals or successes at particular firms, such as the mega-bankruptcy of the company formerly known as TXU, which was a TPG/Goldman Sachs buyout, or industry jousting (who is up or down in various rankings, who succeeding in closing a major fundraising, etc.). So it’s encouraging to see someone who could potentially be an Andrew Ross Sorkin in the wings acting in an independent manner when presented with new information.
Now as we indicated, the private equity firms look to be sitting these stories out thus far. It will be interesting to see them saddle up and try to explain their way around the evidence presented so far and the ones that will be coming out soon.
The more these kingpins stick with to their current approach, that of highly technical defenses, the clearer it will become that their profit model depends less on investment performance and more on upmarket tricks and traps than they’d wanted their investors to understand.
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Isn’t it a rather substantial conflict of interest for CalPERS, for example, to be an investment client of Apollo’s while it owns a stake in the PE firm? Interesting hedging strategy to say the least.
You appear not to understand the relationship.
The limited partners are investors in funds, not in the firm, the same way that investing in a Fidelity fund does not make you an owner of Fidelity. Private equity funds are structured as limited partnerships, and the party that manages the fund is the general partner and the other investors are limited partners.
CalPERS runs huge index funds in house. To the extent it owns any Apollo stock, it’s merely to achieve index replication (indexers care about matching the index at the lowest possible price
CalPERS actually invested in Apollo before it was publicly traded, buying a piece of the management company. Did the same with Carlyle (now public) and Silver Lake (still private). It also was an LP in the funds.
The opening comment was written in present, not past tense. I am aware of CalPERS’ earlier investment in Apollo. And (not that I’m defending it) I’d bet that investing in at the firm level was presented a way to enhance returns (GPs rip out so many fees that they make money even when deals fail) and align incentives better. But it does have the side effect of reducing the odds that CalPERS won’t invest in those GPs’ funds to nil unless the last fund was a total turkey.
But if you want to talk about sus between CalPERS and Apollo, the settlement that Steptoe & Johnson cooked up in their pay to play scandal is really appalling, and Apollo paid far more in fees than any of the other firms, virtually all of which had close ties to Apollo: http://www.nakedcapitalism.com/2014/03/calpers-private-equity-scandals-steptoe-johnson-report-whitewash.html
Without further torturing this subject, note, for example, that CalPERS bought a 9% stake in Apollo’s management in 2007 ($600M). To that extent they were part of the management policies of a private company regarding fees, etc., and their transparency or lack of it. Thus, simply put, CalPERS management stake benefitted from its policies to the detriment of the investors (the pensioners) on the Apollo fund side.
As to CalPERS fund investment decisions, in the early years of their relationship with Apollo, it’s interesting to look at the make-up of those funds. CalPERS was closely involved with Apollo long before the latter went public.
Apollo was formed by former Drexel employees in 1990 on the backs of California-domiciled Executive Life Insurance (ELIC) policyholders. There were 360,000 of them, many whose lives were irreparably damaged when the CA insurance commissioner seized the company in 1991. ELIC’s asset portfolio was at the time the largest junk bond portfolio in the world. Those bonds were created and underwritten by Drexel (Milken, Black, et al) and captured by Black and his newly formed Apollo when the insurance commissioner wholesaled the portfolio to Apollo and Credit Lyonnais for less than half its value. (It’s value grew exponentially.) A PR industry funded by the insurance commissioner and Apollo would have you believe that ELIC was (1) insolvent, (2) policyholders recovered 95% of their losses, and (3) the insurance ‘guaranty fund’ bailed out those with losses for billions of dollars. None of these things are true. Though never disclosed to the courts in lengthy litigation, policyholders’ losses to their contractual benefits and acct. values were more than $4B as of 2000. About the ‘insolvency’ claim, how can one believe that (1) ELIC was insolvent in 1991 when (2) a private equity firm (and its PE partners) began raking in billions at that time as soon as they got their hands on the bond portfolio? What discovery was kept hidden from the Conservation Court (and subsequent courts) as to what the commissioner knew about the true value of the portfolio and what the real losses were to the policyholders? Was the whole bidding process for this jewel a scam?
Why does this matter in the context of CalPERS and its relationship since the 1990s with Apollo? CalPERS was one huge investor who jumped on the corpses of those policyholders and aligned with Apollo. Apollo was formed solely due to the ELIC bond portfolio, which was rich with the various bonds of than 300 corporations and holding companies. Milken, in a prison interview called it ‘THE deal of the ’90s’. The portfolio was organized in tranches: all offered huge returns; high interest payments that were current; or value in debt-equity swaps for those that weren’t.
So if anyone’s interested in the CalPERS saga as regarding Apollo, one only has to look at the players on the CalPERS board over the years, especially those ex officio CA elected officials and their appointments to the board.
One may point to the profits CalPERS made on those investments, but, if it isn’t too old fashioned, I suggest one look at the ethics of the relationship with Apollo over the years, including the whole pay-to-play placement agent scandal. That Apollo could sue the placement agents, including the CalPERS former CEO, after the discovery that they paid them tens of millions to secure CalPERS business is more than a wee bit ironic.
CalPERS began selling its shares in Apollo Global Mgmt. in May 2013, according to Reuters. It appears they registered to sell approximately 1/3 of their stake, which they purchased in 2007. So the present tense concerning CalPERS holdings in Apollo management is accurate.
http://www.pehub.com/2013/05/reuters-apollo-investors-founders-sell-shares/
Congratulations, Yves. Good to see you getting traction on such slimy ground. Even when you write “Curiously, the private equity firms do not appear to be reacting to these stories”, the silence seems similar to the immediate deafness after a bomb detonation or a good example of Gandhi’s observation: “First they ignore you, then they ridicule you, then they fight you, then you win.” (And then they assassinate you). Your suit against CalPERS appears to be following that pattern, including the juvenile putdown piece just prior to the court hearing. It’s very likely you will ultimately prevail in that.
What I don’t get is how the LP attorneys or accountants (not to mention IRS, SEC, and DOJ) can really be such clueless, compliant dupes, or whether there is nefarious collusion going on. Surely, some interests within the LPs themselves would want to ferret that out. Maybe now?
Baker [claimed] that he was not an employee of the private equity firm in question, General Catalyst, but an “executive in residence.”
Did he coin that term hisself, or get it from Barack Obama?
You doubled-up the second paragraph in Primack’s last quote:
Well kudos to Primack.
We need journalists to remember that their job is to be watchdogs for the public, not industry spokespeople and spin-doctors (whichever industry or beat they are covering). Democracy can’t function without an informed citizenry and the citizenry can’t get informed without journalists at large news outlets giving them the straight dope. Thankfully, the internet has allowed for the speedy dissemination of information from Yves to the offices of Fortune, and thankfully Primack did the right thing with it once he got it. Let’s hope he keeps it up and that others catch on as well.
(this, of course, is why our elite overlords are trying so hard to dismantle net neutrality–this sort of thing is dangerous…)
What do PE firms add to our nation, culture, economy, life? These firms seem to be maggots feeding on the accomplishments (bodies) of others. They seem to be the ultimate of “financialization” of our country. They do not invent, or create in any way, perhaps it could be said they add efficiency, but at what cost? I realize they are much smarter than the rest of us, and my lack of understanding their value is certainly proof of this.
Allow me to play the cynic here. If Primack often seems to be on the side of apology for the more powerful folks on the PE universe, and he expects more ‘of these’ leaking, should we not perhaps expect careful leaks of things which will pass muster, to dilute the overall discussion of real abuses here and/or to muddy the waters?
Let me repeat: I can assure you that there are more PE stories coming from MSM outlets. Please look at our post on the Wall Street Journal story on KKR: http://www.nakedcapitalism.com/2014/05/wall-street-journal-exposes-possible-grifting-private-equity-kingpin-kkr-and-kkr-capstone.html.
That is what “muddying the water” looks like. You can infer from the focus on the Journal piece on technical details and the discussion of the Linklaters letter that KKR pushed back, hard, when the Journal contacted them before the story ran. Otherwise their piece would have been more along the line of the post I wrote based on it. The basic facts lead you to much stronger conclusions.
And the other way is that Primack, who basically asked the industry to defend itself in his piece, in his e-mail newletter today said he got pushback from limited partners who said that they valued the services the GPs were paying for on their dime (as in the senior advisers and consultants charged to the portfolio companies). I guarantee that at least 1/3 and probably over half those communications were based on nudging by GPs.
For instance, many fund of funds (which are technically investors in the GPs) sell themselves to wealthy individuals in part based on their ability to get into certain funds (remember, until recently, top quartile performance persisted, so having access to top quartile funds was and probably still is a big selling point, since many people still have not gotten the memo on the end of persistence of top quartile returns (and that’s before you get to the fact that 80% of the PE fund universe can cut the data so as to make them look as if they are top quartile). So they’d need to stay in GP good graces and separately have their own motivations (trying to preserve PE’s good image among their clientele, rich individuals) to defend questionable practices with Primack. And that’s before you get to the other ways that LPs are captured (see my related post today). The fact that the LPs still buy the myth of risk-adjusted PE fund outperformance is a huge tell.
And I am not ruling out the possibility that Primack shifts position based on the GPs and their loyal LPs working on him some more.
At the end of the day, it is all about the Internal Rate of Return. Can the LP, usually a pension fund, generate a return to pay all of their pension obligations. Private Equity is an asset class that can return 16%+ annual return, each and every year. So, LPs may get hit up with a fee here or there, but where else can they get this type of return? If the fees were disclosed in the LPA, the private equity firm can collect. If the private equity firm fears that the fees will bring down the overall IRR and put their next fundraising effort at risk, the private equity can always decline taking those fees. I think we might have a tempest in a teapot.
That is affirmatively untrue. There is no industry-wide data set to perform proper return calculations. Virtually all studies rely on cherry-picked data sets. McKinsey (which is in the pocket of PE, since it gets lots of fees from PE firms) has stated that in teh entire 30 year history of the strategy , only 2 decent studies on returns have been performed. Moreover, as you unwittingly point out, investors have been conditioned to use IRR, which is a deeply flawed metric, particularly for comparing investments of different durations (like PE versus liquid stocks) and for investments with volatile cash flows. Harvard, which is considered to be a savvy PE investor, says PE has not outperformed stocks over the last decade. Studies using public market equivalent, which is a rigorous measure, find either no or only modest outperformance, and “only modest” is insufficient give the illiquidity risk of PE. Finally, NO studies allow for the large cost of accommodating private equity capital calls. Investors make a commitment, and the consequences of missing a capital call are draconian. The ones that are huge investors with a lot of money going in and out still have to stay liquid (you’d assume they invest in a mix of Treasuries, bonds and stocks) and the smaller ones (smaller pension funds, foundations, endowments) stay largely in cash equivalents. If you calculated returns from the commitment date and allowed for that cost, I guarantee it would take a minimum of 100 bps off private equity returns.