Another day, yet another private equity exposé, this one on an atypically simple-minded scam.
Gretchen Morgenson at the New York Times describes how private equity firms arbitrage legal fees. They dispense so much in the way of legal fees, between buying and selling companies, arranging for financing, and raising funds, that they are the most sought-after clients of big law firms and accounting firms. That means they are in a position to obtain discounts.
But guess what? The only beneficiary of the private equity firms’ buying power in too many cases is the private equity firm itself. The general partners get a break for themselves, on the back of the vastly greater dollar value of fees generated at the portfolio company and limited partnership level. The investors pay the rack rate or even a premium.
Let’s use an analogy. Let’s say you inherit a large office building. You’ve got no interest in running it and don’t trust the people your rich relative had running it. You have a good buddy who is a semi-retired real estate maven who owns a couple of small buildings. You ask him to manage it. He arranges to do all the normal things, like bill tenants and deposit their funds, supervise capital investment projects (like upgrading elevators), and handle routine maintenance. As part of what his job, he’s engaged outside companies to handle building cleaning and security.
You learn that he’s arranged with these companies to have them charge you their regular price even though you are such a big customer that you’d normally get a discount. Worse, he’s using the same companies at his buildings and getting the services for nearly free, even though on his own, he’d not get much of a price break.
The Times story is a little leisurely in getting to the the real dirt. At the seventh paragraph provides a crisp statement of the abuse:
Wealthy private equity funds receive discounts on legal, accounting and other outside work while pension fund investors, like retired bus drivers, librarians and teachers, pay full freight or, in some cases, a premium.
And the next bit juicy detail starts at the 21st paragraph:
Consider a filing by Apollo Global Management, the private equity behemoth overseen by Leon Black. It states that Apollo and its funds receive discounts on plain vanilla legal work such as employment contracts and regulatory filings. Apollo and its investors also receive discounts, its filings show, on charges known as broken-deal fees, which arise when a proposed acquisition or sale of a portfolio company is not completed.
No discounts are given on investment transactions, including those charged to investor-owned funds managed by Apollo, however. In fact, Apollo says that for these transactions, outside service providers often receive a premium beyond the level of customary rates.
“Legal services rendered for investment transactions,” the filing states, “are typically charged to the Apollo Private Equity Managers, their affiliates and clients on a ‘full freight’ basis or at a premium.” Because investment transactions typically occur in investor-owned funds, they end up paying the bulk of the premium prices.
Keep in mind that the actual abuse may be greater than what is presented here. Rate breaks aren’t the only way that law firms make price concessions to keep clients happy. Keep in mind that over the last 30 years, the hourly billing model has been under attack. Large corporations often complain that invoices are too high. Many professional firms discount their bills when asked to out of fear of losing the client. Partners can and often do discount bills by writing off hours or never entering them at all. If PE getting any of those indulgences because big clients with investors proportionately, which means bulk of bennines should to go investors.
Mind you, these are all common quid pro quos, but given the pattern Morgenson has exposed with billing rates, it’s not hard to imagine that only the general partners would receive the other forms of preferential treatment. It’s a certainty that requests for advice on small matters, the sort of thing that would be treated as a freebie for a good client would be on the meter for the portfolio companies. Moreover, the beauty is that because there’s no paper trail of written-off or unbilled hours at the general partner, there would be no need for disclosure.
And this issue exposes a corporate governance fiction. The private equity-owned companies have their own officers, such as presidents and corporate secretaries, who owe a duty of loyalty and care to the corporation. Yet the private equity overlords foist lawyers on the portfolio companies, and in the case of Apollo, require them to agree to pay premium rates. The lawyers entering into these arrangements know full well that the executives at the investee companies should challenge these billing schemes, but no one is about to buck a big-ticket paymaster.
It appears that this story got to Morgenson by virtue of a former CalPERS board member turned private equity researcher presenting evidence of this practice to some CalPERS board members, and potentially to other pension funds as well. Board member JJ Jelincic, who has almost become a regular here by virtue of taking the rare role at CalPERS of digging into questionable private equity practices, gave the only sensible reaction of any of the investors quoted in the Times story:
“It puts the lie to the fact that we are partners with the private equity firms,” Mr. Jelincic said. “We are simply a source of income to the general partners; we are not partners.
By contrast, consider the misdirection in the official CalPERS comment:
Joe DeAnda, a Calpers spokesman, said in a statement: “Calpers has long been a leader in advocating for fee economies and transparency, including in private equity. We have been actively engaging with some of our private equity partners to help improve the disclosure and data available, and have been closely monitoring the regulatory announcements and attention around this subject.”
First, DeAnda exhibits precisely the sort of cognitive capture that Jelincic highlighted, that of thinking that someone who sees (and treats) you as a meal ticket should be thought of as a partner. But confusing legal structures with the actual economic relationship is pervasive among investors. Second, the fee issue is not a transparency problem. It’s an abuse of fiduciary duty. And it’s not remedied by ex post facto disclosure in Dodd Frank mandated SEC filings after the investment was made (Form ADV).
The New York City Comptroller, Scott Stringer, gives an even more lame response:
Asked how he views the potential conflicts relating to vendor discounts, Mr. Stringer said: “The S.E.C. has raised serious concerns, and we support them taking a hard look at this issue. It’s clear that we still don’t have enough transparency from our private equity partners.”
“We support the SEC taking a hard look.” How about doing your job for city retirees and asking some questions yourself? Aren’t you the one ultimately responsible for the handling of these funds? Not only does he want the toothless SEC to do his work for him, but he makes it clear he’s not interested in rocking the boat. All he wants is a “hard look”. It looks like Stringer is an ambitious enough pol that he does not want to alienate future campaign donors. And again, we have the “transparency” dodge and the mischaracterization of firms as partners when they are actually taking advantage of his dereliction of duty.
Another ugly bit here is that the law firms are complicit in this behavior, and many of them work both sides of the street. For instance, we wrote early on about how Boston’s blue-chippiest firm, Ropes & Grey, using it to warn the candidate we hoped would win the New York City comptroller’s race, Eliot Spitzer, was not only working on every side imaginable of private equity transactions, but was also taking advantage of a loophole in standard conflicts of interest waivers for its partners to take an economic position in deals ahead of and in clear conflict with that of its longest-standing client, Harvard. We didn’t bother addressing this post to Stringer too because it was clear he was too unsophisticated and spineless to take on private equity kingpins. So why aren’t investors at a minimum also asking law firms that represent them, if they also represent private equity firms, what their discount and other billing practices are?
And as readers are seeing, Stringer, who oversees a pension system that is one of the largest private equity investors in the US, typifies the complacency that makes pension funds such easy prey for private equity firms. It’s time that fund beneficiaries, meaning retirees, as well as taxpayers who are ultimately on the hook, start raising hell with state and local politicians who have a role in pension fund supervision.
Disclosure: We have made a private equity whistleblower filing to the SEC
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It’s amazing what even the little bit of sunshine Dodd-Frank let into the shadowy world of private equity has revealed. Blatant scams like getting discounts on expenses for legal, accounting, auditing and other services while charging investors a premium to cover them only make sense if you think no one in a position of authority will ever look at your actions. Interests of pension funds and other limited partners are clearly not aligned with those of GPs of the funds they invest in. But is there an alignment between the interests of GPs and the asset managers (sometimes recruited from Wall Street) responsible for pension fund investments in private equity? The pay and bonuses of these pension fund managers depend on their ability to get into funds of leading PE firms, which may explain why they turn a blind eye to a range of practices that are arguably not in the best interests of the workers whose retirement income they manage. Its time pension fund boards provided closer oversight of the finance professionals that manage pension fund assets.
Which is pretty hilarious, since the PE industry as a whole hasn’t even managed to keep up with the S&P for the last five years or so. And, of course, there’s the fact that every PE firm manages to be “top-quintile” (which goes to show how good they are at absurdist mathematics).
Well, that’s one step in the right direction, but I think we need a much more radical fix. Finance pros are sneaky sorts, and have managed to work around plenty of oversight attempts in the past. How about we just ban pension funds and other institutional investors from investing in PE all together? We know the PE industry can’t be trusted and that the pension fund managers aren’t clever enough to not get fleeced by the PE guys on a regular basis, so why not just stop pension funds from gambling with these guys and let the PE parasites go after individual wealthy suckers…er, investors.
This whole series of articles about private equity, but this article in particular because the offense is so egregious, are almost worse for the investing funds than for the “General Partners.” The GPs are greedy, yes, but we expected that. Yet it’s really saying the investors are grossly negligent. Some of them could be sued by the people they’re supposedly working for – and that helps explain their determined secrecy.
In fact, that’s a good question: have there been lawsuits by the beneficiaries? Or are any in prospect? And yes, I’m trying to cause trouble – that’s the purpose of exposes.
I’m also unsophisticated in these matters, but it sure seems to me that every alcove of complexity turns into an opportunity for extraction. Why don’t the pension funds just invest in no-load index funds and keep the overhead low? Even more, CalPERS is big enough to impact share prices, and could invest within-state in a way that makes California a better place. Seems like a big wrench to hand off to someone else to twist things with.
Or is that not a bug?
Dem’s features, not bugs.
The point of PE is to extract profits. Complexity makes it easier to extract those profits (from the limited partners) and so complexity is the order of the day.
Ha, ha! Silly man…if they did that, their returns would indeed be higher, but then there would be no reason to pay someone at CalPERS big bucks to get them into those “exclusive” PE funds. And if they switch to index funds, it would be tantamount to admitting that they’ve been wasting money all these years, which would be rather embarassing…so much better to continue to waste OPM on PE so as to “save face.”
Bingo! We need to start directing our public investment resources at local projects with local benefits, rather than handing them over to the Wall Street goon-squad.
Pirate Equity doing bad things to it’s customers. The story never changes.
There are two markets. The stawk market traded publicly, and the seas of private businesses, where the PE pirates ply the waters.
No one needs PE to invest in the stawk market, and no doubt pension funds are partially invested there through index funds or direct ownership of shares.
What pension funds use Pirate Equity for is to access the private businesses, those not publicly traded, where the owners want to retire or sell out for whatever reason, their profitable company.
That this isn’t profitable after the pirates get a hold of these companies, strip the assets for themselves, and load them with debt is no surprise, they are pirates after all. It also isn’t a surprise that the managers of the pension funds couldn’t care less, because it isn’t their own money on the line.
. . Large corporations often complain that invoices are too high. Many professional firms discount their bills when asked to out of fear of losing the client.
Lawyers have their own pirate code. Charging exorbitant hourly rates, and pruning the bill for those that complain, means many more that don’t complain grossly overpay.
I have found that lawyer’s fees are extremely flexible when the task is defined and viable competition is present. I had one firm wanting to charge my company X for a particular type of contract that was essentially a slightly modified copy of one they had done recently for a friend of mine. I located another firm that specialized in the same type of work and got a quote of X/2. I went back to the first company and informed them that they had been underbid, sorry. They immediately halved their fee. Really? So you are admitting that you were just hosing me the first time around? I went with the second firm.
I am coming to the conclusion that just being a PE firm is probable cause for a criminal investigation. There should be standing investigative teams at the DOJ looking at their books and issuing subpoenas, just because.
Nice write-up.
Yes, exactly. Keep in mind that Stringer has no financial experience but got elected by virtue of an extremely well-funded, hipster campaign that received endorsements from NYC’s political and financial elite. Stringer wants to maintain these alliances come time his mayoral campaign.
Here is Matt Levine on Stringer’s disingenuousness: http://www.bloombergview.com/articles/2015-04-09/new-york-discovers-wall-street-charges-fees
so the PE general partners are serving pension funds as the main course at their PE banquet.
I find more and more of the people I talk to are familiar with these issues. Several years ago this was not the case. I think the many lurkers here are talking to people….
Thanks for keeping with it!
Great post and very important reporting from Morgenson. I’d like to see some digging into whether these PE firms are, in addition to doing bad things with billing legal services, also making offering questionable consideration to their lawyers, perhaps as a way to get cooperation with PE firms’ unethical and avaricious practices. I have heard of questionable sales of things like property from big PE guys to their too-close for comfort attorneys. I can’t be sure of anything, but I imagine that that would be a great way to make payoffs.
Finance of any sort is theft.
I heard google and apple spend more on lawyers than research. One wonders to what degree our legal system is impairing economic growth. Figure in the average divorce they take half of the assets….then settle. Worker’s comp. Personal injury. Social security. For most people the fee is half of their assets…..they make up the hours and work to fit the asset stripping they are entitled to.
The fact that Google and Apple spend more on lawyers than R&D is a product of our legal system. It is one that puts an outsized value on intellectual property, and thus companies must spend untold fortunes to protect sacred (profitable) ground. The Amazon One-Click shopping patent was invalidated in Europe but upheld in America. Apple and Barnes and Noble pay Amazon money for the right to use the technology. Something so banal consumed unknown (but likely massive) amounts of work hours and thus money.
https://en.wikipedia.org/wiki/1-Click
If we wanted to reward productivity we would likely have to reform our patent system. How to do that is certainly highly debatable. I don’t have a good idea for how to do it. But the rewards of a patent are potentially so high, that a great deal of energy and money go into litigation and back office work that would be better spent on anything else.