In an earlier post, we discussed the ongoing violation of SEC broker-dealer regulations by private equity firms when they collect “transaction fees” for buying and selling companies on behalf of the funds they manage. The 1934 Exchange Act mandates that only SEC-registered broker-dealers may collect transaction-based compensation (subject only to limited exceptions which are not germane here ). Very few private equity firms are registered as broker-dealers (and even those are flouting the law in ways we’ll discuss later). This means that almost all PE firms are engaged in ongoing violation of the ’34 Act.
Today, let’s look at a particular transaction that not only illustrates this type of violation, but also contains other egregious mis-statements in order to hide truth.
In May 2007, a fund controlled by Apollo Global Management bought Claire’s Stores, Inc. Those with young daughters may be know this chain of 3,500 stores, which sell mostly hair accessories and very inexpensive jewelry aimed primarily at children. This was a height-of-the-bubble PE deal that barely escaped bankruptcy. Apollo took Claire’s private for a $3.1 billion purchase price and financed the deal by loading Claire’s with $2.4 billion of debt.
The deal was aggressive, not only in its very high leverage ratio, but also in the way Apollo “papered it up.” At the closing, Claire’s executed a “Management Services Agreement” with Apollo, where the company agreed to pay Apollo and its co-investors $3 million a year for ten years as payment for nebulously defined services purportedly to be provided by its PE overlords. In addition, the company agreed to pay Apollo $20 million in the form of what the agreement referred to as a “transaction fee.” (see section 2.3 in the embedded document).
Claire's Stores Management Agreement
Helpfully for our purposes, the agreement specified the services that Apollo purportedly provided in order to earn the transaction fee, namely “…certain investment banking, management, consulting and financial planning services…” in connection with the acquisition. (see third paragraph of agreement in the embedded document)
Apollo put the noose around its own neck by acknowledging a direct link between the $20 million transaction fee payment and “certain investment banking” services it had provided prior to the buyout (remember, this agreement was executed at the closing). As a widely-used Davis Polk treatise on broker-dealer law notes, “…persons (other than professionals such as lawyers or accountants acting as such) who participate in or otherwise facilitate negotiations in effecting mergers or acquisitions, and receive transaction-based compensation, are required to register as broker-dealers.” However, Apollo did not register as a broker-dealer until 2011, almost four years subsequent to the Claire’s buyout.
The agreement also contains a bizarre and presumably false statement when it says multiple times that Apollo advised Claire’s itself in the company’s buyout and was getting paid, in part, for that service. This is a departure from the usual shell-game claims used to justify transaction fees. Private equity firms typically state that they earned their fee for advising a shell legal entity that they created and controlled for the purpose of the transaction and into which the buyout target is merged. There are multiple reasons why buyouts are usually done in this merger-into-a-shell format, and one of them is that it provides a legal entity, albeit one controlled by the PE firm itself, that the PE firm can claim to have “advised” in order to earn its transaction fee.
For unknown reasons, Apollo dispensed with this well-established legal fiction and instead claimed in the agreement that it had advised Claire’s itself on the company’s response to Apollo’s buyout offer (see the third paragraph and section 2.3 of the embedded document). If this were actually true, which is possible in theory, the Claire’s board of directors would have been guilty of a glaring breach of fiduciary duty by paying for advice about a potential buyout from the prospective buyer.
There is one other whopper of a false statement that was made as part of the deal. In the proxy statement filed by Claire’s filed just prior to the buyout, Claire’s stated:
Section 3.17 Brokers. No broker, finder or investment banker (other than the Financial Advisors [Goldman Sachs and Peter J. Solomon Company, L.P. (together, the “Financial Advisors”)]) is entitled to any brokerage, finder’s or other fee or commission in connection with the transactions contemplated by this Agreement based upon arrangements made by and on behalf of the Company or any of its subsidiaries.
False statements of this type occur in almost all public-to-private proxies. The companies filing the proxies claim that nobody other than the formally-named investment banker(s) is going to earn a fee as part of the buyout, when the PE firm buyer is actually going to receive a transaction fee larger than any of the formal investment banking fees that are disclosed.
Of course, at the time that companies file these proxies, just prior to the deal’s consummation, they are already effectively already under the control of their soon-to-be private equity owners, so they presumably are following orders by making this routine false disclosure. Often, transaction fees are never disclosed, and when they are, it is typically months or years after the buyout closes, so nobody is the wiser.
This should be easy pickings for the SEC.
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I was with you until the last sentence. Are we talking about the same SEC?
The deal is also a great example of how PE deals are destroying our economy by cannibalizing perfectly good companies, only to gut them for the benefit of the 0.1%. Taken over, sold off, and bled out; behind only the thinnest pretenses.
I am sure somewhere in the deal, you will also find how Claire’s senior leadership got themselves paid off for turning the company over to the chop shop.
The process is entirely, explicitly enabled by generous tax laws, a nonexistent SEC, and Fed subsidies.
Like the Sopranos doing a bust-out.
No, PE deals dont destroy the economy by destroying companies. PE deals destroy the economy by abusing passive investors in those companies who get strip-mined by the PE owner. You got butchered if you owned a bond or was a minority investor, or even were just a creditor.
It doesnt matter for the economy as a whole as a first order effect cos it just damages trust, while also causing massive redistribution of wealth from the original stakeholders. But it does matter as a second order effect – cos it damages trust.
I dont sweat these issues too much cos I cant influence them. However I am making plans to leave the country and go and live elsewhere. I hear Mexico is nice.
I disagree about that it is net zero, particularly from the perspective of the US economy.
You take a company that makes stuff, has a physical location, pays taxes, employs people, buys stuff, and then distributes it up the chain to be sold etc – say, making cream filled snack cakes – and then the PE guys come in, and nothing is left but the brand name, which is sold to China. The money ends up in offshore banks and overpriced luxury watches.
That is a radical redistribution of wealth and wealth-making capacity, that while technically zero sum globally in terms of dollars, is murdering on the US economy. And is very much like strangling the golden goose. Eventually it stops laying eggs.
But, yes, it is also very much a fleecing of minority investors and creditors. But since the pension fund managers are busy chasing the mean return, they don’t notice they are being robbed.
The two are not mutually exclusive. PE does destroy companies. It also abuses investors. The bizarre part is that the investors are often public pension funds, which means government officials are putting money into strategies that wreck their tax base.
Going after these seemingly “technical” violations may seem besides the point, but in fact the PE funds rely heavily on technicalities in all aspects of their business, so the cavalier disregard here (when they spend a fortune on attorneys to paper stuff up) is a sign of their arrogance. And being a broker dealer would expose the PE firms to a ton more scrutiny and enable journalists and industry critics to expose a ton more of their bad practices. That’s why this matters.
You are absolutely right about all this, but nobody at the SEC gives a rat’s ass, since its only function is public relations- making a gullible investing public believe securities markets are being policed.
And I bet even you cannot explain why the ’34 Act limits these buyout fees to registered brokers.
So what about the fact that, according to national atlas.gov, the US has over 35,000 cities and towns? And if even 1/100th of those towns have pension funds being ravaged by the kinds of ‘technicalities’ these PE funds are engaged in, then municipalities need to wake up and bring pressure on DC and the SEC.
And quite a few of those municipalities have over a million residents.
So it’s probably a safe bet that most of the pension managers don’t realize what PE is pulling. It’s a safe bet that at least those who have read the news the past 5 years suspect the SEC has been sleeping on the job, but this is now having repercussions for the pension funds. If you ran a pension fund, would you really roll over and ignore the impact this PE behavior is having on your fund (and your own job security?). Call me crazy, but I have a hard time believing that all the managers of funds for over 35,000 cities and towns are willing to turn a blind eye.
And going after this kind of abuse of ‘technicalities’ would be pay dirt for any ambitious politico.
If the pension funds are being ravaged by PE (and they are), the reason is incompetent management of the funds themselves. The fund managers choose PE in order to boost returns and of course they get ripped off in the process. I would liquidate all the pension funds and require them to distribute the boodle to the worker beneficiaries. That would end the PE scam and nothing else will even touch it.
The pension funds are told by big ticket consultants (and they all hire them, this is the “professional” way to do things, fund management is all about blame avoidance) to allocate as much as possible to PE.
So unless you get more people looking into the kitchen to see how this sausage is made, nothing will change. The good news is the PE firms are addicted to these transaction fees, and there is absolutely no justification for them thumbing their nose at registering as broker-dealers and making the required disclosures.
Ideally, all private equity firms should register as RIAs or maintain affiliations with BDs. This should also apply to small-scale agents like business brokers who collect finder’s fees for selling small and medium enterprises. It’s worth noting that insurance agents and financial advisers who arrange buy-sell agreements for small businesses are duly licensed. PE firms should meet the same standards.
Josh Kosman has written a stunning book about rip-off buyouts like Claire’s: The Buyout of America: How Private Equity will Cause the Next Great Credit Crisis (2010). He has a new book, The Buyout of America: How Private Equity Is Destroying Jobs and Killing the American Economy (2013). See his website: http://www.joshkosman.com/.
Oh man, this is memory lane. A romantic golden glow illuminates the recollections, a cinematic montage of streaming visions on the mind screen, dimming with time and brain cell death. It was many years ago, a young lad (me) two years out of the frat house and, improbably, paid to pick stocks for a small Wall Street research boutique — a circumstance of fate that, to this day, leaves me stunned with bewilderment. A dart board would have been equally qualified. But a dart board can’t write research reports. Therefore I had a job.
I picked one, at $5 per share. Claires’ Stores! It went to $35 and I looked like a genius! Thank you Madonna. She made costume jewelry big business and Claires was in the right place at the right time. they had no debt. They cranked cash like red meat out of a grinder. They were expanding nationwide. In every mall. Everywhere, they were coming and Madonna was on the radio every time you turned it on.
The dude who ran it took me to the Friars Club for a business lunch! I think there were even celebrities there. Guys in their 70s with Flahrida tans. I got drunk. You could in those days at lunch and nobody cared. I shook a number of hands. Old dudes came up to the table and I was introduced and the big hand was pushed at me. They all had big hands, I think, big warm happy hands full of life and money, full of Hollywood and fame. You might have seen their picture on the wall in black and white and there they were, in front of me. There at the Friars Club in New York City. The center of the universe and the center of life itself. Back when you could get drunk at lunch and sleep it off at the desk if you closed your door. Not like today. It’s been downhill ever since! Nobody could have piled on this much debt in those days. They’d have passed out way too soon from the wine. hahahahahah