SEC Chair Gary Gensler, Ever So Politely, Signals Intent to Cut Private Equity Grifting Way Back

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Gary Gensler, the former Goldman partner who is widely credited as being a reformer in his stint as head of the Commodities Futures Trading Commission, despite a secondary regulator being a disadvantaged position for getting much of anything done, looks to be taking a slow and careful aim on private equity abuses. We’ll turn shortly to a deceptively-friendly speech Gensler just gave at the Institutional Limited Partners Association.

Gensler stated that he’s already tasked SEC staff to look into what we have described for years as a central abuse in private equity: that investors have no clue as to the total fees they are paying because private equity fund managers hoover all sorts of charges directly out of the portfolio companies in the funds. And they don’t even pretend these fees are for services rendered. A favorite example is monitoring fees. We first featured this video, “Money for Nothing” by Oxford professor Ludovic Phalippou in a 2016 post. Phalippou had reviewed the so-called monitoring agreements that portfolio companies had to sign with their new private equity overlords. The entire video is worth watching, and the critical section starts at 8:00:

Here is Phalippou’s translation of the services agreement:

I may do some work from time to time
I do some work, only if I feel like it. Subjective translation: I won’t do anything.
I’ll get [in this case] at least $30 million a year irrespective of how much I decide to work. Subjective translation: I won’t do anything and get $30 million a year for it.
If I do decide to do something, I’ll charge you extra
I can stop charging when I get out (or not), but if I do I get all the money I was supposed to receive from that point up until 2018.

Mind you, even as of 2016, it was not news that private equity firms were engaged in embezzlement and all sorts of other misbehavior. What was and remains stunning is that the money, as in the investors, haven’t put a stop to it.

In May of 2014, SEC enforcement chief Andrew Bowden made a speech which seemed to signal that the SEC intended to make real use of its new powers under Dodd Frank to oversee private equity firms as investment advisers. Bowden explained that the SEC’s initial exams has found serious abuses in over half the firms examined, including what in other walks of life would be called stealing. Privately, the agency was saying that unlike in other areas, the abuses were if anything more frequent at the biggest players.

This salvo has a wave of press disclosures driving it: in-depth exposes by Gretchen Morgenson of the New York Times and Mark Maremont of the Wall Street Journal. Your humble blogger got some digs in too.

As we reported at the time, this show of resolve was followed quickly by a retreat. Yes, the SEC did fine big firms, typically one prototypical abuse at one big name firm you heard of. But the agency was clearly in “one and done” mode. Bowden acted like he really believed that the reason these alpha predators got caught out was they’d made honest mistakes, and now that they knew better, they’d fly right and investors would also police them.

Less than a year after Bowden’s famous speech, he was on a panel at a private equity conference at Stanford. Not only did he fawn over the industry, but he even said he’d told his son he should work in the industry, leading an audience member to offer him a job. As reader JohnnyGL said, ” It’s like we’re watching the revolving door actually spin right in front of us.” Three weeks after we publicized that video, Bowden had resigned.

More and more work by experts, such as Eileen Appelbaum and Rosemary Batt and benchmarking expert CEM, continued to confirm there were substantial abuses and investors still had no idea what private equity cost them in fees and expenses. Since nearly all investors in private equity are fiduciaries, that should have preventing them from committing funds to private equity. One of the duties of a fiduciary is to evaluate the reasonableness of fees and their impact on returns. You can’t evaluate a black box. Even so, Professor Phalippou came up with a ballpark estimate that private equity, all in, cost 7% per annum in fees and expenses. CalPERS confirmed that level in a 2015 private equity conference it sponsored.

For reason it would take too long to unpack here, investors have continued to exhibit an advanced case of Stockholm Syndrome. Stunningly, for instance, in 2015, a group of 13 major government trustees asked the SEC to step in, effectively asking the agency to protect them the way it protects retail investors. As we wrote then:

Nothing like elected officials using letter-writing to a weak agency and asking it to exceed its powers to hide the fact that they aren’t willing to do their jobs…

The only good news in this pathetic case of responsibility three-cared monte by state and city officials is that it shows that they feel the need to be perceived to be Doing Something about private equity abuses.

Trust me, I am sparing you many many chapters of this sorry history.

So why is this speech by Gensler an unexpected and genuinely hopeful sign?

The first is that Gensler has a solid record as a no-show-pony reformer. He’s already wealthy as a former Goldman partner, and critically, unlike many who’ve done well in finance, Gensler also has have enough. He appears to be cut from the cloth that the Goldman of its partnership days (back in the stone ages when Wall Street was criminal only at the margin) particularly prized: someone who was emotionally matures, smart and hard-working, and not into display in their private lives. In my day, the guys who got divorced and drove flashy cars were less likely to make partner quickly than the stolid, nose-to-the-grindstone types who made lots of money for the firm and were content to be well respected at the firm and bring up kids who did well, or at least weren’t messed up.

I feel compelled to say that because too many go into Manichean mode and act as if anyone who worked for (fill in the blank big financial firm) has to be tainted. In fact, it’s awfully hard to know how the secret sauce is made if you haven’t been in or at least near the kitchen.

Some members of the public may underestimate Gensler because he still has something of a baby face and plays the naif well. While it may be more gratifying to see Elizabeth Warren and Katie Porter go out guns-a-blazing, as single legislators, their best weapon is their bully pulpit. By contrast, Gensler as a regulator with staff and the ability to levy fines and refer cases for prosecution has far more power. But deploying it, particularly at the SEC, is tricky, since aggrieved targets of SEC enforcement can go whining to their Congresscritters seeking to have the SEC’s budget cut.

I’ll admit that I have seen Gensler give innocuous-seeming speeches where it seemed he didn’t have the plot. But this speech takes an exceedingly clever approach. It anchors SEC demands of private equity on unassailable principles. The industry can hardly disagree with the motherhood and apple pie positions Gensler takes, and some pretty obvious and unwelcome consequences come from them.

I strongly urge you to read Gensler’s highly accessible speech in full. Notice that he made it an Institutional Limited Partners Association meeting. ILPA, as it is called in the trade, is another symptom of private equity capture. It nominally represents the investors, the limited partners, but the overwhelming majority of its budget comes from private equity firms.

Gensler almost cutely asks whether fund managers know enough about their private equity fees, as if this question is even remotely in doubt. He then drives the knife in:

Together, those fees might add up to 3-4 percent in private equity and 2-3 percent per year in hedge funds…

That may not even be counting other fees that private funds collect from limited partners and portfolio companies. These can include consulting fees, advisory fees, monitoring fees, servicing fees, transaction fees, director’s fees, and others…

. Hundreds of billions of dollars in fees and expenses are standing between investors and businesses.

More competition and transparency could potentially bring greater efficiencies to this important part of the capital markets. This could help lower the cost of capital for businesses raising money. This could raise the returns for the pensions and endowments behind the limited partner investors. This ultimately could help workers preparing for retirement and families paying for their college educations.

That’s why I have asked the staff to consider what recommendations they could make to bring greater transparency to fee arrangements.

Then Gensler reveals that he’s much more plugged in than his “aw shucks” setup reveled. He next goes after side letters. As we discussed based on an important new paper by law professor William Clayton, private equity investors devote far more effort to try to get a better deal via side letters than the base contract, the “limited partners agreement”. Investors weirdly act as if it’s OK to have all the other investor tying to cut better arrangements because many also have “most favored nation” agreements, that they get to have all the special terms any lesser-dollar investor got.

But the big flaw is only the very biggest investor can get the full benefit of all these side deals. In addition, as Clayton points out, the general partner can play cute and not be fully forthcoming about what all the side letters provide.

Without going into sordid details in his talk, Gensler makes clear he is not keen about side letters that lead to some investors getting a better financial deal than others:

Each limited partner may be negotiating its own deal..

Some of these side letters are benign…Other side letters, however, can create preferred liquidity terms or disclosures…

Thus, I have asked staff to consider recommendations regarding how we can level the playing field and strengthen transparency, or whether certain side letter provisions should not be permitted.

That’s benign compared to what comes next. Gensler doesn’t like that investors have to rely on performance figures prepared by the general partners, who aren’t held to any standard as to how they run the numbers. Recall that not just this humble site but even highly respected investors like Howard Marks have pointed out that one increasingly used gimmick, fund level leverage via so-called subscription lines of credit, make financial performance comparisons meaningless.

Again from Gensler:

There’s a debate about whether private equity outperforms the public markets net of fees, or taking into account leverage and liquidity…basic facts about private funds are not as readily available — not only to the public, but even to the investors themselves.

Regardless of that overall economic debate… there may be benefits to fund investors to increasing transparency of the performance metrics. I have asked staff to consider what we can do to enhance such transparency.

Gensler is also unhappy about private equity funds asking investors to give a fiduciary duty waivers. The SEC chief makes clear that’s an absolute no-no as far as Federal fiduciary duties are concerned. The wee problem historically has been that only the SEC has the right to enforce those fiduciary duties.

General partners have gotten too used to the SEC being asleep on this front. The SEC could easily crack down on a broad basis.

Gensler also does not like that the general partners often seek and obtain waivers of fiduciary duty at the state level. Unless a state has particularly fiduciary law provisions that are stronger than those at the Federal level, it’s hard to see how a state law waiver would not encroach on Federal law fiduciary duties too. I hope the SEC has some very bright minds considering this question.

Gensler implies that he’s only just ask his staff to look into these matters. I doubt he’d go public before he were far enough along to be pretty sure the agency was going to Do Something. Let’s hope he continues with his “speak softly but carry a big stick” school of oversight.