Investors may get more fee info from GPs

Private equity general partners, spurred by a speech by the SEC's chief of compliance inspections, are reviewing fee practices they had not specifically disclosed to limited partners.

The managers are considering clarifying fee disclosures to specify what services are charged to the fund or portfolio companies, what fee income paid to the general partner would be deducted from management fees and what services would be covered by management fees paid by the limited partners.

The bigger issue for the managers is whether to get investor approval for past practices, most of which they thought were understood by investors even though the practices were not spelled out in fund documents. For example, when fund documents list that the fund pays for general partners' travel, is it clear that travel includes the fully loaded expense of a general partner's private jet? Or is it understood that when fund documents state that fees paid by a portfolio company for services of an operating partner are not credited against management fees, those fees include an operating company created by the general partner?

These fees and expenses can add up, amounting to permanent income for private equity managers regardless of a fund's performance and, in turn, crushing the alignment of interests between general partners and limited partners, critics say.

The problem is that if managers try to clarify past practices, it could be a signal for the SEC to take a closer look at their firms, said industry insiders who did not want to be identified. No firm wants to be among the first scrutinized by the SEC. Unlike first-mover advantage in an investment scenario, investment firms first investigated by the SEC for expected impropriety tend to get the book thrown at them, while consequences tend to diminish over time, the insiders said.

Andrew J. Bowden, in his speech to a Private Equity International forum, said: “The results of our exams indicate that because of the structure of the industry, the opaqueness of the private equity model, the broadness of limited partnership agreements, and the limited information rights of investors, we are perceiving violations despite the best efforts of investors to monitor their investments.” Mr. Bowden is director of the Securities and Exchange Commission's office of compliance inspections and examinations.

When Mr. Bowden called out these practices in his speech, the text of which also was posted on the SEC's website, there was a quick reaction from the private equity industry, said Daniel Evans, partner in private equity practice of New York-based law firm Ropes & Gray LLP. “After Bowden delivered his speech on May 6, overnight there was a paradigm shift,” Mr. Evans said. “The paradigm shift was occasioned by a potential perfect storm of political and media attention and enforcement interest, causing GPs to re-examine reality.”

The speech “got everybody's attention in a way that caused people to look at (the question of hidden fees) anew and ask "What if I were a potential enforcement target? Am I comfortable doing what I am doing — I know it's the right thing, but would an enforcement official see it that way?'” Mr. Evans said.

Most general partners are likely to provide more transparency in the future. But that is the easy part, industry sources said. “Historical practices are not that simple,” Mr. Evans said. “Nobody provides explicit disclosure or got explicit approvals before because they didn't think it was necessary. GPs were comfortable that their practices were generally understood by their LPs.”

Mr. Bowden's speech also got investors' attention. The Oregon Investment Council, Tigard, which runs the $68.2 billion Oregon Public Employees Retirement Fund, Salem, is examining fees it pays its private equity managers in response to Mr. Bowden's statements that some private equity firms might have overcharged institutional investors.

“We take seriously recent reports regarding the SEC's investigations,” said Richard B. Solomon, chairman of the council, in a written statement. “Accordingly, we have directed our consultants and treasury staff to continue to verify that the private equity firms with whom we invest have assessed only those fees allowed by the terms and conditions of their contracts.” Oregon has $15.6 billion invested in private equity.

New Mexico State Investment Council, Santa Fe, likewise is prepared to act. “We will be actively monitoring developments and if appropriate, leading efforts to reform this aspect of private equity investment practices,” said Charles Wollmann, director of communications for the $19 billion council.

Indeed, investors are beginning to demand more transparency on private equity fees and expenses.

“Generally speaking, there is an increasing trend toward transparency between LPs and GPs,” said Sebastien Burdel, partner at private equity secondaries firm Coller Capital, London.

Some general partners are disclosing more during the fundraising process and, as a result more investors have questioned some fee practices during the due diligence or negotiation phase, said Mary Hornby, New York-based managing director and general counsel at Abbott Capital Management LLC. Abbott has more than $7 billion in assets under management in private equity.

In his speech, “Spreading Sunshine in Private Equity,” which he said was not intended as a “gotcha” to the industry, Mr. Bowden urged more transparency, giving institutional investors an opportunity to object to excessive fees. The reason, he said, is that private equity is subject to “temptation and conflicts that are not present in the more common adviser model where an adviser buys and sells shares of publicly traded companies.”

The SEC, in conducting more than 150 exams of private equity firms, found “violations of law or material weaknesses in controls over 50% of the time,” he said in the speech.

Steve Judge, president and CEO of the trade and lobbying group Private Equity Growth Capital Council, Washington, said in a written statement that private equity fund agreements are struck between sophisticated institutional investors and private equity firm executives.

“Every private equity fund agreement is negotiated by professional investment managers on both sides, creating an alignment of interests that consistently delivers the best returns — net of fees — of any asset class over the long term,” he wrote.

Industry insiders, including some private equity fund-of-funds managers, agree that general partners need to be more transparent. They say that knowing generally what sorts of fees might be charged does not mean investors agreed to the fund being charged for things such as placement agent travel expenses to raise a fund or fully loaded private plane expenses incurred by the general partner.

Some investors are not adept at figuring out the minutia in fund documents, often the size of small phone books, insiders say.

“With the lower return environment, investors are finally waking up and paying attention. The fees have always been there and the LPs have no one to blame but themselves. They can simply say no. But you can't say no if you are not asking the right questions,” said Jon Harris, CEO of Alternative Investment Management LLC, New York, which invests about $1 billion in private equity and hedge funds on behalf of its clients.