April 21, 2016
Private equity (PE) operated without oversight until the Dodd-Frank Financial Reform Act gave the Securities and Exchange Commission (SEC) authority to examine PE fund advisors. Regular audits, which began in 2012, turned up widespread and serious abuses. PE firms collect fees from the companies that PE funds buy with investors’ money – so-called portfolio companies. The SEC found that PE firms made unauthorized charges and failed to share fees collected from the portfolio companies with their investors as required in the investment agreements. Recently, two major PE firms – Blackstone and KKR –settled enforcement actions with the SEC for $39 million and $30 million respectively over failure to disclose fees collected from portfolio companies to PE fund investors.
Despite these revelations, PE investors remain in the dark about how much private equity firms collect from their portfolio companies. They are not privy to the contracts between PE firms and portfolio companies, and fees are paid directly to the PE firm without passing through the PE fund. The result is that pension funds and other PE investors cannot determine whether portfolio company fees are reasonable or excessive, and whether they have received their fair share.
The private equity business model operates at multiple levels. The private equity firm raises capital from pension funds and other investors for its private equity funds. These funds then acquire companies for fund portfolios. All too often, PE firms fail to provide a clear accounting of fees collected at these levels – management fees paid by PE fund investors, monitoring fees paid by portfolio companies as well as PE firm expenses allocated to PE funds and portfolio companies.
As a remedy, California State Treasurer John Chiang issued a welcome call for legislation to establish transparency and set new reporting requirements for PE firms. In February, Assemblyman Ken Cooley responded by introducing Assembly Bill 2833 to require “private equity fund managers, partnerships, portfolio companies, and affiliated alternative investment vehicles, as defined, to make specified disclosures regarding fees and expenses in connection with limited partner agreements.” The bill would require PE firms to provide a full accounting of management fees, carried interest, and other payments and expenses, as well as all fees and expenses paid by portfolio companies.
Surprisingly, on March 17 an amendment to the Bill was submitted that would have excluded the reporting of fees and expenses paid by portfolio companies to PE firms, which the SEC had flagged as a key source of mischief. This amendment would have gutted essential transparency provisions in the original bill. The bill was ‘unamended’ a week ago and approved Wednesday morning by the Assembly Committee on Public Employees, Retirement, and Social Security with the reporting of fees paid by portfolio companies reinstated.
This is important because portfolio company fees are sizable. A study by finance economists of fees paid by a subset of portfolio companies required to file this information with the SEC documented $20 billion in fees paid between 1995 and 2014. HCA, the largest for-profit hospital chain in the US, was acquired by PE in 2006. By the time of its IPO in 2011, HCA had paid $245 million in portfolio company fees.
Even when these monitoring fees are shared with PE investors, it may not turn out well. Excessive monitoring fees strip the portfolio company of resources it could have used to improve its performance and raise its value. The result? A weaker business that ultimately sells at a lower price – to the detriment of PE fund investors whose returns are correspondingly lower.
The bill approved by the Assembly committee on April 20 is intended to restore the original intent of AB2833 and achieve Treasurer Chiang’s goal of greater transparency. However, one concern remains. The bill calls for reporting of payments received by the GP and “related parties,” but the term “related parties” is not defined. Portfolio company fees are typically paid to a subsidiary of the PE firm that provides services to portfolio companies and receives the fees. If AB2833 is to assure transparency with regard to these very important fees, “related parties” will have to include such subsidiaries.