A commenter in our prior “Memo to Spitzer” post questioned whether big private equity firms could really be getting away with scamming their investors, arguing that:
…firms are under more scrutiny than ever these days by LPs (and their attorneys) since the financial crisis. Everything is under spotlight, fees, fund size, deals, track record, etc. Firms live in a hyper-scrutinized environment these days and it’s hard to believe the entire universe of PE LPs would be missing outright criminality.
Notice the straw man: we never claimed that the “entire universe” of private equity firms was engaged in “outright criminality”. You can have a hell of securities law and contract violations before you hit criminal conduct.
But we’ll put that aside and deal with the widespread myth: private equity is a world of big boys, and the limited partner investors are well-informed, well-advised consenting adults. If you believe this story, it follows that it would be unlikely that anyone could take advantage of them, and if so, it must have been due to some lapse on their end.
The problem is we’ve seen what happened in the mortgage backed securities world. In a realm of SEC registered prospectuses, which have much higher disclosure standards than the super-secret limited partnership agreements, we saw widespread abuses and an inability of investors to band together effectively or to get any meaningful restitution individually*.
There are many reasons for investor passivity and ineffectiveness, but one was that the presumption of an ongoing relationship, which you would assume would operate in favor of the customers, meaning investors, actually worked in favor of the banks. Many important investors like mutual funds and pension funds didn’t want to rock the boat because they felt the needed to maintain good relationships with the Street to get access to product like this (erm, with product like this, less might be better, but no one seems to want to think that way). As we’ll discuss in later posts, we have similar motives at work here.
You see close analogies to the RMBS problem, of hopelessly meek investor representatives and advocates, in the private equity world.
Investors in private equity funds (technically, limited partners or “LPs”) rely on their outside law firm as their first line of defense against PE firm misconduct. Outside counsel plays such a critical role because they – far more than the investors themselves – are the ones who review and analyze the fine print of the super-secret limited partnership agreements (“LPAs”) that are the contracts between PE firms and the investors. These contracts are always drafted by the private equity firms, not by the investors.
And remember, these documents are the only vehicle for the investor to insure that the business is operated for his benefit and not that of the private equity fund sponsor. And the central lesson of the mortgage backed securities disaster was that investors incorrectly assumed that a party that had contractual duties actually fulfill those obligations. That did not happen in reality because the trusted intermediaries had strong economic incentives not to.
Here are some examples of similar conflicts from the PE world: nothing prevents the private equity fund sponsors like Bain, KKR, and Blackstone from hiring affiliates (that is, paying fees to themselves at the expense of the investors) except the terms of the contracts. One would assume that typical agreements permit the hiring of affiliates as long as the fees are comparable to those paid in an arms-length transaction. But this language is meaningless if there is no independent party to assess that decision, no one to enforce the results of such a review, and no one to insure that any affiliated service-provider is competent and then executes its duties well.
That problem could be solved in the agreement in several ways, such as having an independent party review everything of value that PE firm affiliates received from portfolio companies and require any proposed affiliate to be disqualified or face automatic clawbacks if fees were too high, or require similar independent audits of randonly-selcted transactions for fee and performance levels (again with automatic clawbacks and going-forwared prohibitions in the event of violations). But the cheapest and most effective way would be simply to bar the PE sponsor from getting paid for any services provided by anyone to a portfolio company, since the PE firm is already being paid a management fee and carried interest by the investors who ultimately own the portfolio companies. However, this approach is effectively never used in the private equity industry.
We’ve used the example of hiring affiliated companies. Similar issues apply to every major decision made by the fund sponsor, also referred to as the general partner, including buy-out offers, going public transactions, dividends and distributions, borrowing, and other related party transactions.
And these issues are real. Like all complex agreements, PE LPAs can be Trojan horses for clever drafting that make the investors think they are getting a particular deal, when they are really getting a different, inferior one. The law firms that review the agreements for LP investors generally have entire practices dedicated to it, where the law firm generates economies of scale by reviewing the same LPA multiple times for numerous different clients participating in different closings, and where each client is paying the law firm tens of thousands of dollars.
On one level, it is a sweet deal to get paid tens of thousands of dollars to re-read the same document over and over and re-issue the same memo to LP investors. However, those fees are chicken compared to the fees paid by private equity firms, either directly by having the PE firms as a client or indirectly by representing their portfolio companies. For example, the formation of a new fund can easily generate a million dollars paid by the private equity general partnership. Likewise, a good-sized acquisition for a private equity fund can be a million dollar payday for the PE firm’s outside counsel. Smaller but very steady legal fees are generated by law firms acting as counsel to companies that the private equity fund general partners like Bain and Blackstone have acquired for their various funds. These portfolio companies also buy and sell companies, engage in financings, and have routine corporate legal matters and the law firms have them as clients only by staying in the good graces of the private equity fund sponsor.
This results in a major conflict of interest at big law firms: virtually all of them are making much more money from private equity firms, either directly or indirectly, than they are from the investors in private equity that they also represent. And the investors have little in the way of good options, since those big law firms are the most expert in the PE space by virtue of all the work they do for the private equity firms themselves.
The problem of inadequate review and oversight is further compounded by the fact that many investors operate in what amounts to a convoy system. They often can’t afford to pay for the full-blown deal and document review process (and cynically, why should they, given that they are not getting an individualized review?). Many simply copy the PE investment decisions of investors recognized as being sophisticated and diligent, such as TIA CREFF, Calpers, Harvard, and Yale, and do only cursory reviews of their own.
Let’s look at a particularly egregious conflict involving the Boston law firm Ropes & Gray. Ropes is Boston’s ultimate Brahmin firm, with a pedigree dating back to 1865. Past partners including Henry Cabot Lodge and Archibald Cox.
Industry insiders report that Ropes does the legal work for Harvard’s investments in private equity funds. Notably, Harvard’s endowment is one of the most important PE investors in the world. Harvard is not only in the top tier of private equity investors in terms of the total size of its commitments, but also has a very high percentage of its assets invested in private equity, making the strategy critical to the university’s financial well being. Moreover, the Harvard Management Company, Harvard’s investment arm, is widely considered to be sophisticated and well run, and is widely viewed as a “thought leader” among PE investors.
Ropes & Gray also represents two of Boston’s leading PE firms: Bain Capital and Thomas H. Lee Partners. Ropes has long been the main outside counsel to Bain Capital, meaning it almost certainly drafted the some of the agreements it is reviewing for investors like Harvard, as well as working on numerous other matters for Bain at the management company level (for Bain Capital itself) and also representing Bain funds as well, which are legally comprised of Bain’s investors and are theoretically legally distinct from Bain itself. Ropes’ name is on literally hundreds of SEC filing made by both Bain and TH Lee over a period of decades.
Harvard is an investor in multiple Bain and Thomas H. Lee funds. You can already see the potential for trouble. How can Ropes be a fair broker between such high profile players? And can it really be an aggressive negotiator for Harvard when on a dollars basis, Bain and Thomas H. Lee are much more lucrative clients? And in particular, how can you expect Ropes to tell Harvard about any clever tricks and traps it dreamed up and incorporated in the documents for Bain funds in which Harvard invested?
It’s hard to fathom how Harvard let this situation arise. From its earliest days, Ropes’ marquee client has been Harvard University. By contrast, the consulting firm Bain came into being in 1973, when the Ropes/Harvard relationship was already more than 100 years old. Bain Capital was founded even later, in 1984. Harvard could easily have refused to let this situation arise or could have put limits on it. But even now, despite the large fees Harvard Management Company alone makes to Ropes ($10.8 million in 2012, making Ropes Harvard’s highest paid provider of any non-investment service), Bain and other private equity firms almost certainly pay more to Ropes than Harvard does in fees, which means one has to question how hard Ropes would push when their interests are in conflict.
But wait, it’s worse – much worse. The March 6, 1998 Federal Register contained an application to the SEC by Ropes & Gray to form an in-house 1940 Act “investment company” that would be owned by the employees of the firm in order to invest their capital. Critically, as part of its investment company application, Ropes sought and was granted by the SEC an exemption from the normally comprehensive and ongoing public reporting requirements to the SEC that investment companies normally provide.
How has RGIP been investing the Ropes partners’ money? Thanks to the SEC waiver, it’s impossible to know everything. But RGIP appears regularly as an investor in Bain and Thomas H. Lee (another top Boston-based PE fund) deals.
Pay attention, because the distinction I’m about to make is critical to understanding how stinky this is. I am not talking about RGIP being an investor in Bain and Thomas H. Lee funds. To the extent that were the case, RGIP’s interests would be aligned with Harvard as a fellow fund investor, since they’d be in all the same deals, be subject to the same gains and losses, and presumably pay the same or similar fees.
Instead, Ropes & Gray, Harvard’s counsel, is investing alongside Bain and Thomas H. Lee funds in which Harvard is an investor. From an economic perspective, Ropes & Gray is investing ahead of Harvard, because it is not paying the fees a limited partnership investor pays. Moreover, it may well be in an even more advantaged position by virtue by getting access to only the best deals (as in cherrypicking within the funds**) and could potentially better rights on other fronts than its client.
The proof from the Dunkin Brands prospectus:
The validity of the issuance of the shares of common stock to be sold in this offering will be passed upon for us by Ropes & Gray LLP, Boston, Massachusetts. Some attorneys of Ropes & Gray LLP are members in RGIP, LLC, which is a direct investor in Dunkin’ Brands Group, Inc. and is also an investor in certain investment funds affiliated with Bain Capital Partners, LLC and Thomas H. Lee Partners, L.P. RGIP, LLC directly and indirectly owns less than 1% of our common stock and is a selling stockholder in this offering. The validity of the common stock offered hereby will be passed upon on behalf of the underwriter by Simpson Thacher & Bartlett LLP, New York, New York.
The key language here is “direct investor” in the company. That means it holds shares, rather than holding a limited partnership interest in a private equity fund.
From the Sungard prospectus:
Some partners of Ropes & Gray LLP are members in RGIP LLC, which is an investor in certain investment funds affiliated with certain of the Sponsors [the PE firms, of which Bain Capital was one] and often a co-investor with such funds. RGIP LLC owns, directly and indirectly, shares of the capital stock of our Equity-Issuing Parent Companies representing less than 1% of the outstanding shares of stock of each such company.
And here are more links to deal documents filed with the SEC showing RGIP as a co-investor with Bain:
How do we know investing in the portfolio companies directly is a better deal than investing at a fund level? The limited partners themselves say so. From a March article in Pensions & Investments:
“Many large institutions are clamoring for co-investments because most co-investments are made on a no-fee, no-carried-interest basis, said David Fann, president and CEO of San Diego-based consulting firm TorreyCove Capital Partners LLC.” …
“The push is from limited partners that want to co-invest to drive down the cost of investing in private equity and to gain control over investments, Mr.[Delaney] Brown [of the UK activist investor Hermes GPE] said.
Let’s understand how the economics work. RGIP owns shares directly in Bain/Thomas H. Lee fund portfolio companies. When those companies pay a dividend, it’s a near certainty that 100% of the dividend amount from its shares flows directly into RGIP’s coffers. The fund investors, by contrast, could get as little as none of that same dividend, if that particular cash flow occurs during the “100% to GP catch-up” portion of the waterfall.
Generally speaking, it’s well nigh impossible for a private equity firm to bring in a co-investor on a single deal and have that co-investor situated exactly parri passu with its fund investors in terms of economic and legal exposure. A basic reason for that is that the cash flows that get paid out to fund LPs on a particular deal are calculated based on the prior cash flows of all the fund’s other deals. If the co-investor is in just one or a subset of all of the fund’s deals, it would be impossible to replicate that provision for them. Further, there is no point to seek co-investor status unless one is getting a better deal than the fund. Otherwise, one might as well invest in the fund and avoid the administrative cost of managing the investments directly. Thus the bottom line according to one PE insider I consulted is:
RGIP’s deal must be different than the fund investors in some respect, which means that RGIP is not fully aligned with the interest of fund investors like Harvard and
It is extremely likely that RGIP’s deal is better than fund investors’ deal, as that is the generally recognized purpose of PE investors seeking co-investments rather than simply signing up to funds
As bad as all of this seems, we have either peculiar ineptness or an effort at obfuscation by Bain in some of its descriptions of RGIP and the role played by law firms generally. Bain portfolio companies have repeatedly mischaracterized the relationship between RGIP and Bain in SEC filings over the years, claiming that RGIP is an arm of Bain even though it is clearly not. For example, here is an SEC filing by Bain where, in a footnote, it refers to RGIP as an affiliate of one of its funds:
1. Includes 37,121 shares of stock owned by BCIP Associates II, 15,026 shares of stock owned by BCIP Associates II-C, 10,664 shares of stock owned by BCIP Trust Associates II, 8,964 shares of stock owned by BCIP Associates II-B and 2,669 shares of stock owned by BCIP Trust Associates II-B, 964 shares of stock owned by PEP Investments PTY Ltd., 16,843 shares of stock owned by Sankaty High Yield Asset Partners, L.P., and 3,717 shares of stock owned by RGIP, LLC, affiliates of Bain Capital Fund VI, L.P.
Now, in SEC-speak, the term “affiliate” has a very precise legal meaning, which is that an entity controls, is controlled by, or under common control with another entity. There is no way that RGIP is an affiliate of a Bain fund. The SEC would almost certainly view this mis-statement as an unintentional foot fault unworthy of sanction, but one does wonder whether in fact the false disclosure was done deliberately to mask the role of the lawyers co-investing in the deal.
But if that statement is a foot fault, what about this? Having been dragged into the supervision of the SEC by Dodd Frank, Bain now maintains a public form ADV. In that form, Bain makes the following apparently misleading disclosure about the investment activities of its law firms:
Partners of the law firms engaged to represent the Funds may be investors in the Funds, and may also represent one or more portfolio companies or limited partners of the Funds.
Note that Bain language conveniently omits what its and the Thomas H. Lee filings have repeatedly disclosed about RGIP, which is that the partners of law firms invest in the deals directly (as a “direct investor”), rather than in the funds. Of course, the finesse may be that PE fund partners do invest in Bain funds (as do some employees of investment banks) but RGIP is not a partner of a law firm, but an investment vehicle. So the disclosure is arguably narrowly accurate if substantively misleading.
And in case you think the behavior we’e uncovered is infrequent, language from other Bain disclosures indicates otherwise. The Clear Channel prospectus, another Bain deal, discloses specifically that it isn’t just unnamed “partners of law firms” but that is it specifically Ropes that both invests in the funds and is “often” an investor in the portfolio companies:
The validity and enforceability of the exchanges notes and the related guarantees offered hereby will be passed upon for us by Ropes & Gray LLP, Boston, Massachusetts. Ropes & Gray LLP and some partners of Ropes & Gray LLP are members of RGIP, LLC, which is an investor in certain investment funds associated with the Sponsors and often a co-investor with such funds. RGIP, LLC owns, directly and indirectly, shares of capital stock of Holdings representing less than 1% of the outstanding shares of stock of Holdings.
This ADV disclosure earlier also suggests yet another whopping conflict of interest on the part of Bain’s lawyers, which given all of the disclosures above, is almost certainly Ropes & Gray. If you combine this ADV disclosure with all the other SEC disclosures from this post, it appears that Ropes & Gray represents not only Harvard (“…may also represent one or more limited parters”) as a single LP in Bain funds, but simultaneously, Ropes represents all of the partners collectively (“…the law firms engaged to represent the Funds…”[the Fund is the entity comprised of the limited partners and the general partner]).
So Ropes is professing to provide fair and objective advice when it appears to be on every side of these transactions imaginable, as counsel for Bain Capital, as counsel to the Bain funds, as counsel to some investors individually (Harvard), in certain cases, to the portfolio companies, and with at least some firm partners acting through a firm-sponsored investment vehicle as a direct investor in particular deals.
I ed Ropes & Gray, the Harvard Management, Bain Capital, and Thomas H. Lee for comment. Ropes & Gray, Harvard Management, and Bain did not respond, and Thomas H. Lee declined to comment.
Understand the issue here. I am not saying that Ropes & Gray is doing something technically impermissible. Lawyers are expected to get waivers when they are representing clients who have conflicts of interest, and presumably Ropes got one from Harvard. Similarly, the fact that Ropes represents both Bain as a fund sponsor and the fund itself as a separate legal entity would certainly be disclosed in Bain’s fund offering documents. One does wonder, however, why on earth Harvard would have ever granted Ropes a conflict waiver along these lines.
On the other hand, the LPs would almost certainly not have been notified of Ropes’ conflict of interest in representing them corporately as fund counsel while also co-investing alongside them. The reason for this is that Bain itself, as the fund’s general partner, is the party that would waive the conflict between Ropes acting as fund counsel while co-investing alongside the fund. As the GP, Bain is designated as the agent for the fund and its investors in this respect and can therefore sign-off on egregious conflicts of interest on the part of the fund counsel. Ropes appears to be exploiting what is effectively a loophole in the structure of private equity funds, where the GP is the legal agent for the LPs, in order to get sign-off on a massive conflict of interest with the LPs.
So look at the money and power imbalances. On issues where the Bain’s and Thomas H. Lee’s interests are directly opposed to Harvard’s, how aggressive an advocate do you expect Ropes to be? The very fact that they are co-investors with the private equity kahunas is an awfully strong indicator of where they think their real interests lie.
And this picture is broadly replicated, without the RGIP kicker, at every firm considered to be top drawer in this field. So even if Harvard were to become disaffected, it’s highly unlikely that it can get better representation elsewhere.
In the end, the question is for Spitzer, or whoever is the next New York City Comptroller: Who can you really trust to represent your interests in as outside counsel advising you on private equity investing, given the state of legal ethics even at white shoe law firms like Ropes & Gray?
*The parties that have had the best track records so far are not investors, but bond insurers, and that is by virtue of having better contractual rights, most important, access to loan files, than MBS investors.
**This is very plausible in the case of Bain deals. As Bain’s lead outside firm, Ropes would have ongoing communications with the partners and one would expect would often be chosen as counsel to handle acquisitions for various Bain funds. Serving as deal counsel would make Ropes an active part of the due diligence process. That would give Ropes a considerable information advantage over the limited partner investors, and allow the law firm to pick and choose on the basis of privileged information.