KKR made what amounted to an admission of guilt to the blistering charges that the SEC laid at the doorstep of the private equity industry last May. Then, Andrew Bowden described in unusually specific detail the widespread, serious abuses it was finding in its initial private equity examinations, including what amounted to embezzlement. Those reviews came about because Dodd Frank required general partners who with funds bigger than $150 million to register as investment advisors.
Mark Maremont of the Wall Street Journal, based on a document obtained by FOIA from the Washington State Investment Board, learned that KKR had disgorged some ill-gotten fees. :
KKR & Co. refunded money to investors in some of its buyout funds after regulators found it overcharged them, marking one of the highest-profile results yet of regulators’ increased scrutiny of the private-equity business.
The decision by KKR, one of the world’s largest private-equity firms, came in response to an examination by the Securities and Exchange Commission, which found the firm wrongly charged investors for some expenses and failed to properly notify them of certain fees it collected, according to a document from one of KKR’s largest investors.
The SEC last year publicly lambasted the industry for charging “hidden fees” to investors in its funds—including public pension plans managing money on behalf of teachers, firefighters and other government employees—and for shifting expenses onto those investors without adequate disclosure…
KKR officials said the SEC determined that the private-equity firm from 2009 to 2011 had allocated certain expenses to its private-equity funds that “should not have been allocated to the funds.”
As a result, the notes said, KKR gave “fee credits” to the investors in those funds. The sums were blanked out, but the total of such credits was listed as “$X million,” and the credit to the Washington state pension fund was listed as “$X thousand.”
Notice how KKR won’t even give back hard dollars. It’s all “fee credits”.
The document reveals KKR as a recidivist, with it making rebates to Washington State across three funds. While the exact amounts were redacted, the Journal’s analysis suggests that one set of rebates rebate to all investors was under $10 million. Those resulted from the improper expense allocations.
A second, likely smaller rebate resulted from a more complicated scam. KKR has a captive consulting firm, KKR Capstone, that KKR tries to pretend is independent when it controls the firm’s economics (this would make it an affiliate in terms of the definitions used in the KKR limited partnership agreement we’ve obtained, and thus obligate KKR to share those consulting fees with investors). KKR’s portfolio companies get group purchasing discounts through a company called CoreTrust. KKR Capstone got referral fees, aka a kickback, for sending portfolio companies over to Coretrust.
KKR last year pegged the total of such fees it collected over the prior three years at $6 million.
Although KKR, like other private-equity firms, is obliged under contractual arrangements to share with its buyout fund investors most of the extra revenue it garners from managing portfolio companies, it hadn’t been sharing any fees collected by Capstone, including the group-purchasing fees.
“KKR did not disclose” to its fund investors that Capstone was collecting the group-purchasing fees, the notes show. Because the fees went to Capstone, not KKR, KKR felt there was no need to disclose them, the notes show. “However, as a result of the [SEC’s] finding, Capstone agreed to ‘give these fees up’ ” to fund investors, the notes show. The Washington pension fund’s portion of this second rebate was blanked out, but it was less than $1 million.
Long-time Cfdtrade readers will see this sort of grifting as troublingly reminiscent of the low-life behavior of the mortgage servicing industry, where the servicers worked every angle they could think of, many not kosher, to wring more cash out of borrowers and ultimately, investors. Here, the myth of the private equity industry is that the limited partners can rely on the general partners to serve their interests and generate great returns. The reality is that private equity returns have been faltering and the general partners’ revenues come 2/3 from risk-free fees (and cheating) and only 1/3 from performance-based compensation. That gives the general partners incentives to churn companies whether or not the deals make a lot of sense.
Even though the KKR returning money to wronged investors is a modest accomplishment, it still demonstrates that regulation works. KKR, which is famously aggressive and advised by the best lawyers money can buy. It clearly thought it was critical to make restitution pronto rather than risk having the SEC levy fines. Mind you, we’d argue that KKR’s action means a fine is still in order, that is, that coughing up the dough when caught out is not sufficient, and that KKR should also pay fines to show that misconduct is not acceptable and results in real sanctions.
But as the report we’ve embedded below by Eileen Appelbaum, co-author of the important new book Private Equity at Work, demonstrates, the KKR abuses are only the tip of the iceberg of rampant stealing and sharp practices in the private equity industry. And as she stresses, this is proof positive of the need for the SEC to do more, not less. The SEC has only gone after conduct it has found on the investment advisor side. Most private equity firms also take investment banking fees, which means those activities should be housed in SEC-registered broker-dealers. Even though some of the larger firms do have broker-dealer entities, they are in fact not using them to provide private-equity-related broker-dealer services, meaning this abuse is flagrant and ongoing.
The Applebaum report is accessible yet specific about the nature and extent of private equity misconduct. I strongly suggest you read it in full. She reminds reader that even these disturbing exam findings have come about despite private equity exams being more superficial than those of other investment advisors. From the overview:
At the time that the Dodd-Frank Act passed, many observers doubted that the reporting requirements for private equity fund advisers would be effective. As Professor Rosemary Batt and I observed at the time, the reporting requirements for private equity fund advisers are thin compared with what publicly traded companies must disclose to the SEC. PE fund advisers are not required to report the incomes of partners and senior managers, which companies their funds own, or financial information about the individual companies in their portfolios. There is no legal requirement to notify employees, unions, vendors, or other stakeholders when private equity takes over the ownership of a company or to publicly disclose the amount of leverage used in the acquisition.
Not only are the reporting requirements for private equity fund advisers far less stringent than for publicly traded companies or for mutual funds and other similar types of investment funds, but the budget deal worked out in the U.S. Congress in January 2014 denied the SEC’s request for funds to hire additional inspectors. The probability that an SEC inspector would examine a particular private equity fund adviser appeared slim. No one expected the new regulatory scrutiny of private equity fund advisers to yield information about improper practices or to have much of an effect – including, no doubt, the private equity firms that sponsor these funds…
Despite the weak provisions in the law and understaffing at the SEC, the reporting requirements in Dodd-Frank have enabled SEC regulators to identify widespread abuses. Misdeeds by private equity fund advisers include manipulating the value of companies in their fund’s portfolio, waiving their fiduciary responsibility to investors (including pension funds), misallocating PE firm expenses and inappropriately charging them to investors, failing to share income from monitoring fees charged to portfolio companies with their limited partners, and acting as broker-dealers and collecting transactions fees from portfolio companies without registering as broker-dealers as required by law. We discuss these problems identified by the SEC in greater detail below. The SEC’s revelations have led a few PE firms to voluntarily rein in some of the most egregious practices for their new funds. While changes in behavior that improve the treatment of limited partners and portfolio companies by GPs are a welcome development, the changes to date consist of piece-meal and voluntary agreements by a handful of PE firms to behave better in the future. The majority of PE firms found to have violated securities law have not taken steps to make amends for past misdeeds or to stop such practices.
Still up in the air is the question of whether past bad behavior by PE fund advisors and the PE firms with which they are affiliated will lead to enforcement actions by the SEC. Will those Wall Street firms that have engaged in improper behavior going back many years or even decades that borders on – and sometimes crosses over to – fraud be held accountable? Their misdeeds have resulted in billions of dollars in ill-gotten gains for the PE firms’ partners or top executives. Will these firms be required to disgorge the money they and their partners or executives wrongly appropriated? The SEC’s enforcement record to date is not encouraging: enforcement actions have been brought in very few cases, most of them small bore and involving relatively unknown private equity firms such as Lincolnshire Management and Clean Energy Capital. Enforcement is a necessity if the bad behavior by so many PE firms that the SEC has identified is to be halted. But these are still early days and if, as some in the finance community expect, the SEC is planning much larger enforcement actions, these may take time to investigate and develop. That is especially true in cases where the PE fund investment adviser acted as an unregistered broker-dealer – a situation rife with conflicts of interest and possibilities for fraud. This is a serious violation of securities law, and one that carries heavy penalties.
It is important to remember that one of the top targets of financial services lobbyists is that very issue that Appelbaum mentions at the close, the potential for large fines to major private equity firms for acting as unlicensed broker-dealers. The private equity firms don’t even bother denying this lawbreaking. Their sense of entitlement is so large that their argument is that the rules should not apply to them.
This is an important issue not simply because it is such flagrant misbehavior, but also because the potential fines are enormous: dollar per dollar of transaction value. It’s a huge weapon that the SEC could use to great effect to level the power imbalance in now has in facing off against the private equity kingpins.
So naturally, the broker-dealer issue is one of the Dodd Frank weakening measures that the industry is trying to slip through in HR 37, which has passed in the House but has yet to come to a vote in the Senate.
I urge you to call your Senators () and tell them you are opposed to weakening Dodd Frank, and in particular, gimmies for too-big-to-fail banks and relaxing the rules for private equity firms that have already been found to have broken securities laws on a widespread basis. And if you have time, call your Representative () and tell you either support their vote on HR 37 if they voted against it (see ), or if they supported the bill, that you are disappointed on how they are soft on too big to fail and private equity misconduct. The fight to gut what little financial reform was enacted is going to be a multi-act drama. Let your legislators know that you are watching and care about the outcome.