As we’ve been examining private equity abuses, readers have been incredulous that investors have put up with one-sided, deliberately vague, complex, and/or obfuscatory contracts, unreasonable demands for secrecy, and lack of access to critically important information, such as the financial statements of the portfolio companies that they own. This failure of limited parners to protect their own interest is particularly troubling given that so many are fiduciaries.
We have another example of this sort of conduct that comes out of an important story in the Wall Street Journal yesterday by Mark Maremont. Private equity kingpin KKR made what amounted to an admission of guilt by rebating fees that the SEC had found were improperly charged, meaning stolen from the limited partners. We’ve obtained the document that was the foundation of the story and are embedding it at the end of this post. It’s a remarkable example of how cronyistic the relationships are between hapless, captured investors and the general partners who lead them by the nose.
We are about to do some document forensic work, so put on your gumshoes!
The document below comes from the Washington State Investment Board, which is a large and long-standing private equity investor with particularly close ties to KKR. WSIB was not only a pioneer in investing in private equity in the 1980s, responding to solicitation by KKR, it played a proselytizing role on behalf of KKR, encouraging other public pension funds to participate. As a result, private equity has roughly 25% of total industry assets from public pension funds, making it, as an industry insider put it in 2012, a government sponsored enterprise.
After the SEC made it clear it was finding widespread abuses in the private equity industry in a May 2014 speech, the WSIB, like many limited partners, sent questionnaires to their general partners to try to get answers as to whether they were engaged in dubious conduct. Needless to say, it’s hard to expect that anyone would ‘fess up, particularly if the questions are put in broad enough terms to give the general partners wriggle room in how they reply. The WSIB’s questionnaire, as you’ll see below, wasn’t terribly pointed and should not have set alarm bells off.
Nevertheless, KKR’s response was a marked departure from how other respondents chose to respond to the inquiry: they refused to send a written reply, as has ever other general partner in response to WSIB’s and other public pension fund questionnaires. They instead asked to maker their answers verbally. And bizarrely, the head of private equity at WSIB, Tom Ruggels, agreed to this request.
KKR’s Apparent Plan to Avoid Creating a Reliable Record of Its Answers
Scroll down to the document at the end of the page. You’ll see four participants listed as being on the call. Ruggels is the only one from WSIB. The other three are all KKR employees. I would never agree to have a call on a matter of legal significance (and remember, WSIB is a fiduciary) where I did not have a witness on my side. Here, KKR has three people who can back each other up in the event of any “he said, she said” disputes about what happened in the call. That was presumably the intent.*
The only reason that one can fathom for KKR seeking to proceed in this manner is to avoid creating a reliable written record of its responses.
Yet what do we see here? Scan the first few paragraphs. It is an impossibly precise record with language that looks to be carefully crafted from a legal perspective; indeed, some of it even tracks KKR’s Form ADV filings with the SEC.
While the KKR representatives could conceivably have spoken with this degree of precision, how realistic is it to think that someone other than a court recorder or stenographer could make such an accurate record? Not at all. In my day, McKinsey would sometimes send as many as three people to conduct important client interviews, one to run the interview, two to take notes, and they’d never be as detailed as this.
Similarly, have a look at a record from the AIG trial, which I’ve embedded after the WSIB document. Scroll to page 5. It’s a Congressional Oversight Panel interview. This is as good as it gets in notetaking by someone who is not a full time transcriptionist. You’ll see both that the notes are clipped at many points, that words have been omitted, and the interaction is still conversational even if formal.
So here is the nutty part: KKR reviewed and corrected the call notes, according to a WSIB spokesperson. That makes this record unambiguously a KKR product, and not something where there can be any doubt that KKR is effectively the author of every word in this document.
So how did this come about? It’s impossible to know. Second guessing at KKR after the call, perhaps a concern that someone had said something so potentially damaging or embarrassing that they were nervous about having it in a form that could be accessed by FOIA, and thus felt the need to tidy it up? Or did Ruggels call with questions afterwards and someone on the client services team insisted it be reviewed (as in there was a power struggle over how to deal with this request and the client services team won this round)?
Why are KKR’s Responses Dodgy?
Rather than go through the document exhaustively, let’s highlight three responses which are misleading. One is on the status of KKR’s affiliate, KKR Capstone.
KKR has maintained that KKR Capstone is not an affiliate in its SEC filings to shareholders. However, as we discussed at length, the definition of an affiliate for accounting purposes is not what is relevant to investors like WSIB. What matters to them is whether KKR Capstone is an affiliate as defined in its KKR’s limited partnership agreements. It certainly fits the definition that KKR used in a 2006 limited partnership agreement that we’ve obtained.
So how does KKR finesse that? KKR claims that “Capstone fees are not subject to fee offsets [rebates], as Capstone is owned by its employees (not KKR).” This is misleading because ownership is not the sole means by which a firm or entity is an affiliate. As we wrote last year, in disputing a defense of KKR by Bloomberg’s Matt Levine:
KKR is simply trying to pull yet another fast one on investors and the press. What matters is not how “affiliate” is defined in GAAP, which is the basis for how KKR describes what is and isn’t an affiliate in its SEC filings. What matters is how “KKR Affiliate” is defined in KKR’s 2006 limited partnership agreement, and any other limited partnership agreements that require that consulting and monitoring fees be substantially rebated. Here is the relevant section:
KKR Affiliate means each entity that, directly or indirectly, controls, is controlled by or is under common control with KKR, other than (i) Portfolio Companies or companies in which other KKR-sponsored investment funds invest, (ii) any investment vehicle the formation of which was sponsored by KKR but which is not managed by the Principals, the other members of the general partner of KKR or employees of KKR, and (iii) any investment vehicle the formation of which was sponsored by KKR and which is a Limited Partner in the Partnership.
Notwithstanding clause (iii) of the preceding sentence, KKR PEI will be deemed a “KKR Affiliate” for purposes of Section 6.3.2(g).
So what are the critical tests? First, that an affiliate need to be an entity. Check. Second, that it is “controls, is controlled by or is under common control with KKR.” In fact, , and consistent with our earlier analysis, KKR most assuredly controls KKR Capstone:
….KKR consolidates Capstone for accounting purposes, meaning that as a matter of accounting Capstone is part of KKR…So you can see why someone sitting at KKR would say, wait, it is unfair that we’re doing all this operational consulting for our portfolio companies, but we can only get 20 percent of the fees.
Levine acknowledges that both from an operational and financial perspective, KKR Capstone is not independent of KKR.
The WSIB call notes provide evidence that the SEC may not be buying what KKR is selling on the KKR Capstone front. What is telling but not obvious is the fact that KKR rebated referral fees that KKR Capstone had collected from sending business to a group purchasing business called CoreTrust (see the response to Question 2). If KKR Capstone were not an affiliate, KKR would be completely within its rights to not rebate those fees. This suggests that the SEC does not buy KKR’s position on KKR Capstone, which is a very big deal since KKR Capstone has taken lots of consulting fees out of KKR portfolio companies for itself. If KKR Capstone is indeed deemed to be an affiliate, then KKR would owe its investors a great deal of money for failing to substantially or entirely rebate those fees. While you’d expect this matter to be covered in an exam, this is so high stakes for KKR that it almost certainly pushed back hard on the exam findings. KKR may be taking the position that that issue was still up in the air at the date when the comment letter was issued and hence it could sidestep disclosing it.
The second misleading response involves advisors, Question 6. Here WSIB set up such a softball question that it allowed for an incomplete response. The controversy around advisors is that they are presented as part of the “team” when a fund is marketed, leading investors to assume they are paid for out of the management fee. Instead, what the investors thinks is general partner overhead is instead charged as expenses to portfolio companies. In other words, the answer is narrowly accurate but does not address the bone of contention because WSIB didn’t frame the question to get at the real nub, perhaps by design.
Another misleading answer is one that is obviously incomplete, Question 3. WSIB asked for an explanation of the fees that KKR charges to portfolio companies and how the limited partnership offsets are applied. KKR did not enumerate the fees, since it used the word, “including”. When in the next section, it says “these fees” it is not clear whether it means the “various fees” it mentioned at the beginning of the first sentence, or the fees specifically listed after “including”. The practice of private equity firms is to share only fees specifically listed in the limited partnership agreement, since those are the only ones it is obligated to offset against management fees. KKR’s failure to list all the fees it and its affiliates charge to portfolio companies, which was the response WSIB sought, is consistent with KKR charging fees not listed in the limited partnership agreement and hence not shared with the limited partners, contrary to their belief otherwise.
And why is this problematic? Gretchen Morgenson, in an article published over Memorial Day weekend, exposed that . These payments amount to tens of millions of dollars and diminish the sale value of the company. Yet Morgenson suggested that these termination fees weren’t shared with the limited partners as they believed. This article ran well before the WSIB conference call. It would be a critically important point for any prudent investor to nail down. Yet Ruggels was derelict in his fiduciary duty and let KKR avoid discussing that issue.
So here we have KKR insisting on a less than honest process and giving less than complete and accurate answers to what is arguably its very best client. And with no reason to believe any special inducements were offered to Ruggels. We simply have a complacent limited partner who is unwilling to press KKR to get the answers his beneficiaries deserve.
This case alone is proof that public pension funds are not competent to invest in private equity. They are unable or unwilling to take the steps necessary to protect themselves from its chicanery and predation. They should be stripped of their accredited investor status by the SEC.
*Washington is an “all party consent” state, so Ruggels would not have been able to record the call without the agreement of everyone on the call.