Almost four years ago, we wrote about a then relatively new scam in private equity. Private equity fund managers forced portfolio companies they owned to pay them kickbacks. The scheme was that they had set up “group purchasing organization” middlemen who then paid fees based on the value of goods that the portfolio companies bought through.
The headline of our 2014 post, SEC Investigating Group Purchasing Kickbacks by Private Equity Firms, stated plainly what was occurring, including that the SEC was sniffing around.
Two weeks ago, almost four years after our post, the SEC finally pulled the trigger on a wet-noodle-lashing enforcement action, entering into a penny-ante $779,000 settlement with the blue chip private equity firm Welsh, Carson, Anderson & Stowe (also known as “WCAS”) .
The weak enforcement action demonstrates the institutional failure not just of the SEC but also investors in private equity. One might ask why we don’t include the private equity firms themselves to our list of shame, since they have failed to act honestly and honor their contracts with investors. At this point, we hope that our readers understand that we don’t consider it newsworthy that a tiger attacks its prey but do think it worthwhile to expose the fools who profess surprise at the tiger’s behavior.
The fact set presented in the WCAS settlement tracks almost exactly the scheme we described in our original post. As the SEC notes, Welsh Carson manages multiple private equity funds totaling $7.7 billion, and those funds buy “portfolio companies.” Investors allow Welsh Carson to collect multiple revenue streams from the funds and directly from the portfolio companies. From the funds, WCAS receives management fees (1.5% annually while the funds are being invested) and so-called “carried interest,” which is 20% of the fund profits. In addition, Welsh Carson charges portfolio companies fees for “services” that Welsh Carson claims to provide.
Even complacent and captured private equity investors have come to question the legitimacy of the supposed “services” supplied by almost all U.S. PE firms. These limited partners have taken the view that a fund manager should not benefit from these fees. However, the private equity fund managers have made a mockery of many of the investors’ efforts to halt this back-door looting.
Investors wanted the company-level fees stopped, but agreed to a poor compromise. Thei contracts that routinely specify that the investors’ management fees are reduced by 80-100 percent of portfolio company fees received by the fund manager.
Not surprisingly, the fund managers only gave lip service to the notion of refunding all or virtually all of the portfolio company fees to investors. It wasn’t hard to circumvent the contracts. First, for tax reasons, portfolio company fees cannot appear in fund books and records but must be paid to the fund manager outside of the fund structure. Second, foolishly, private equity investors have failed to insist that they have access to the financial records of the portfolio companies.
That lack of disclosure made it child’s play to short-change fund investors, especially when fund managers discovered that they got no push back when the occasional investor asked for a full accounting of portfolio company fees received, and the manager simply said, “NO,” or when a bill was introduced in California last year to require such an accounting and the legislature dutifully gutted it to the point of uselessness.
As sophisticated people who like to buy status (university chairs, names on buildings), PE managers prefer methods of cheating that don’t expose themselves to criminal liability but are, at worst, practices that could result in a lawsuit and the possibility of a civil monetary judgment. So best not to just take money out of the cash till but instead to use lawyers to construct a practice that provides at least a thinly plausible argument, if caught, that one’s chiseling activities are merely a difference of interpretation of complex legal language. This is where the group purchasing kickbacks came in for Welsh Carson and a large number of other private equity firms. As the SEC presents the essential elements of the scam:
1. This matter concerns an investment adviser’s disclosure failure regarding conflicts of interest between the adviser and its private equity fund clients and fund investors in connection with an agreement (the “WCAS Services Agreement”) between the adviser and a group purchasing organization (the “GPO”). WCAS is the investment adviser to various private equity funds which owned portfolio companies that used the GPO, which is a company that aggregates companies’ spending to obtain volume discounts from participating vendors. Under the WCAS Services Agreement, the GPO paid WCAS compensation based on a share of the fees the GPO received from vendors as a result of the WCAS portfolio companies’ purchases through the GPO. WCAS did not disclose the conflicts of interest associated with the WCAS Services Agreement, and could not effectively consent on behalf of its private equity fund clients. By virtue of this conduct, WCAS breached its fiduciary duty to its private equity fund clients in violation of Section 206(2) of the Advisers Act, and also violated 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.
In layperson terms, Welsh Carson struck a deal with a “group purchasing organization” (“GPO”), whereby Welsh Carson got a cut of every dollar that its fund portfolio companies spent with the GPO. Welsh Carson then used its control over these same portfolio companies to force them to buy goods from the GPO. WCAS kept for itself the revenues generated from this scheme and did not rebate them at all to the fund investors, even though the investors foolishly believed that their contracts with Welsh Carson required treating all fees received from portfolio companies as subject to the rebate formula.
So what was the WCAS rationalization for such a blatant kickback scheme? The SEC doesn’t say, but it is pretty apparent that WCAS and the myriad other private equity firms engaged in this precise scheme take the position that because the fee is best described as a “referral” fee, it does not fit into any of the fee categories specified in the WCAS investors contracts as subject to rebating to investors.
In other words, investors in PE funds, meaning institutions like CalPERS, have historically believed that their contracts with PE managers subjected all portfolio company fees received by the manager to the rebate formula. However, the private managers have the better part of the argument, no doubt because they wrote the agreements, that the contracts require only specifically enumerated fees to be rebated. For example, if you look at the Blackstone, supposedly trade-secret, contract on our site, you can see that it lists precisely which fees are subject to a 65% rebate to investors:
65% of net monitoring, transaction, directors’ and organizational fees received by the Advisor and its Affiliates.
If your thought on reading this is, “But doesn’t that give the private equity manager an incentive to simply think of new types of fees that aren’t specified in the contract?” you are on the right track.
Like most commercial contracts, private equity contracts are quite standard-looking. Investors’ lawyers are generally looking for the same prototypical list of fee types subject to rebate. As long as the private equity manager hews to that list, the sky’s the limit in terms of then inventing other types of undisclosed fees not on the list and therefore arguably able to be pocketed 100% by the fund manager.
The SEC enforcement action shows the limitation of this approach. All the SEC cares about is adequacy of disclosure. Mere securities law violations suit manager’s objective, since they result in only couch-lint level civil penalties, as we see here.
So what other novel kinds of fees are general partners using to move money from portfolio companies into their pockets? We’ve heard that some firms charge “recruitment” fees, where they are effectively taking a headhunter fee for interviewing candidates for upper level management at portfolio companies. The Financial Times reported a few years ago where someone who had worked at a PE portfolio company said they had to pay a “conference room fee” every time they were hauled into their private equity overlord’s offices for a meeting. Most U.S. private equity firms hold an annual “firm retreat” during the winter months. This is not the annual “LP investor meeting” that consists of feting public pension fund hoi palloi over elaborate meals and entertainment for a couple of days. Rather, the firm retreats are even more elaborate affairs for the private equity firm staff only, plus usually the CEOs of the portfolio companies. They typically occur at places like the Breakers in Palm Beach during the winter months. You may have already guessed, but the inclusion of the lowly portfolio company CEOs does not reflect a love of their company – it’s how the PE firms are able to hand the bill for the event to them.
The SEC settlement contains some noteworthy information. For example, WCAS apparently received just $623,000 in GPO kickbacks over a bit more than four years, from late 2012 through 2016. That averages out to approximately $145,000 per year, which seems like a trivial sum compared to the firm revenues of Welsh Carson, which likely exceed $100 million annually.
How can one explain this willingness to risk the firm’s reputation for such a pittance? Several factors likely play a role. First, a tiger’s nature is to hunt. Even their tiny cousins, house cats, kill birds for sport rather than for food. So it is with private equity professionals. Investors hire them because of their skill and willingness to grab any available dollar and naively hope that the impulse is directed exclusively in their service.
The pettiness of thees kickbacks also reveals another reality, which is the utter preposterousness of the argument, trotted out across the ideological spectrum, from libertarians to establishment Democrats, that respected financial firms have a great disincentive to commit fraud because the cost to their reputation if caught dwarfs any realistic payoff.
In the WCAS case, we can see the most naked kind of grifting, sleazy kickbacks, the value of which could never have been economically justified if Welsh Carson rationally weighed the likely cost to its reputation if caught.
A second factor that may have driven Welsh Carson’s behavior is something that behavioral economists call the “multiple pockets” phenomenon. In this case, the partners of Welsh Carson might not have viewed their firm revenues as just a single pocket of, say, $125 million per year. Instead, they might have viewed it as many pockets, one containing the cash flow stream allocated to paying the junior investment staff, another allocated to paying for a plane, etc. In this scenario, the $145K per year could have been significant in justifying the hiring of a particular staff person whose job focused on working with portfolio companies and whose champion for the position’s creation needed to come up with a set of revenue streams to pay for the position, where the GPO kickbacks were one such stream.
The SEC’s yawning response is disappointing but hardly surprising. Major law firms have been advising their clients to expect enforcement actions in this area for almost three years. Presumably, as the first, and maybe only enforcement action on the GPO kickback issue, WCAS has been in the SEC’s sights all that time. Yet the elapsed time for the investigation is more what one would expect for a complex fraud, when the facts in this case were simple. The SEC should have been able to establish and analyze them in a couple of months at the most, including time for a nice vacation for each SEC staffer involved.
Moreover, in light of the elapsed time, it’s a reasonable bet that there won’t be more than one or two additional enforcement actions for this behavior. The SEC loves to “make an example” of by bringing 1-3 enforcement actions on an issue and claims that everyone in the industry “gets the message” and changes behavior as a result.
But, a huge portion of the U.S. private equity industry has already acknowledged to investors in their annual Form ADVs that they engage take GPO kickbacks. If anything, the practice continued to spread during the period when lawyers were warning that there would be SEC enforcement actions.
So the reality, despite the SEC’s wishful thinking, is that financial firms see the SEC exhaust its feeble energy by slapping a few firms on the wrist. They conclude that they have won the investigation lottery and it’s full steam ahead on the practice.
Finally, it’s worth noting the nearly universal practice of the SEC allowing defendants to write large portions of the SEC’s settlement agreement, which causes facts to be obfuscated to the point that even knowledgeable experts end up scratching their heads wondering what the defendant did wrong. In the Welsh Carson’s case, one can see the hidden hand of the WCAS drafting in the settlement’s claim that, rather than coercing portfolio companies to spend money at the GPO so that Welsh Carson could receive a kickback, Welsh Carson merely would “recommend the GPO’s services to the WCAS Portfolio Companies.” As readers know, there’s a guy in Brooklyn named Tony who also “recommends” that businesses buy his protection services.