Forbes, April 29, 2014
The modern private equity industry got its start in 1979 when, for the first time, a large, publicly traded company was taken private in a leveraged buyout. For the next 30 plus years, the industry escaped regulatory oversight by the Securities and Exchange Commission (SEC) by adopting complex and opaque organizational structures designed for that purpose. That changed with the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in the wake of the recent financial crisis. Since 2012 most mid-size and large private equity funds have been required to disclose their activities to the SEC. Last week reports of what the SEC found began to leak out.
Staff at the SEC has reviewed about 400 private equity funds. What did they learn? According to Bloomberg, the SEC found that in about half the cases, general partners of the PE funds have collected fees and expenses from companies owned by the funds without telling the pension plans and other fund investors about the fees. In a civil case filed last month against one PE firm, the SEC charged that the firm collected more than $3 million in fees that it used for its own office and other expenses – money that should have been disclosed and shared with investors in the PE fund. Some 200 PE firms were found to have engaged in such abusive behaviors.
The issue that appears to concern the SEC is the lack of transparency. General partners of PE funds – who are also PE firm partners – typically collect a variety of fees from companies they own – transaction fees, monitoring fees and fees for providing services. The problem the SEC appears to be focused on is that PE firms often do not disclose or share these fees with the investors in their funds. This boosts the earnings of the PE firm at the expense of investors in their funds.
Dan Primack, who writes about private equity at Fortune, noted: “… this may be what the SEC is referring to when it talks about inflated fees and expenses. After all, the SEC shouldn’t really care if a private equity firm is pillaging its portfolio company, so long as it is transparently and equitably sharing the booty with its investors. But if it’s pocketing monies in a manner that reduces the value of fund assets, then it’s a question of investor protection.”
Transparency is an important issue, and the possibility that PE firms are fraudulently profiting at the expense of the investors in their funds certainly warrants SEC scrutiny and enforcement action. But is it the most serious problem created when PE firms collect fees and ‘pillage’ the companies they own?
As Cornell University Professor Rosemary Batt and I document in our new book, Private Equity at Work: When Wall Street Manages Main Street, the effects of these fees on the portfolio companies are sometimes disastrous. Cambridge Industries, a Michigan-based automobile plastics supplier owned by Bain Capital, was in serious financial trouble in 2000, having lost money for three years and accumulated a mountain of debt. Yet Bain Capital continued to collect nearly $1 million a year in “advisory fees” even as the company headed towards bankruptcy. After collecting more than $10 million in fees from Cambridge over the period 1995 to 2000, Bain took the company into bankruptcy in 2000.
Buffets Restaurant chain is another example of abusive use of the ability to collect fees from portfolio companies. At its peak, Buffets operated more than six hundred restaurants under a variety of brand names and employed thirty-six thousand workers. PE firm Caxton-Iseman (renamed CI Capital Partners), the general partner in the fund that owned Buffets, collected an annual service fee of 2 percent of Buffets’ earnings, and continued to collect this fee even as Buffets sank into bankruptcy. Creditors of the PE firm accused it of “bleeding out” the company and causing the bankruptcy of the once profitable company.
Apollo Global Management’s service agreements with the companies it owns allow it to collect these fees for years of service it will not provide. As its Management Services Agreement with Claire Stores documents, Apollo-owned companies typically agree to pay millions of dollars annually for ten years. But the median length of time that Apollo holds a company is less than 6 years. When Claire Stores and five other companies went through an IPO and sold their shares to the public in 2012-2013, the companies paid Apollo as much as $126 million for a combined 43 years of advisory services Apollo will not provide.
It’s not just investors who lose out. Vendors, creditors and employees all suffer losses when PE firms abuse their ability to collect fees from the companies they own. In these cases, resources are unfairly shifted from the companies to their private equity owners, disadvantaging a wide range of stakeholders. If protecting these stakeholders falls outside the SEC’s purview, then perhaps the tax authorities should get involved. When companies pay these fees to their PE owners, they send pre-tax dollars to the PE firm and deduct the expenditures from their taxable income as business expenses. The IRS can examine whether, in fact, the management and advisory fees paid to private equity are commensurate with the services provided, and whether the tax write-off companies take for these expenses is warranted. That kind of scrutiny and transparency would go a long way toward ending the abusive collection of fees.