Eliot Spitzer, now the top contender to be the next New York City Comptroller, has said he wants to use the office to pursue financial reform. He has a ready, obvious, and comparatively easy target: the private equity industry.

There is clear evidence that private equity (PE) firms have been scamming their investors for decades. Most of these investors are public pension funds, like the funds invested by New York City on behalf of its employees. These PE investors have been largely clueless as to how their money is being stolen. When they have sensed that something is wrong, they’ve taken a collegial approach, relying on exhortation and negotiation. Not surprisingly, the “let’s handle this among friends” strategy has not been effective.

Despite being stymied and despite ample evidence of large scale abuses, public pension PE investors have been reluctant to use their bully pulpits, band together effectively, or take PE firms to court. This broken status quo is a great opportunity for what Spitzer does best, which is to use both the law and the media to tackle powerful, predatory interests. This is one big reason why his candidacy has evoked horror and aggressive attacks from the financial elite.

Let’s start by examining the relationship between private equity firms and the New York City Comptroller.

The New York City employee pension system is one of the largest private equity investors in the U.S., with $8.3 billion invested in this strategy. Though a board of trustees is technically the fiduciary for each of the City pension funds, and the Comptroller has only one seat on each of those boards, in reality, the City Comptroller is, to an extreme degree, first among equals on all of the boards. The reason for his disproportionate influence is that all of the City pension funds are managed day-to-day by a combined staff, and those staff members are all employees of the New York City Comptroller, making him effectively their boss.

Moreover, the super-secret contracts that the NYC pension funds enter into with PE firms are held at the Comptroller’s office, as are the super-secret cash flows showing what the pension funds contributed to the funds and what they got paid out in return. It’s impossible to overstate the importance of the Comptroller’s access to PE fund contracts (known as limited partnership agreements or LPAs) and cash flows. PE firms accomplish much of their investor scamming via fees that are contrary to LPA terms and that they take from portfolio companies owned by the funds they manage. The PE firms also scam by charging the funds they manage for expenses that the LPA says should be paid by the PE firm itself.

I’ve seen a tiny bit of this first hand through my work as a hired gun to PE firms. One of the things that PE firms do is manage portfolio companies. While a small subset of PE firm do have their staff roll up their sleeves and play a meaningful operating role, for the overwhelming majority, their oversight consists largely of financial engineering, possibly changing some of the executives of the portfolio business, and pushing like crazy for cost cutting.

The PE firm babysitting typically includes periodic meetings with the top employees of the portfolio company, in which the PE staffers harass the portfolio company management over their progress towards targets the PE firm has set. I’ve seen the actual and projected monthly financial statements used as part of this exercise. They clearly included as a separate line item a management fee paid to the PE firm. This was over and above the “management fee” paid by investors.* Yet most investors would assume that fund-wide management fee would cover the supervision of the portfolio companies. My understanding is that this second level of fee skimming is not disclosed to the investors in the PE fund.

And this isn’t the only type of double-dipping that has taken place. In the 1990s, following the practice of then industry leader KKR, it was common for large PE funds to charge “transaction fees” for buying and selling companies, again over and above their management fees, even though they often hired an investment bank, which charged its own fees, to do the work. This was such an egregious abuse that even the normally complacent investors eventually roused themselves to push back.**

The sad truth is nobody who invests in PE looks closely at whether PE firms are complying with the fee and expense provisions of their agreements. Part of the reason is that the PE firm lawyers draft the terms in these LPAs to be almost incomprehensible. Another reason is, astonishingly, that PE investors have accepted the argument of PE firms that these contract provisions are a form of “trade secret.” Public pension fund investors have almost universally acceded to the demands of PE firms to exempt the LPAs and cash flow reports from state FOIA laws, which keeps the eyes of the press and the public off the documents.

This information lockdown prevents a worst-case scenario for scamming PE firms, that a mid-level accounting employee at a portfolio company would use public documents to compare the payments made to fund investors with what was taken from the portfolio company where the accountant works. State qui tam laws, which are designed to prevent precisely this type of abuse by awarding a portion of the government’s recovery to people who uncover fraud, would provide a powerful incentive for employees at portfolio companies to rat out their PE overlords. But that’s not going to happen as long as public pension fund PE investors keep the contracts and cash flows behind the FOIA wall. However, the New York City Comptroller has access to this critical information. Hence the freakout at the prospect that Spitzer might get the job.

How do we know that private equity firms are stealing from their investors? It turns out that the SEC has been surprisingly vocal, though unspecific, in recent public statements about the fraud it is finding in private equity. Historically, the SEC had basically no nexus with the private equity industry, as virtually no PE firms in the past were “registered investment advisers”. That meant that PE firms were not subject to SEC supervision or the regular compliance audits that all registered investment advisers undergo. However, Dodd Frank changed the law that allowed PE firms to avoid registration. Virtually all institutional PE firms were required to become registered investment advisers by early 2012, making them subject to regular SEC audits (known as examinations).

Within months of the SEC corralling the private equity industry into its registered investment adviser program and initiating examinations, SEC Commissioner Elisse Walter spoke on a conference panel about early findings of these examinations. For instance, the law firm Ropes & Gray dutifully reported the SEC’s emerging awareness of PE fraud to its clients:

…SEC Commissioner Elisse Walter indicated that the SEC, in proceeding with its “presence examinations” of newly registered private fund advisers, has already noted many instances of poor controls, often regarding fees and expenses. Commissioner Walter elaborated that the staff has noted instances where advisers miscalculate fees, improperly collect fees and inappropriately use fund assets to cover their own expenses. Commissioner Walter noted that SEC staff will continue to examine and question advisers income and fees.

Note that, according to Ropes & Gray, Commissioner Walter described these impermissible fee practices by PE firms as “poor controls,” rather than fraud or theft. It will be key for the next NYC Comptroller – as well as the interested public – to hold the SEC’s feet to the fire, so that the Commission doesn’t give PE firms a pass based on a “we didn’t mean to steal” defense.

Shortly after the Walter panel discussion, Bruce Karpati Chief, SEC Enforcement Division’s Asset Management Unit, gave a speech where he further outlined findings of the new SEC examinations of private equity. Like Walter, he noted finding instances of illegal shifting of fees to investor funds and the charging of dubious fees to portfolio companies.

These petty frauds by PE firms should be low-hanging fruit for Spitzer. The critical questions he needs to ask all of the PE firms doing business with the city’s pension funds are:

1. What is everything of value you receive, either directly or indirectly, from the portfolio companies owned by the funds you manage? 2. What are all the charges you have imposed on the funds in which New York City pension funds are an investor?

Once he has the answer to these questions, Spitzer should compare the fees with the language of fund LPAs and figure out which ones are impermissible. PE firms will stonewall on the first question, claiming that they already disclose to investors all the fees that they are required to share with investors. Don’t get caught in this logical trap. It’s the fees that the PE firms don’t share with investors that they don’t disclose. If the PE firms drag their feet, Spitzer should not hesitate to wield the Comptroller’s subpoena powers.

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* Almost all funds provide for the right of the general partner to receive a management fee. While the media commonly describes the fees as “two and twenty” meaning a 2% annual fee and 20% of the profits (as defined), the 2% is the “rack rate” for management fees, meaning it’s the starting point for negotiations. Funds of less than around $500 million, particularly venture capital, can negotiate for and may obtain a higher fee.

Funds larger than $2 billion face enormous investor pressure to charge less than 2%. SEC filings for some of the biggest public funds indicate management fee levels in the neighborhood of 1.25%. Typically, the general partner does not get that level of management fees for the full life of the fund. Instead, the GP gets that rate for the duration of a fund’s “investment period”, the time during which the fund is expected to acquire a portfolio of investments.

Once the investment period ends, the management fee steps down. Using a 2006 KKR fund as an example, that rate through the tenth anniversary of the fund’s life is 0.75%. Unlike during the investment period, that percentage is applied only to the capital still invested in the fund, as opposed to the original fund size.

** We may return to this bit of history in later posts, since it’s revealing and the remedy was not straightforward. Suffice it to say that the resulting contractual provisions were drafted by attorneys for the private equity firms, and are sufficiently vague that skeptical insiders are not convinced they are as effective as most fund investors would like to believe.