At a private equity conference this week, Drew Bowden, a senior SEC official, told private equity fund managers and their investors in considerable detail about how the agency had found widespread stealing and other serious infractions in its audits of private equity firms.

In the years that I’ve been reading speeches from regulators, I’ve never seen anything remotely like Bowden’s talk. I’ve embedded it at the end of this post and strongly encourage you to read it in full.

Despite the at times disconcertingly polite tone, the SEC has now announced that more than 50 percent of private equity firms it has audited have engaged in serious infractions of securities laws. These abuses were detected thanks to to Dodd Frank. Private equity general partners had been unregulated until early 2012, when they were required to SEC regulation as investment advisers.

Bowden heads the SEC’s examinations unit, and his rap sheet was based on his two years of experience in auditing private equity firms. As bad as embezzlement and other sharp practices are, at least as troubling is the revelation that the limited partners have been derelict in their duties. They’ve agreed to terms in their relationship with the general partners to make it easy for the general partners to abuse the investors. The general partners can steal from their limited partners because the limited partners are asleep. The LPs have failed to negotiate for contractual protections when they have the most leverage, prior to investing, and they’ve been unwilling or unable to monitor their investments effectively once they’ve handed over their money. Note that the industry was warned about this possible outcome; it corresponds to the worst scenario, ” A Broken Industry,” in a 2011 paper by Harvard Business School professor Josh Lerner.

Bowden pointed out that private equity is unique among the investment advisers the SEC supervises. The general partners’ control of portfolio companies gives them access to their cash flows, which the GPs can divert into their own pockets in numerous ways. Naked Capitalism readers may recognize that this arrangement is similar to the position mortgage servicers are in: they control the relationship with the funds source, and they are also responsible for records-keeping and remitting money to investors. And as we’ve chronicled at considerable length, servicers have shown remarkable creativity in lining their wallets and investors have been unable to discipline them.

Bowden described some of the ways that general partners can filch:

[A] private equity adviser is faced with temptations and conflicts with which most other advisers do not contend. For example, the private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services … or to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company … or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment.

Translation: private equity provides uniquely lucrative temptations and opportunities to steal from investors. Yet, perversely, limited partners have blinded themselves to these risks. For over 30 years, their relationship has been been shrouded in secrecy, a “trust me” operation. As Bowden noted, “Lack of transparency and limited investor rights have been the norm in private equity for a very long time.” Even worse, limited partners defend the general partners’ obsession with secrecy and reflexively reject requests for information even when it isn’t confidential.

Needless to say, this overly cozy arrangement has proven to be a ripe breeding ground for illegal conduct. Again from Bowden:

By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.

He went on to describe some of the common fee skimming models. For example:

Some of the most common deficiencies we see in private equity in the area of fees and expenses occur in firm’s use of consultants, also known as “Operating Partners,” whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not independently afford.

Here’s how this scam works. PE firms raise funds by showing prospective investors a strong team of professionals who are going to find attractive companies to buy and manage them. The limited partnership agreement, which is the contract between the private equity firm and the investors, typically says that the private equity firm has to pay for the wages of people working on the fund’s behalf. However, unbeknownst to the investors because it was never disclosed, part of the PE firm “team”, usually the members that work with portfolio companies, are actually being paid as independent contractors. The private equity firm then bills most or all of these sham independent consultants to the portfolio companies with whom they interact.

In other words, the private equity general partners are trying to have it both ways: the operating team members are an integral part of the private equity firm “team” for marketing purposes, but when it comes to who pays their bills, they are mere independent contractors referred to the portfolio company by the private equity firm (as if the portfolio company is in any position to reject these “referrals”).

From an economic perspective, every dollar that comes out of a portfolio company this way is effectively stolen from the limited partner investors, since they would otherwise have the first claim on the portfolio companies’ cash flows. And of course, we are also assuming these “independent contractors” were doing useful work. Bowden described a related con as “Hiring related-party service providers, who deliver services of questionable value.”

Bowden cited other scams as well, for example:

[A]dvisers bill their funds separately for various back-office functions that have traditionally been included as a service provided in exchange for the management fee, including compliance, legal, and accounting — without proper disclosure that these costs are being shifted to investors.

It’s not clear whether the SEC yet understands the objective of all these maneuvers. Many PE firms try to achieve the goal of having the management fee, which investors believe is a charge for the service of making and overseeing the investments, actually be pure profit. That can be achieved only by shifting all of the expenses of firm operations onto funds they manage and portfolio companies.

Most troubling of all is that we have reports from industry insiders that Bowden failed to mention the most egregious forms of stealing, which may cost investors billions of dollars annually. As we understand it, the SEC is on to a couple of large-scale scams perpetrated by some of the biggest firms.

The SEC may be pulling its punches because it may be uncertain about what to do with the rot it has found. Side by side with the the unprecedented, detailed litany of numerous forms of lawbreaking and bad conduct, Bowden was also peculiarly deferential, which gave his speech a schizophrenic feel. For instance:

Some questioned why we would show our hand in this way, to which there’s a simple and sensible answer. We believe that most people in the industry are trying to do the right thing, to help their clients, to grow their business, and to provide for their owners and employees. We therefore believe that we can most effectively fulfill our mission to promote compliance by sharing as much information as we can with the industry, knowing that people will use it to measure their firms and to self-correct where necessary. Put another way, we are not engaged in a game of “gotcha.”

Please tell me how to square Bowden’s “most people in the industry are upstanding” patter with the discussion that follows of how more than 50% of the firms reviewed thus far are engaged in serious bad conduct.*

Woven into his litany of scams, of which we have provided only a starter list, Bowden also set forth how limited partner investors fail abysmally at protecting their own interests. He noted:

Investors may not be sufficiently staffed to provide significant oversight of managers. When they are, and even when they conduct rigorous due diligence up front, they often take a much more hands-off approach after they invest their money and funds are locked up. This is especially true when managers have completed their investment period and the investor does not plan to reinvest.

Investors’ best protection against getting scammed is via making sure their rights are protected contractually. However, Bowden reports that investors have been remiss: the contracts that govern these deals, the limited partnership agreements, are poorly drafted to achieve that end:

But we’ve seen limited partnership agreements lacking in certain key areas. Many limited partnership agreements are broad in their characterization of the types of fees and expenses that can be charged to portfolio companies (as opposed to being borne by the adviser). This has created an enormous grey area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors.

State legislators need to understand what is going on here. They have granted public pension funds and public endowments across the U.S. the exorbitant privilege of secrecy in private equity investing, even to the point of making these contracts virtually the only ones that are exempt from state-level Freedom of Information Act laws.

Now we learn from the SEC that these secret LPA contracts are often a joke in terms of protecting investor interests. Though taxpayers are on the hook for pension shortfalls, we are not allowed to see just how badly our interests have been served. The magnitude of negligence makes it clear that public investors in private equity can no longer be allowed to act in secrecy. State FOIA laws need to change.

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*The obvious answer is that the “most people” includes all the working oars, who have little or no direct role in the questionable conduct. But as readers and the SEC should know, the people who count are the ones driving the bus, and it’s hard to see them as innocents.

SEC: Spreading Sunshine in Private Equity