There’s so much chicanery afoot in private equity that I sometimes don’t write about important aspects on a timely basis.

One of the big ones that most investors manage to kid themselves about is how the general partners’ fee structures really work. The widely-cherished fantasy is that the prototypical 2% annual management fee (the “2” in the “2 and 20” formula; the “20” is a 20% profit share once a hurdle rate has been met) is meant to pay for the overhead of the firm. For instance, as a 2010 article in Business Law Today stated:

The ILPA [Institutional Limited Partners Association] Principles state that management fees should be set on the basis of a disclosed fee model that reflects the manager’s budgeted expenses to cover professional and staff salaries, rent, and operating and overhead expenses.

The reality is that the general partners seek to have as much of that 2% management fee as possible be pure profit to them. How do they do that?

One ruse is by charging many of the elements of the general partner’s operation back to portfolio companies as expenses. We’ve discussed a major example at some length, of how the general partner will present a “team” when a fund is being marketed. The investors will often size up the number of bodies relative to what they expect the total management fee payments to get a rough and ready sense of reasonableness. But as exposed by the Wall Street Journal and the New York Times, many of those “team” members wind up on the investors’ dime, by being charged to portfolio companies. As the New York Times’ Gretchen Morgenson explained:

One example involves senior advisers hired by private equity firms to help oversee acquired companies… Traditionally, these executives have been employed directly by the private equity firms, meaning that the firms, not their investors or the portfolio companies, have paid the executives’ salaries, which can be substantial. In other cases, they are paid by portfolio companies, which means that the salaries may be considered a fee to be partially reimbursed to the investors. Recently, however, some private equity firms have found a way around this. Salaries of executives hired as unaffiliated contractors are not subject to reimbursements, private equity filings show, and by making these people contractors, rather than employees, firms can avoid reimbursing the investors for their costs. The private equity firms also increase profits by shifting the salary of the contractor to the payroll of portfolio companies.

In a July newsletter, Michael Flaherman, a former CalPERS board member and head of its investment committee, now a researcher at Harvard’s Safra Center for Ethics, stressed how another large-scale gimmick for shifting costs from private equity general partner overheads to fund investors has gone largely unnoticed.

A $29 million SEC settlement with KKR managed to sidestep this elephant in the room with a set of charges called “broken deal expenses” while whacking KKR for how it allocated these expenses among investors.

Moreover, Flaherman provided information that strongly suggests that Blackstone and other large firms are engaging in the same type of conduct that led to the SEC action. So why have there not been similar fines and disgorgements by other big firms?

The “Broken Deal Expenses” Con

The deception of the all-too-clueless limited partners, and perhaps the SEC as well, starts from the clever use of the term “broken deal expenses” in limited partnership documents. In M&A, a “broken deal fee” is sometimes required by a seller if a buyer wants to enter into exclusive negotiations. You only see these fees agreed to and incurred in competitive deals and then only in very advanced stages of talks.

Thus, the “broken deal” nomenclature gives the impression that “broken deal expenses” are similarly for transactions in which the PE firm got to verge of consummating a deal, when it possible to rack up a lot of costs (legal, accounting, specialized due diligence firms) but had it come apart.

However, the definition of the term “broken deal expenses” in the limited partnership agreements can be construed to be so generous as to include all the costs related to routine deal-stalking. Yet the fee structures explicitly assume that those costs belong to the general partner; that’s why management fees step down after the first few years, because the investors recognize that the general partners have much less to do once they’ve bought all the companies that their funding allowed for.

As Flaherman explains:

KKR’s “broken deal expenses” are typically NOT confined to the common connotation of the term, which is extraordinary, occasional expenses that are incurred late in the transaction process, as an almost-closed deal breaks. Rather, as applied to KKR, the expenses are inclusive of costs incurred in the normal course of hunting for deals. These include expenses like travel—potentially even to first meetings with prospective business sellers—or subscriptions to specialized industry publications in sectors of potential deal interest…. the SEC settlement order was quite specific regarding KKR’s practice of defining many general “deal hunting” costs to be “broken deal expenses”: Broken deal expenses include research costs, travel costs and professional fees, and other expenses incurred in deal sourcing activities related to specific “dead deals” that never materialize. Broken deal expenses also include expenses incurred by KKR to evaluate particular industries or geographic regions for buyout opportunities as opposed to specific potential investments, as well as other similar types of expenses. Further evidence for KKR’s broad definition of “broken deal expenses” is found in its ADV Part 2 where, amid a lengthy disclosure regarding broken deal expenses, KKR acknowledges certain very general firm expenses are classified as “broken deal expenses,” including: …travel costs, fees and expenses of consultants (including Senior Advisors and Industry Advisors, KKR Capstone and RPM and other Technical Consultants) and costs and expenses of research and technology (including costs of specialty data subscription and license-based services and risk analysis software). Many LP investors mistakenly believe that PE managers rely exclusively on fund management fees to support the cost of their general deal hunting activities. In many situations, such as KKR, this is not the case.

Let’s stop right here. Was this overly broad definition the result utter ineptitude on behalf of the limited partners and their not-willing-to-rock-the-private equity-boat semi-captured attorneys?

Have a look at the germane section from our handy copy of a 2006 KKR fund (emphasis original):

Broken Deal Expenses means all out-of-pocket costs and expenses incurred by or on behalf of the Partnership or any Alternative Vehicles in developing, negotiating and structuring prospective or potential Investments that are not ultimately made, including (i) any legal, accounting, advisory, consulting or other third-party expenses in connection therewith and any travel and accommodation expenses, (ii) all fees (including commitment fees), costs and expenses of lenders, investment banks and other financing sources in connection with arranging financing for a proposed Investment that is not ultimately made, and (iii) any deposits or down payments of cash or other property that are forfeited in connection with a proposed Investment that is not ultimately made, but not including Other Expenses.

So the trick here hinges on what one makes of the use of “developing” in “developing, negotiating, and structuring” and “potential” in “prospective or potential”. All the verbiage about expenses that occur only at the advanced stages of transactions is a distraction.

The KKR position, which the SEC apparently bought, is that “developing….potential Investments” covers pretty much all deal trawling activity, allowing KKR to dump a boatload of expenses on the hapless investors. Never mind that this interpretation of that type of language is at odds with what the limited partners understand, as clearly evidenced by the step-down in management fees. Again from the Business Law Today article cited earlier, continuing its recap of ILPA Principles:

Management fees should step down significantly (50 percent) after the investment period or after the manager closes a successor fund, with fees from that point on calculated on invested rather than committed capital.

So the limited partners should be howling about what the KKR settlement revealed, charitably assuming that they were not previously aware of this abuse. Yet we’ve heard nary a peep from them.

Why Hasn’t the SEC Gone After Blackstone and Other Funds for Similar “Broken Deal Expense” Related Abuses?

So if the SEC didn’t whack KKR for treating “broken deal expenses” as a huge mechanism for shifting costs onto clueless limited partners, pray tell what did it do? From a June post:

The scam is straightforward: KKR incurred what are called “broken deal expenses” for transactions that were not completed. For the funds in question, these charges totaled $338 million from 2006 to 2011. KKR had so-called “flagship” funds, which were marquee funds, and co-investments in these funds, where preferred parties invested in particular companies in these funds without paying the same fees the limited partners pay. Co-investors are in a preferred position, effectively investing alongside the general partner. The co-investors here included KKR executives and consultants (almost certainly from its captive consulting firm, KKR Capstone). The SEC found that KKR had been making the preferred status of the co-investors and KKR itself too preferred, by virtue of allocating virtually all the broken deal expenses to the chump limited partners when 20% should have been allotted to the co-investors.

Flaherman ferreted out evidence of similar misconduct at Blackstone. And when he contacted Blackstone, the explanation was demonstrably untrue. Again from the newsletter:

We were intrigued by potential parallels between ongoing practices at other firms and the KKR practices that triggered SEC enforcement. In particular, we noted that Blackstone’s ADV acknowledges that it, too, uses co-investment vehicles that do not bear broken deal expenses: …similarly, such co-investment vehicles (including any vehicles established to facilitate the investment by Blackstone Investors) generally do not bear their share of broken deal expenses (such as reverse termination fees, extraordinary expenses such as litigation costs and judgments and other expenses) for unconsummated transactions. The ADV also acknowledges that Blackstone executives co-invest alongside Blackstone funds: Additionally, and notwithstanding the foregoing, these senior advisors, consultants, operating partners and/or other professionals, as well as current and former chief executive officers of Blackstone portfolio companies, may be (or have the preferred right to be) investors in Blackstone portfolio companies and/or Other Blackstone Funds and/or be permitted to participate in Blackstone’s side-by-side co-investment rights. We contacted Blackstone for comment and pointed out that one co-investment fund, in particular, seems highly analogous to the KKR vehicles that brought SEC enforcement. This Blackstone fund is called “Blackstone Capital Partners VI-Executive Fund L.P.”, and it is described as a “parallel fund” in section 2.8.1 of the LPA for the flagship Blackstone Capital Partners VI. That section also makes clear that the Executive Fund will invest “generally on a pro rata basis” with the flagship fund. Our question to Blackstone was, essentially, how did they defend not allocating expenses to the Executive Fund, given the clearly expressed intent in the flagship fund LPA that the Executive Fund would invest pro rata, and also given that the term “Executive Fund” is generally used in PE to reference vehicles containing the capital of firm employees and their “friends and family.” Peter Rose, a senior managing director, was kind enough to offer an official response on behalf of Blackstone…. Rose claimed, essentially, that our question was moot, because the Executive Fund “never had any investors” and “never became fully operational.” However, serious questions exist about what Rose’s statements mean.* Blackstone filed a Form D with the SEC on August 14, 2008 that categorically states that the fund had 23 investors and $87,250,000 in commitments [see Section C, question 2]. In March 2010, Blackstone filed a second Form D, presumably to update the capital commitments to the fund, indicating that commitments now totaled $123,750,000. One can locate at least two SEC filings (here and here) indicating that the flagship Fund VI and the Executive Fund invested alongside one another in particular instances. However, it does not appear that the Executive Fund invested in other Fund VI deals that have made SEC filings.

Shorter: Blackstone said it didn’t do anything bad like KKR did because even though its funds had language that allowed for similar underhanded conduct, the vehicles that Flaherman fingered as sus were never “operational”. But multiple SEC filings show that that claim is false.

This example shows yet again how private equity chicanery is allowed to continue even as proof of abuses comes to light. The SEC apparently lacks the savvy or inquisitiveness to look at private equity conduct against ILPA statements, guides by major law firms, and other evidence of what limited partners understand industry practices to be, as developed over decades of marketing, negotiating, and admittedly-too-lightweight limited partner supervision. The agency apparently either does not even bother to question or too often accepts general partner arguments as to how ambiguous language should be construed.

Since the SEC takes the view that general partners are fiduciaries (indeed, that’s one of the bases for its order on broken deal expenses), that alone should argue against interpreting unclear language generously, since a fiduciary is required to put the interest of his principal ahead of his own. But that’s so utterly out of character for private equity that if the SEC decided to root out all the private equity bad conduct it found, it would put the industry out of business.**

____

* From the newsletter, the full text of Rose’s e-mailed reply to Flaherman:

Mike: Thanks for reaching out. We just want to make two points: • The Blackstone Capital Partners VI – Executive Fund you refer to never became fully operational and never had any investors. It was intended for third party investors and would have in any event borne broken deal expenses. • In general, we have reviewed the structure of and our approach to co-investment and broken deal expenses and believe that there are meaningful and relevant differences between our practices and the particular practices cited by the SEC in recent orders. I hope this is helpful Peter Rose

Senior Managing Director, Public Affairs,

Blackstone

345 Park Avenue, NY, NY 10154

** This is not an exaggeration. Private equity firms that take transaction fees without being SEC registered broker-dealers are subject to fines of dollar-for-dollar value for the transaction amount. Even the private equity firms that have broker-dealer operations are not using them for the purpose of legitimating those transaction fees; the revenues reported by those broker-dealers are far too small for that to be the case.