(c) Luso

Will private equity investors keep getting their pockets picked?

May 28, 2014

FORTUNE -- Over the weekend, there were two key developments in the growing brouhaha over private equity fees, with a particular focus on fees charged by large firms like KKR.

First, blogger Yves Smith published 12 entire limited partnership agreements (LPAs) – including for Kohlberg Kravis Roberts & Co.’s (kkr) 2006-vintage flagship fund – after finding them posted on the Pennsylvania State Treasury website. Chances are these were inadvertent postings, since the KKR LPA (for example) specifically says that LPs – including government-backed LPs – may not publish such documents. No word back yet from Pennsylvania Treasury on that.

Smith makes three main points in her companion post:

(1) The whole idea of LPAs being some sort of “trade secret” is absurd, at least judging by this particular dozen. There’s more information on investment strategy on the typical firm’s website, while the only real tangible differences are around tax strategies (not the sort of thing that gives firms competitive advantages over one another, outside perhaps of how they keep more to pay more).

(2) Some of the LPAs – particularly one for TPG Capital – suggest that some U.S. non-government, non-profit LPs may be using their own tax dodge when collecting their share of monitoring fees. After all, there is a very strong argument that monitoring fees, for example, should be considered “unrelated business taxable income” (UBTI). If the IRS dug into this, you could be talking about billions of dollars in back taxes.

(3) KKR’s 2006 LPA is indeed very confusing when it comes to Capstone, the operational efficiency group that works exclusively on KKR-backed portfolio companies and for KKR itself. I've learned that KKR later clarified the ambiguity in its 2011-vintage funds (so that all LPs were clear that they weren’t getting a dime of share in Capstone fees), but any cursory reading of the 2006 document could reasonably leave the impression that such a share was forthcoming. Also worth noting that KKR now reports Capstone fee income to its LP advisory committees for all active portfolio companies, even though such reporting requirements did not exist pre-2011 vintage funds. As for the issue of whether or not Capstone actually is a KKR affiliate (despite what KKR says), we'll deal with that at a later date.

Second, Gretchen Morgenson wrote a detailed piece about monitoring fees in Sunday’s NY Times. We’ve previously discussed much of this, and I’ve cheered the fact that monitoring fees are on a sharp decline. But she also includes the following quote from Andrew Bowden, the SEC’s director of compliance inspections and examinations:

“In some instances, investors’ pockets are being picked.”

Let’s be clear here: What Bowden is saying is different than just: “LPAs are highly-negotiated documents in which both sides are represented by counsel.” He’s arguing theft. Or, perhaps more accurately, theft in which the victim is complicit by virtue of not paying attention.

My understanding is that the SEC thinks the following is happening, broadly speaking: LPs and their attorneys negotiate the LPA, and include all sorts of fee rebates. And then the LPs let their (outside?) accountants handle the incoming checks from the GP. What doesn’t apparently happen is any reconciliation between what the LP is owed from the GP (per the LPA) and what actually gets paid. Perhaps because the LPAs are written in such tortured language that the average accountant would likely give up. Thus the massive potential for pocket-picking.

Today I’m really just looking to sort through a bunch of the varied issues, including the Capstone controversy, to make sense of it all for myself. But there is at least one thing I’ve concluded:

LPs, the ball is in your court.

It remains entirely unclear if the SEC will or won’t act on the alleged abuses that it has found (and I can almost assure you that even more of these will leak within the next few weeks). But if LPs believe they’ve been dupes, then they do have the power to collectively stand up and demand LPA amendments and/or reparations. Not necessarily per terms of existing contracts, but by refusing to support future fundraising. Kind of like many LPs did after the placement agent scandal broke wide open. For example, put a line in the sand on operating partners and their ilk. Or insist on operating partner offsets (why pay so much in management fees when the GP needs to bring in so much outside help).

After all, fiduciary responsibility should outweigh embarrassed ego. Unless LPs disagree with the SEC on this matter. If so, then say so publicly, because your general partners are getting put through the ringer.

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