New York Times reporter Gretchen Morgenson recently wrote a startling piece about how private equity firms allegedly steal from their investors by shifting expenses associated with attorneys and other outside vendors. Essentially, her argument was that private equity firms receive discounts for legal work done on the firms’ behalf, but pay full freight on legal work done for the firm’s investment funds (which are primarily financed by institutional investors like pension systems and university endowments).
In other words: Cut us a break and we’ll bring you extra work. Quid pro quo.
Most of Morgenson’s evidence came from publicly-available documents filed with the SEC by private equity firms, including Apollo Global Management (APO), The Blackstone Group (BX) and The Carlyle Group (CG). The trouble, however, is that these were top-level documents that didn’t include information on any specific arrangements, nor any expense breakdowns. For example, here is what Blackstone wrote:
“Advisers and service providers, or their affiliates, often charge different rates or have different arrangements for specific types of services. Therefore, based on the types of services used by the funds and portfolio companies as compared to Blackstone and its affiliates and the terms of such services, BMP L.L.C. or its affiliates may benefit to a greater degree from such vendor arrangements than the funds or such portfolio companies.”
That could be nefarious. Or maybe not. There’s no real way to tell from the outside, although another Blackstone filing says that the SEC is investigating. While we await federal enforcement actions (or lack thereof), here are a bunch of related notes based on conversations with private equity executives, pension officials and attorneys.
1. Lack of evidence: Morgenson’s piece leaves readers with the impression that private equity fund managers are getting rich(er) at the expense of their investors, by securing volume discounts on their own “plain vanilla legal work” in exchange for sending more lucrative investment work to the same law firms. The trouble with her conclusion, however, goes beyond the fact that such arrangements were not explicitly laid out in the SEC filings. Instead, it ignores the reality that “plain vanilla legal work” is a commodity, and that private equity firms would be willing to hire just about any white-shoe firm to carry it out. Investment work, on the other hand, is much more specialized and often requires a high level of trust between the private equity firm and the law firm. “We give volume discounts not only to private equity firms, but all sorts of corporate clients and even pension funds, on basic legal work,” explains one corporate attorney. “But not on completed investment transaction work. That’s not how the business works.”
2. Completion is key: One investment area where law firms often do give a discount is on work done for transactions that are not ultimately consummated (i.e., “broken deals”). And that’s no small thing, given how competitive the private equity landscape has become. For example, a law firm may give a 30% discount on broken deals to a private equity firm, with the understanding that the firm will pay regular rates (or even a slight premium) on completed deals, so as to move toward making the law firm whole. Therefore, private equity firms will argue that the key statistic to look at isn’t one discount vs. another, but rather the overall “blended rate” paid by investment funds to outside vendors. Not surprisingly, several firms argued to me on background that their blended rate was below par, although I’ve been unable to independently verify.
3. Speaking of par: One problem the SEC will run into with its investigation is that vendor fees aren’t like sticker prices on cars. There is no objective value to an hour of legal work, nor is there consensus that a particular task (such as an investment transaction) deserves a senior partner working with two associates, or two senior partners working with five associates. And that doesn’t even take into account geography, as New York-based corporate attorneys typically charge more than, say, a Boston-based corporate attorney for the same work.
4. Speaking of completion: One big problem with the broken deal/completed deal arrangement is what happens when the private equity sponsor is only trying to buy part of the company, rather than all of it (e.g., club deals, minority equity investments, etc.). If a firm’s last deal broke and then it successfully buys 60% of Primack Corp., is Primack Corp. effectively subsidizing 100% of a prior failed effort?
5. Is it illegal? Here’s an analogy I heard while researching this story: You go to your auto mechanic for an oil change, and he offers to give you 20% off future oil changes if you send him a new customer who will pay the regular price. You get a discount for yourself, your friend gets a quality oil change and your mechanic gets extra business. It’s a quid pro quo in which no one is hurt.
The trouble with applying it to private equity, however, is that there is no fiduciary relationship between me and my auto mechanic. Private equity fund managers do, however, have a fiduciary duty to their limited partners, and such an arrangement could be considered self-dealing. Particularly under The Employee Retirement Income Security Act (ERISA), which is applicable when a significant amount of a private equity fund’s capital comes from covered pensions. Were the SEC to prove that applicable private equity firms got discounted services from a vendor in exchange for sending over investment business at regular rates, then it could indeed be an ERISA violation. Very tough to prove or prosecute — “I could argue both sides of it pretty convincingly,” said one ERISA-focused attorney — but potentially problematic.
6. If not illegal, then what? If federal regulators do find evidence that private equity firms are getting discounts by virtue of their “full freight” investment fund work but don’t consider the self-dealing itself to be illegal, any possible enforcement decision likely would be based on what the private equity firm did, or didn’t, tell its investors. If such arrangements were adequately disclosed, then there may not be a case. Certain pension system directors at places like CalPERS may think it’s a bum deal, but it’s the deal they agreed to (also worth remembering that pension higher-ups often know less about investment structures than do their investment staffs). If private equity firms withheld material information about self-dealing from their investors, however, they could be in a whole bunch of trouble.
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7. Penny wise, pound foolish? One thing that’s difficult to get one’s mind around is why a private equity firm would fight for discounts that aren’t extended to its funds and underlying portfolio companies. After all, the private equity firm’s partners also invest their own money in the funds, and every dollar spent by a portfolio company today is one dollar of lost value when it’s sold tomorrow. Wouldn’t that mean that saving some upfront cash on low-cost, “vanilla” legal work is less important than maximizing portfolio value, which helps attract investors for the next fund (and next fee stream)? Here is how one private equity insider explained it to me: “To raise the next fund you only need to be good enough, not the best.”
As I wrote in the beginning: We don’t know specifics about the arrangements between private equity firms and their vendors, and thus cannot say whether or not retirees are getting ripped off (Morgenson’s conclusion notwithstanding). We also don’t know if private equity firms are being entirely equitable with their pension clients from a dollars and sense perspective, but remain guilty of self-dealing. Or if all of this is shameless greed-mongering by the yacht club set, yet still legal.
In fact, all we know is that the issue is being looked into by the SEC, which means we need to wait and see…
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