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Term Sheet — Wednesday, June 24

Is private equity ripping off retirees?

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, The Blackstone Group and The Carlyle Group. 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 the 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 completely 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 PE 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, PE 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 one 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, Boston-based corporate attorneys for the same work.

4. Speaking of completion: One big problem with the broken deal/completed deal arrangement is what happens when PE sponsors only try to buy part of a 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 arrangements 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 PE firms got discounted services from a vendor in exchange for sending over investment business at regular rates, then it could 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 compelling evidence that PE firms are getting discounts by virtue of their “full freight” investment fund work but don’t consider the self-dealing to be illegal, any possible enforcement decision would likely rest 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 and/or consultants). If private equity firms withheld material information about self-dealing from their investors, however, they could be in a whole bunch of trouble.

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…


• Koninklijke Ahold (Netherlands) and Delhaize Group (Belgium) have agreed to an all-stock merger that will create a U.S. and European supermarket behemoth worth around $29.5 billion. Ahold’s U.S. business includes the Stop & Shop and Giant chains. Read more.


• Palantir Technologies, the data analytics company that counts government agencies like the FBI and CIA as clients, is raising upwards of $500 million in new equity funding at a $20 billion valuation, according to BuzzFeed. Read more.

• Credit Karma, a San Francisco-based platform that provides credit scores and helps users search for certain financial products, has raised $175 million in new VC funding at a $3.5 billion valuation. Participants included Tiger Global Management, Valinor Management and Viking Global Investors. The company previously raised over $190 million from firms like Felicis Ventures, 500 Startups, Ribbit Capital, Susquehanna Growth Equity and Google Capital. Read more.

• HackerOne, a San Francisco-based vulnerability management and bug bounty platform, has raised $25 million in Series B funding. New Enterprise Associates led the round, and was joined by Benchmark and individual angels like Marc Benioff, David Sacks, Yuri Milner, Jeremy Stoppelman and Drew Houston.

• Auth0, a Bellevue, Wash.-based “universal identity platform,” has raised $9.3 million in new VC funding. Bessemer Venture Partners led the round, and was joined by K9 Ventures.

• VenueNext, a new tech platform for attendees a live events, has raised $9 million in Series A funding. Backers include Causeway Media Partners, Live Nation and Twitter Ventures.

• Smart Vision Labs Inc., a New York-based developer of a scanning laser ophthalmoscope, has raised $6.1 million in Series A funding. Techstars Ventures led the round, and was joined by Heritage Group, Connectivity Capital, and Red Sea Ventures.

• SQZ Biotech, a Somerville, Mass.-based developer of a platform that “enables a variety of materials to enter a cell,” has raised $5 million in Series A funding led by Polaris Partners.

• Alert Media, an Austin, Texas-based platform for interactive mass notification, has raised $4.16 million in Series A funding. Silverton Partners led the round, and was joined by ATX Ventures and Capital Factory.

• ViraTherapeutics GmbH, an Austria-based developer of cancer immunotherapies based on oncolytic viruses, has raised €3.6 million in Series A funding. Boehringer Ingelheim Venture Fund and EMBL Ventures co-led the round, and were joined by Austria Wirtschaftsservice.


• Bolder Healthcare Solutions, a Louisville, Ky.-based portfolio company of The Edgewater Funds and JZ Capital Partners, has acquired Avectus Healthcare Solutions, a Duluth, Ga.–based coordinator of third-party liability accounts and resolution of complex workers’ compensation accounts for hospitals and trauma centers. No financial terms were disclosed. The seller is Catamaran Corp. (TSX: CCT).

• Fort Dearborn Co., a Denver-based portfolio company of KRG Capital Partners, has acquired Core Label LLC, a Tyrone, Penn.–based label supplier to the beverage market. No financial terms were disclosed.

• GI Partners has completed its previously-announced acquisition of MRI Software, a Solon, Ohio–based provider of real estate property and investment management software, from Vista Equity Partners. No financial terms were disclosed.

• Goldman Sachs and La Caisse de dépôt et placement du Québec have acquired SterlingBackcheck, a New York–based provider of background screening services, from Calera Capital. No financial terms were disclosed.

• MaxPower Group Pte Ltd., an Indonesia-based power plant company, has raised $60 million in private equity funding from Standard Chartered Private Equity. The company also finalized a $222 million debt refinancing in which it was advised by Standard Chartered Bank.

• MDLive, a Sunrise, Fla.-based provider of virtual health services, has raised $50 million from Bedford Funding. Existing company shareholders include Sentara Healthcare, Sutter Health, Heritage Group and Kayne Anderson Capital Advisors.

• Mercator, a Dubai–based portfolio company of Warburg Pincus, has acquired Catapult International, a Lenexa, Kansas–based provider of tech-enabled solutions for freight forwarders, shippers and carriers. No financial terms were disclosed. Sellers included Five Elms Capital.

• Myelin Communications, a Boston–based portfolio company of Baird Capital, has acquired two companies: HY Connect, a Chicago-based ad agency, and Dodge Communications, an Atlanta-based PR firm. No financial terms were disclosed for either transaction.

• Silverfleet Capital has agreed to acquire Masai Clothing Co., a Danish womenswear clothing brand. No financial terms were disclosed.


• Acelity LP Inc. (f.k.a. Kinetic Concepts), a San Antonio, Texas–based wound-care product maker owned by Apax Partners, is prepping an IPO for later this year, according to the WSJ. The offering could raise around $1 billion, with JPMorgan, Goldman Sachs and BofA Merrill Lynch serving as underwriters. Read more.

• Freeport-McMoRan Oil & Gas Inc., a Houston, Texas-based oil and gas exploration and production company focused on deepwater projects in the Gulf of Mexico, has filed for a $100 million IPO. It plans to trade on the NYSE under ticker symbol FMOG, with Barclays serving as sole underwriter. It is being spun out of Freeport-McMoRan Inc. (NYSE: FCX).

• Oressa Ltd., a UK-based metal can packaging unit of Ardagh Group, has filed for a $100 million IPO. It plans to trade on the NYSE under ticker symbol ORES, with Citigroup serving as sole underwriter.

• SoulCycle, a New York-based operator of indoor cycling studios, has hired Goldman Sachs and BofA Merrill Lynch to manage an IPO that is expected to come later this year, according to Reuters. Read more.


• Charterhouse Capital Partners has retained J.P. Morgan to advise on strategic options for Tunstall, a British provider of “care services and assisted living for elderly and disabled people at home,” according to Reuters. A sale reportedly could value Tunstall at upwards of $1.1 billion. Read more.

• FullBeauty Brands Inc., a plus-sized fashion retailer owned by Charlesbank Capital Partners and Webster Capital, has hired J.P. Morgan to explore an IPO or sale of the business, according to Reuters. The company is expecting a valuation north of $1.5 billion, including debt). Read more.

• Ladbrokes PLC (LSE: LAD) said that it is in talks to merge with fellow British bookmaker Gala Coral Group, whose shareholders include Apollo Global Management, Cerberus Capital Management, Park Square Capital and JGD Management. Read more.

• Qatar Sports Investments and a holding company controlled by Miami Dolphins owner Stephen Ross reportedly are working on a £5 billion bid for a control stake in auto racing business Formula One, which currently is held by CVC Capital Partners. Read more.


• American Clinical Solutions LLC, a Sun City Center, Fla.–based provider of regulated drug testing to aid physicians in the monitoring and managing of prescription pain medication intake and levels, has secured $10 million in senior secured debt from Capitala Finance Corp.

• Bouygues Telecom has rejected an unsolicited €10 billion cash takeover offer from Altice SA (Amsterdam: ATC). Read more.

• Liberty Global (Nasdaq: LBTY) is in talks to acquire Irish television channel TV3 for more than €100 million, according to the FT. Read more.

• Reno, a family-owned German shoe store chain with around €650 million in annual revenue, has retained Rothschild to find a buyer, according to Reuters. Read more.


• Adams Street Partners is raising up to $300 million for a new fund-of-funds focused on small and mid-market buyout funds, according to LBO Wire. It also is targeting $800 million for its next flagship fund-of-funds and co-investment vehicle.

• Barclays is in talks to sell Barclays Natural Resource Investments, a private equity business focused on natural resources, according to Reuters. The unit has committed to invest around $3 billion into 28 companies since being launched in 2006. Read more.

• DBL Partners, a San Francisco-based “double bottom-line” venture capital firm, has closed its third fund with $400 million in capital commitments. Read more.


• Tim Fitzsimmons has joined Moelis & Co. as a managing director in the firm’s private funds advisory unit. He previously was with Credit Suisse. Read more.

• Hiroshi Mikitani, founder and CEO of Japan’s Rakuten, will join the board of ride-sharing company Lyft. Read more.

• Lenny Pruss has joined Redpoint Ventures as a principal focused on early-stage enterprise tech opportunities. He previously was with RRE Ventures.

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