The Deal's Done. But Not The Fees.

5/25/2014 The Deals Done. But Not the Fees. - NYTimes.
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BUSINESS DAY
The Deals Done. But Not the Fees.
By GRETCHEN MORGENSON MAY 24, 2014
There was joy on Park Avenue as the news arrived from Warsaw, a small
Indiana city.
Two companies, twin pillars of Warsaws economy, had decided to
merge. It was the biggest business story to hit the town in decades; an area
newspaper, The Elkhart Truth, called the deal nothing short of an
earthquake.
Back in New York, in the Midtown headquarters of the Blackstone
Group, the tie-up meant a handsome payday for Blackstone and a handful
of other private equity specialists. Together, they had bought one of the
Warsaw companies, Biomet, in 2007. Now they had agreed to sell it for
$13.4 billion, or $2 billion more than they paid.
Such is the way of private equity, a signature Wall Street business of
the past two decades. The sale Biomet was bought by Zimmer Holdings,
creating a leading orthopedics company meant a nice return for
everyone, including public pension funds that had invested their money in
the private equity partnerships that owned Biomet.
But for Blackstone and the other private-equity partnerships in the
deal overseen by Goldman Sachs, Kohlberg Kravis Roberts and TPG
Capital this deal will be a gift that keeps giving. Thats because, beyond
the profits they share with their clients, they will be paid millions more in
fees for work that they are never going to do.
In addition to a 20 percent share of gains from the sale, as well as
management fees of 1.5 percent to 2 percent charged to investors, the
5/25/2014 The Deals Done. But Not the Fees. - NYTimes.com
private equity firms will also share in an estimated $30 million in
monitoring fees. These fees were to be charged through 2017, but given
that the deal is expected to close early next year, Blackstone, Goldman
Sachs, K.K.R. and TPG will be paid for two years of services that Biomet
isnt receiving.
Private equity is huge. It is now a $3.5 trillion corner of the $64
trillion asset management industry. There are 2,700 of these firms
nationwide that use borrowed money to acquire companies that they hope
to sell later at a profit. Once called leveraged-buyout firms, private equity
firms have changed American business in the 21st century. By buying
companies, getting them into shape and selling them or taking them
public they have brought a focus on efficiency to many companies and
generated sizable gains for their investors.
As they have grown, private equity firms have also redefined the upper
levels of rich. Last year, Stephen A. Schwarzman, who runs Blackstone
and has given money and his name to the main building of the New York
Public Library, received $375 million in compensation and returns on his
investments in the firm; Leon D. Black of Apollo Global Management (hes
a trustee of the Metropolitan Museum of Art, the Museum of Modern Art
and Mount Sinai Hospital) received $546.3 million.
That wealth comes largely from the firms often-extraordinary profits;
Blackstones revenue rose 65 percent last year, and Apollo reported a profit
increase of 19 percent over 2012. But it also comes from fees those big
fat management fees, and the less obvious pile-on of smaller fees that
investors might notice only if they scoured regulatory filings.
Private equity firms say they are completely transparent in their fee
disclosures. But that is not the view of the Securities and Exchange
Commission, which is taking an increasing interest in private equity and
especially in their fees. The S.E.C., as is its custom, declined to identify any
firms that it was investigating, and there is no indication that the Biomet
deal is among the transactions of interest to the S.E.C.
Until the Dodd-Frank Act of 2010, private equity firms were relatively
free of regulation. The law required that firms with at least $150 million in
assets under management register as investment advisers; it also
instructed the S.E.C. to take a close look at them. So, over the last year and
a half, S.E.C. officials have visited approximately 150 firms and say they
have found serious deficiencies in both practice and disclosure at many of
them.
In some instances, investors pockets are being picked, Andrew J.
Bowden, director of the S.E.C.s office of compliance inspections and
examinations, said in a recent interview. These investors may be
sophisticated and they may be capable of protecting themselves, but much
of what were uncovering is undetectable by even the most sophisticated
investor.
The S.E.C.s findings come as more endowments and public pension
funds, looking to diversify and get better returns to pay their obligations,
have put their money in private equity investments. From 2006 to 2012,
public pension investments in so-called alternatives hedge funds, real
estate and private equity more than doubled, to 24 percent of total
assets from 10 percent, according to a report by Cliffwater, a consulting
firm. Private equity investments made up 42 percent of the money pouring
into alternatives in 2012.
Private equity firms also raise money from accredited individual
investors those the S.E.C. considers wealthy enough and the firms
argue that their investors are savvy enough to understand and agree to the
fees they are paying. The Biomet monitoring fees, for example, were stated
in a contract, said a representative for all four private equity firms.
The monitoring-fee agreements were put in place when Biomet was
acquired by its current owners, the spokesman said. Once the sale to
Zimmer goes through, the annual payment of monitoring fees ends, and
the monitoring fee agreement provides that a lump-sum present value of
future monitoring fees is payable in the form of a termination payment.
Translation: The contract says Biomet must pay up. And, ultimately,
that means less return for the investors.
Certainly, some private equity investors view the fees as the cost of
getting a potentially great return. Over the 10 years through September
2013, private equity generated returns of 19.2 percent, annualized,
according to Preqin, an alternative-investment research firm. That
compares with 7.6 percent for the Standard & Poors 500-stock index. In
recent years, however, the S.&P. has outperformed private equity.
Noting the industrys success, Mr. Schwarzman, the Blackstone
chairman, told an audience at the Milken Institute Global Conference last
month that individual investors beyond just institutional funds or the
accredited wealthy should be allowed to buy into private equity. These
people should really be able to take advantage of the things the
institutions get, he said.
Money from individuals would also feed growth for private equity
with few regulatory safeguards for those investors. Even the institutions
that now invest in private equity might be unaware that they are paying
steep fees, Mr. Bowden said. On money moving from the portfolio
company to the adviser, he said, there is not a level of transparency
sufficient to allow investors to protect themselves, no matter how smart
they are.
Reimbursed, in Part
When Mr. Bowden and his group started visiting private equity firms
in October 2012, they didnt know what to expect. The firms had never
been examined. But as teams of two to 10 examiners embedded themselves
in firms across the country and started interviewing portfolio managers
and compliance personnel, and reviewing records and emails, they quickly
identified some problematic practices.
In a recent speech in New York, Mr. Bowden said the agency had
uncovered either violations of law or material failings in the way private
equity firms handled fees and expenses more than 50 percent of the time
a significantly higher share than at other asset managers.
Asked about the S.E.C.s criticisms, Steve Judge, chief executive of the
Private Equity Growth Capital Council, the industrys lobbying group, said
in a statement: Every private equity fund agreement is negotiated by
professional investment managers on both sides, creating an alignment of
interests that consistently delivers the best returns net of fees of any
asset class over the long-term.
Even before the S.E.C. became involved, private equity investors had
become frustrated with the high fees in these deals. The standard structure
requires investors to pay the management fee on the assets they park in
private equity firms and 20 percent of the gains those funds generate.
But private equity firms also charge fees for services like providing
merger-and-acquisition advice to the portfolio companies they oversee.
Many investors, arguing that they shouldnt have to pay anything beyond
the standard fee structure, began demanding that fund advisers give back
a portion of those ancillary fees.
In response, fund advisers agreed to fee-sharing arrangements, in
which they would reimburse investors for some ancillary fees. These
reimbursements effectively offset the 1.5 percent to 2 percent management
fees. In the Biomet deal, for example, the private equity firms are sharing
some monitoring fees with their investors, though they declined to say how
much.
There are two problems with these reimbursements. Because they can
offset only the amount an investor pays in management fees, ancillary fees
in excess of those payments are not shared; they are kept solely by the
private equity firm. And some fund advisers have found ways to limit the
amount of fees they must give back.
One example involves senior advisers hired by private equity firms to
help oversee acquired companies. These advisers tend to be corporate
executives with experience in a particular industry who work with the
acquired companies; a former hotel executive might work with a portfolio
of companies in the hospitality business, for instance, to help them run
more efficiently.
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.
Silver Lake Partners is a huge Silicon Valley private equity firm with
$23 billion in assets, including investments in Dell, Groupon and Virtu
Financial, the high-frequency trading firm. In a 2014 filing, Silver Lake
noted that when it retained senior advisers, advisers, consultants and
other similar professionals who are not employees or affiliates of the
adviser, none of those payments would be reimbursed to fund investors.
Silver Lake acknowledges that this creates a conflict with its investors,
because the amounts of these fees and reimbursements may be
substantial and the funds and their investors generally do not have an
interest in these fees and reimbursements. Similar language is found in
regulatory filings across the industry.
A spokeswoman for Silver Lake declined to comment.
Some institutional investors have criticized the litany of fees that
private equity firms charge their investors. At a 2012 conference in
London, Sandra Robertson, the investment chief overseeing Oxford
Universitys endowment, complained about the tricks we have to look out
for such as transaction fees, monitoring fees, fees for paying the fees for
your software licenses, fees for visiting limited partners. She added, with
apparent exasperation: Come on, guys, pay your own bills.
Consider a regulatory filing by Brazos Private Equity Partners, a
Dallas firm with $1.4 billion under management. Its executives and their
family members are entitled to generous travel expenses for business
functions. The portfolio companies will be billed for expenses that may
include the cost of traveling on commercial or private aircraft or other
public or private transportation services such as trains, buses, taxis,
personal vehicles, rented or hired cars, shuttles, boats, limos or other
vehicles; hotels or other overnight accommodations; parking; meals and
beverages; entertainment; and/or other costs of any and all types or
descriptions.
Earlier this year, Brazos announced that it would not raise new money
from investors and that it was winding down its current portfolio. A
spokeswoman for Brazos did not respond to a request for comment.
Monitoring fees, like those in the Biomet deal, are a source of
particular concern at the S.E.C. because of their ubiquity. Portfolio
companies generally agree to monitoring for 10-year increments. But when
a company is sold, typically after about five years, the monitoring fees for
the remaining years of the contract must still be paid.
TPG, the private equity firm with $59 billion under management, has
a contract with Par Pharmaceuticals, one of its portfolio companies,
stating that Par must pay TPG at least $4 million a year for 10 years. The
contract was struck in 2012, but filings show that it will renew
automatically each year after 10 years have passed. If Par is sold or goes
public, the company will pay TPG the amount of monitoring fees that is
left under the terms of the contract, as was the case in the Biomet deal.
A TPG spokesman declined to comment.
There is no evidence that any of these firms are under the regulatory
microscope.
S.E.C. officials did describe general practices they find especially
troubling, including contracts that renew annually for 10 years. This
means that no matter when the contract is terminated by a sale or public
offering, there will still be a decade of monitoring fees that must be paid to
the private equity firm. Regulators call these evergreen fees.
Ultimately, investors are the ones who lose out when companies pay
these fees. Each dollar that a portfolio company pays in fees is one less
dollar that it can invest in its operations, thereby shrinking its net worth
and ultimate resale value.
Private equity firms dont have to reveal their investors, but the
Oregon Investment Council, which oversees $88 billion on behalf of state
employees, is known to be a large investor in several TPG private equity
funds. What does it think about companies that pay fees for services not
rendered? James Sink, a spokesman, declined to comment, but he did
provide a statement from Richard B. Solomon, the councils chairman.
We take seriously recent reports regarding the S.E.C.s
investigations, Mr. Solomon said. Accordingly, we have directed our
consultants and treasury staff to continue to verify that the private equity
firms with whom we invest have assessed only those fees allowed by the
terms and conditions of their contracts.
Temptations and Conflicts
In recent testimony before Congress, Mary Jo White, chairwoman of
the S.E.C., praised the agency for helping investors recoup money from
private equity firms. She said the agency has facilitated millions of dollars
in reimbursements by private equity advisers since 2012. These
reimbursements represented fees and expenses that were not properly
disclosed to investors.
The S.E.C. recently filed a complaint against a small private equity
firm, contending that it entered into undisclosed revenue-sharing
agreements through which it received kickbacks in return for
recommending investments to its clients. The firm, Total Wealth
Management, is based in San Diego and oversees $90 million in client
assets. The firm did not return phone calls seeking comment.
It is unclear whether the S.E.C. will refer any cases arising from its 18-
month review to its enforcement division. But agency officials like Mr.
Bowden suggest that, failing public disclosures and oversight, improper or
excessive practices will continue.
A private equity adviser is faced with temptations and conflicts with
which most other advisers do not contend, Mr. Bowden said in the recent
New York speech. We have seen that these temptations and conflicts are
real and significant.
A version of this article appears in print on May 25, 2014, on page BU1 of the New York edition
with the headline: The Deals Done. But Not the Fees..
2014 The New York Times Company

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