Much like the fast-spreading and deadly swine flu, the effects of a recent kick-back scandal within the private equity industry has infected many of its participants, impacting everyone from fund managers to placement agents to pension funds. While the long-term consequences are not yet known, many in the industry may have to consider making changes to how they do business for now.
The domino effect was accelerated in April when New York Attorney General Andrew Cuomo indicted Aldus Equity Partners managing partner Saul Meyer over an alleged scheme in which Meyer knowingly paid sham fees to a placement agent connected to the New York State Common Retirement Fund (CRF).
CRF has announced it will ban the use of placement agents, paid intermediaries and registered lobbyists from participating in its investments, while New York City Comptroller William Thompson asked trustees of the five city pensions, with combined assets of around $83 billion, to approve a ban on placement agents as well.
Such moves may be permanent, as New York State Comptroller Thomas DiNapoli has drafted legislation to codify the ban on agents, including entities “compensated on a flat fee, contingent basis or any other basis”. Cuomo has also issued more than 100 subpoenas to investment firms and agents and is coordinating with other state agencies as well, as Aldus has ties with other pensions throughout the US.
Beyond New York, other states officials have taken their own actions in response to the broadening pay-to-play scandal.
CALIFORNIA – The $164.9 billion California Public Employees’ Retirement System (CALPERS) – the largest public pension in the US – charged its staff with drafting a new disclosure policy requiring its investment partners and external managers to disclose their retention of placement agents, the fees they pay them and the services performed. Placement agents must also register as broker-dealers with the U.S. Securities and Exchange Commission (SEC) or the Financial Industry Regulatory Authority (FINRA). Meanwhile, the $9 billion Los Angeles City Employees’ Retirement Fund (LACERS) also mandated that investment firms looking for commitments must reveal the identity of any third-party marketers involved in the investment process. Both pensions had indirect ties to the scandal through a California-based placement agent called Weatherly Capital Group
NEW MEXICO – The New Mexico State Investment Council, which until recently employed Aldus as a private equity adviser, is developing its own policy mandating disclosure of third-party firms who get paid an administrative, consultant or attorney fee related to an investment. It has also been ordered by Governor Bill Richardson to suspend alternative investments until the policy is in place, and has requested information from more than 200 investment managers – some of whom have declined to answer – about any fees paid to external consultants.
ILLINOIS – As part of a reform effort related to the impeachment of former Governor Rod Blagojevich, the Illinois legislature passed a wide-ranging law banning contingent fee arrangements and placement fees to win an investment. The law applies to virtually all pension systems at the state and local level, including the pension system of the city of Chicago.
CONNECTICUT – Connecticut Treasurer Denise Nappier fired Aldus as a manager of small and emerging fund managers for the state pension, and announced she is bolstering disclosure requirements over placement agents.
Under fire
With North Carolina’s state pension preparing similar placement agent rules, and other states likely to follow, the all-out pension assault on placement agents comes as the use of such intermediaries has grown, with more than 54 percent of private equity firms using agents to help close funds last year, according to research firm Preqin. It is also a worrisome development for those in the industry who believe such bans will hurt firms and pensions in the long run.
“I think it is unfortunate because placement agents perform a legitimate service,” said Roger Singer, a partner in the fund formation practice of Clifford Chance. “They help the firm shape its message, identify an investor’s needs and present information in a way that is useful to the state fund. I’m also not sure how it is that these state funds are going to function without one of the real sources of opportunities to them. If you take away that middleman, you create more work for the state at a time when many of them are cutting back their staffing.”
At the same time, the rush to push through hastily formed regulations – which make little distinction between unregulated firms and reputable agents like Probitas and MVision – may also come back haunt many state pensions, says Bruce Ettelson, head of the private funds group at Kirkland & Ellis. Unfortunately it may take some time to correct the damage.
“This is a populist movement that is moving very quickly, without nuance, and once legislation and orders are in place, legislators don’t have a large appetite to go back and amend the provisions,” he said. “To have certain state pension plans not be able to use those services will hurt those states that prohibit the use of placement agents. The market goes in cycles. When we are back to a world in which some funds are oversubscribed, placement agents will just skip over Illinois, New York etc., which will be to the detriment of those plans and pensioners.”
Other unintended consequences could include a retrenchment effect at pensions which decide it is easier to reinvest with existing managers, as without agents it will be harder to find and develop relationships with new managers. Another could be a growth in the fund of funds business as such pensions look to get some of the additional investment sourcing off their plate.
Getting noticed
Until the dust settles GPs need to consider several options for dealing with new reality.
First, with firms such as The Carlyle Group – which has not been accused of wrongdoing and has decided to end its use of placement agents – getting caught up in the various investigations, managers currently using intermediaries should take another look at the agreement signed with the agent, making sure there are appropriate protections such as a certificate of legal compliance, as well as do thorough background checks.
“If you’re talking to a one-man band, with no team, no nothing, then you’re talking to the wrong agent,” said Antoine Drean, founder of European placement agent Triago. “Another key issue is when placement agents subcontract some of their business to special entities, which clients usually don’t know about. Every GP should ask their agents not to subcontract any business or not to make any payments to an outside firm.”
Those GPs that opt to do without an agent may have to take on additional staff such as investor relations people or pension liaisons, adding extra costs at a time when most are watching the bottom line. One way that a fund manager can try to get noticed without the use of an intermediary is tracking down the consultants, or gatekeepers, that are retained by many pension funds, especially as they are the ones that screen potential investments and advise the money managers at these pensions.
Another method that fund managers have used in the past and may assume greater prominence is the Request for Proposal (RFP) process, akin to the typical process to win a government contract, for getting an allocation from a pension fund. Nearly every major fund posts an RFP form on their website, and many private equity and hedge funds have someone fill out as many of these RFPs as possible.
“Some of them get lost in the void but quite a few result in feedback,” said one fund formation lawyer. “It’s like an extensive due diligence form, some can be 20 to 25 pages worth of information to fill out, so it’s kind of like a blocking-and-tackling approach as opposed to a who-you-know approach typically employed at major pensions. But it is a way to get your fund on the radar screen of someone making a decision.”
Many questions, few answers
As the reform campaign in many states continues, a number of questions still must be sorted out: if a manager uses a broker-dealer within an institution, such as an investment bank, that is paid a contingency fee, is that prohibited? Do due diligence and other materials that agents provide get caught up in these state prohibitions? Can an agent be paid on a flat fee rather than based on the capital they raise? Will a manager be penalised for having used an agent in the past but not in relation to the pension they are pursuing currently?
But despite the uncertainty and harm caused by lumping good agents in with the bad, even those that tout the positive role of agents also hope that the end result may improve the current process which often favours political connections or ambiguous contributions to win a seat at the pension’s table. “In the placement agent business there is a need for some cleaning up, and this is what is going to happen over the next weeks and months,” said Drean. “Once this is done I’m pretty sure it will start over.”
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