Under pressure

When top inspector at the US Securities and Exchange Commission Andrew Bowden made his now infamous “Spreading Sunshine in Private Equity” speech at the PEI Private Fund Compliance Forum in May, the statement immediately sent waves throughout the private funds community. And apparently his words created a ripple effect outside the industry as well. Over the past few months major media outlets like the Financial Times and Wall Street Journal  have begun investigating what types of fees public pension funds are paying private fund sponsors, only to run into a roadblock when LPs refused to disclose their fee receipts, citing legal concerns stemming from confidentiality agreements.
For starters, it’s worth noting that since Bowden’s warning the primary tier of transparency—that established between an LP and a GP—has been improving, according to trade bodies like the Institutional Limited Partners Association (ILPA); but now a second tier of transparency has been introduced by recent press coverage—that between a public pension fund and its constituents. You can imagine the headlines already, all of which hint something to the effect of shady private equity types wanting to hide their fees from firefighters, teachers and the public at large.
Both mainstream and niche publications speaking out on the issue argue that pensioners deserve to know detailed fee information from the confidential sections of the Limited Partnership Agreement (LPA), while detractors insist that the contents of a private contract should remain private, and that revealing fee information would diminish a manager’s competitive advantage.
Despite the media uproar, however, most within the industry are not too bothered about this fee transparency debate. Managers say they would prefer to keep their confidential terms confidential, but would not consider it the end of the world to reveal some fee details. Meanwhile, pension funds’ first priority seems to be to honor their non-disclosure agreements and maintain their relationships with managers, rather than divulge information to the public. This fee debate is low on their list of priorities, in other words.
Indeed, the issue is a complicated and nuanced one, and difficult to see clearly with such disconnect between the two sides of the debate, but the true dilemma lies in the paradox of keeping private equity contracts private in an environment where transparency is increasingly important to LPs and regulators. The media, managers, investors and lawyers have all spoken out on the issue, and it seems that for now, the status quo will remain.
The hubbub 
In mid-October, The New York Times ran an article that aimed to glimpse behind the “curtain” of the private equity world, publishing alongside the story a heavily redacted LPA from The Carlyle Group’s Carlyle Partners V, obtained from a Freedom of Information Act (FOIA) request to the Teachers’ Retirement System of Louisiana. Removed from the redacted version, among other terms, was the fund’s fee structure.
The story was followed by a Financial Times piece, exposing discord on the other side of the pond, purporting that UK-based pension funds are up in arms over being “forced” to sign non-disclosure agreements, although the article was not specifically targeting private equity funds.
These stories ignited a flurry of media activity, prompting a response from watchdog website Naked Capitalism, praising the “revolt” in the UK and condemning US-based pension plans for not speaking out on the issue in a similar manner. Conversely, head of the Private Equity Growth Capital Council (PEGCC) Steve Judge published his own piece on peHUB, dismissing the calls for public transparency, claiming that publishing LPAs would be akin to Coca Cola publishing its secret recipe.
Finally, The Wall Street Journal chimed in, stating that such pension funds as Iowa Public Employees Retirement System and the Florida State Board of Administration were being pushed by KKR to keep fee information confidential with threats from the manager to bar them from future funds should they fail to comply with non-disclosure agreements.
Although all this attention has arisen in recent months, lawyers and managers note that FOIA requests from the media for LPA material and fee information have been steadily streaming in since Bowden’s speech. One lawyer notes that his clients have been receiving requests for SEC exam findings from the Journal for months.
The LP stance 
In most of these articles, the principal argument has been that pensioners – deserve to know how their retirement dollars are being used, and therefore should know how much pension money is going into the GP’s pocket in terms of fees and expenses. However, it appears as though the pensions themselves do not share this concern to expose that level of fund detail to the public.
“Their job is to maximize returns to the pension. That’s the bottom line,” says Kathy Jeramaz-Larson, ILPA executive director. “If there is some sort of competitive advantage that their GP has, the LP does not want that out there in the public domain.”
As long as LPs are making the returns they have promised, pensioners should be content with the fund information that is currently available in the public domain, she adds.
Furthermore, fee information on its own might be easily misconstrued because the public would not be privy to the negotiations that took place in order to bring those fees about.
“Every LP might have a different focus and or have a different fee structure in order to maintain their objectives,” explains Jeramaz-Larson. “You really have to read the entire contract to understand, and even then if you weren’t apart of those conversations you might not understand how they came to the fee structure.”
The real issue at hand, she says, is that first tier of transparency – whether or not LPs are getting the information about fee allocation from their GPs. From its discussions with LPs, ILPA has heard of an increase in that transparency since the introduction of its best practice “Private Equity Principles” in 2009.
Moreover, when LPs questioned their managers regarding SEC exam findings to understand the misallocation of fee money after Bowden’s speech, many found that the mishandling occurred in earlier vintage funds before the ILPA principles were published, says Jeramaz.
“The board of trustees and the CIOs at these pensions are looking for more transparency. I would err on the side of saying that transparency is there between the GP and the LP, but the media just isn’t getting it for publication,” says Jeramaz-Larson.
The manager’s side 
According to ILPA, LPs would prefer to keep fee information under wraps just as much as their managers would. However, some managers hint that even they would not mind revealing this data if that is the direction in which the industry is heading.
“Do I really think it would be the end of the world if the public knew more about the terms of these agreements? Not really,” comments one GP. “If the fees were out there, the world would continue to spin on its axis.”
Although not yet prepared to disclose confidential information without a push, he says comparing fund fee information would not necessarily diminish his competitive advantage, because others could not copy his firm’s investment strategy and expertise just from looking at his negotiated fee rates.
Similarly, a fund formation lawyer adds that while his clients do not necessarily want to reveal how much they’re getting paid in management fees or carried interest, keeping fees under wraps is not the primary concern with non-disclosure agreements, but rather the exposure of portfolio company financials.
Indeed, fee information can be found in other documents such as private placement memoranda that are easier to obtain than an LPA. Also, when Naked Capitalism leaked 12 full LPAs last May, the reaction from many in the industry was that the documents were mostly legalese, not revealing anything particularly “trade secret.” So why the fuss about confidentiality?
“If all the fees came out it would be a huge feeding frenzy for the media and they’d lose further sight of what’s important for these pensions: the returns that private equity is generating,” says the GP. “There’s no way state pension funds would come close to meeting their benchmarks if it weren’t for these returns.”
GPs are afraid of private equity being seen as “too expensive” by the public, and of the media misconstruing the information they receive, which, as Jeramaz-Larson mentions, would be out of context given the negotiation process for fees.
Another push to keep documents confidential comes from manager’s legal counsel, whose years’ worth of work and meticulous language would be published and available for possible pilfering by lesser law firms. One GP notes you can tell which law firm penned a document just by looking at its language.
“It’s their intellectual property, they don’t want it out there,” comments the GP. “That more than anything else is truly why the restrictive language is in there.”
The bottom line 
Most media outlets are contending that public pensions want to increase the transparency between themselves and their constituents and that managers want to prevent them from doing that at all costs. But there seems to be more reluctance on the part of LPs, more ambivalence on behalf of GPs and more of a grey area in this controversy than has been presented.
So, where is this big debate leading? Is it worth the hype or is this, as one manager described it, “much ado about nothing?”
If an LP were to refuse to sign a non-disclosure agreement in order to make fee information and other terms available to the public via FOIA request, the Journal suggests that a GP would turn that money away. Managers and fund formation lawyers agree.
“It’s matter of trust, if we’re living up to the terms and everyone else is willing to sign, we wouldn’t want them in the fund,” comments one GP.
Some argue that allowing one LP to invest without signing a non-disclosure agreement would potentially harm the rest of the investors, especially those who do not operate in the public sphere like sovereign wealth funds, insurance companies or family offices, who would not want fund information in the public domain.
“The general partner in its fiduciary obligation should force mandatory redemption or withdraw that investor, especially if it might harm the opportunities and the performance of the other investors,” says one lawyer.
If, however, many pension funds were to band together and reject the concept of non-disclosure agreements, GPs would likely give in to the pressure. That kind of response is unlikely any time soon, notes Jeramaz-Larson. Although the media is pushing for universal transparency, they are far ahead of any kind of industry standard overhaul.
The SEC plans to release a risk alert or further guidance on how much detail should be provided to LPs regarding the types and degree of fees that investors are being charged, according to lawyers. Such steps from regulators may help strengthen that trust between the GP and the LP, which is the primary focus in the industry now. Once the first tier of transparency is firmly established, perhaps the second tier will be close behind.