The main objective of the US Securities Exchange Commission (SEC) is to protect investors. Recently in the private equity industry, providing that protection has meant examining registered investment advisers and issuing deficiency letters or enforcement action when examiners have discovered wrongdoing. Oftentimes, that wrongdoing has been related to the disclosure and allocation of fees and expenses.
At PEI’s CFOs & COOs Forum in late January, fund managers expressed how they’ve been increasing the amount of disclosures they make to investors, altered their operations and enhanced their written fee and expense policies in order to avoid SEC action. Many GPs, however, voiced speculation as to whether their investors truly cared about or even noticed the changes.
In a transparency debate that focuses on increased investor protection, one group has remained markedly mum: investors. So what do LPs really think of fees, the SEC’s initiative and the changes their managers are making in order to comply? pfm spoke to a number of LPs and consultants, most on the condition of anonymity, and the results are mixed. While some fully support the role that the SEC has taken as an investor advocate, others have an “if it ain’t broke, don’t fix it” attitude. Either way, both sides speculate whether or not the commission will affect the right kind of change at the end of its private equity sweep.
Tempest in a teapot?
When discussing the matter with pfm, one state endowment was particularly skeptical of the efficacy of the SEC’s initiative.
“The SEC spends so much time protecting ‘ma and pa investors’ from hordes of retail brokers that they think the people who invest in private equity have the same level of sophistication,” says the LP. “We’re well aware of fees and potential fees.”
The endowment has been investing in private equity for nearly three decades. They ask about fees and request budgets during due diligence, and analyze annual audit statements to ensure that the fee structure laid out in the LPA is being followed. The LP, an investor in a fund the SEC took issue with regarding operating partner fees, downplayed the seriousness of the matter.
“The magnitude of those fees really was not that big. It was disclosed in the LPA that the fees were not going to be offset and it was discussed during due diligence and we accepted it. The then SEC came in and said how it should have been treated,” says the LP. “It’s a tempest in a teapot.”
This view, however, is not shared by all LPs. The Connecticut Retirement Plans and Trust Funds, for example, is one of the investors in KKR’s 2006 fund. In March 2014, Connecticut received a miscellaneous $68,765 credit from KKR. However, it was not until The Wall Street Journal published an article on the matter that Connecticut learned the credits were in response to a KKR Capstone-related fee allocation policy that was questioned by the SEC during an exam.
“This credit, while modest, underscores our belief that the SEC’s examination of private equity firms and the fees charged to their investors – and the greater transparency that will inevitably result – has been, and will continue to be, positive news for investors,” said Connecticut State Treasurer Denise Nappier in a statement.
Most LPs demonstrate a mix of the state endowment’s wariness of the SEC and Connecticut’s support of the commission. One private equity consultant mentioned that, while he sees transparency improving, his clients are still intrigued as to what the SEC will conclude following its sweep of private equity managers. “The SEC has insight on the inner workings of a general partner that even an LP does not have,” he notes.
One deputy chief investment officer at a large public pension plan says that the SEC’s focus on transparency is not much of a concern for her. The fund began seriously investing in private equity in 2009 after the great financial crisis and, and as one of the few LPs with dry powder to deploy in the asset class, they were able to push for favorable transparency terms from the get-go with in their relationships with managers.
“As far as the more recent concerns that the SEC has been addressing, I feel like we were already getting that transparency. Perhaps if we had been investing in private equity prior to 2009 it may have been different,” she says, noting that her team is often told by managers that they ask transparency-related questions that other investors aren’t asking.
“We take pride in that. We make it very clear that we need transparency on expenses and fees so when we get distributions for capital calls we’ll know,” she adds. “We want to make sure that managers aren’t getting rich off our management fees and they’re using them to do what they need to, which is keep the firm going, and the real incentive is on the back end with the carry.”
Even if LPs themselves are not worried about the fees and expenses they are being charged, recent media attention is bringing the issue into the public spotlight. Pensioners and constituents are now joining in on the conversation after seeing coverage about their retirement dollars on the pages of the Wall Street Journal and The New York Times (for more on this process, see page 30).
“It’s a headline risk issue,” says a second consultant who advises some of the largest US public pension plans on their private equity portfolios. He notes that most of his clients still value the asset class for its fruitful returns. On one hand, it is not much of a concern if the portfolio is returning 15 percent when, without the extra fees, it might have returned 15.1 percent.
“But our clients are paying benefits to retirees and their families. Even if it’s a basis point, a basis point for a large pension fund client means a lot of benefits,” he says.
The state endowment, while not too concerned about the fees it is being charged, agrees that it is important for the public to see a pension addressing the issue. However, the LP notes that when it has held public meetings disclosing average fee costs for the private equity portfolio, the public has never taken much interest.
The large public pension plan has not been rattled by the recent headlines, trusting the relationships it has with its managers. “We don’t get bothered by those stories,” says the deputy chief investment officer.
Awaiting the outcome
The SEC’s ultimate objective is to increase transparency between LPs and GPs, and every LP with which pfm spoke agreed: the more transparency, the better. They are not all certain, however, how the SEC will go about increasing that transparency.
Already, the commission and industry guidelines like the Private Equity Principles from the Institutional Limited Partners Association (ILPA) have been moving the needle. The Blackstone Group, for example, recently chose to share 100 percent of deal or monitoring fees with limited partners, as well as end the practice of collecting accelerated monitoring fees from portfolio companies. Following a presence exam with the SEC, Freeman Spogli revealed that it would allow investors in its latest fund to hire an independent adviser in order to monitor the fund’s financial records and scrutinize the fund’s governance practices for conflicts of interest.
The SEC is due to publish some guidance based on its two-year sweep of newly registered investment advisers in the coming months. Most LPs are eagerly awaiting that report.
“LPs are being patient to see the results of what the SEC comes up with,” says the first consultant. “The best thing investors can say to the SEC is: give us all the info, we’re educated investors and we can make an educated decision whether or not to invest.”
The second consultant expressed a fear that the new SEC guidance will simply mean more paperwork for the GP. “I’m just concerned that the SEC will come up with a new system of required filings that don’t really get at the problem,” he adds. “Implementing a new compliance program is expensive; it requires hiring someone and takes away resources from the primary objective: to go out there and make money for us.”