Lessons from the Blackstone case

Say goodbye to accelerated monitoring fees.

That’s one of the takeaways from the $39 million fine levied by the US Securities and Exchange Commission (SEC) against The Blackstone Group in relation to accelerated monitoring fees.

Many GPs put in place 10-year monitoring fee agreements after acquiring a portfolio company, but often these agreements are terminated before a decade passes. Some GPs “accelerate” the remaining fees owed after the company is sold, even if no future consulting work is performed. In contrast, evergreen monitoring fees, which have also come under scrutiny, automatically renew on an annual basis.

The SEC penalized Blackstone for failing to sufficiently disclose its practice of accelerating monitoring fees to LPs in three of its funds, Blackstone Management Partners, Blackstone Management Partners III and Blackstone Management Partners IV.

Except that Blackstone, to a considerable extent, did disclose them. Each accelerated fee was mentioned in distribution notices, quarterly statements, and, in the case of IPOs, Form S-1 filings. The SEC didn’t feel that was enough, wanting Blackstone to disclose the fees before investors pledged their capital, the idea being that LPs should be given the chance to object before the fees are charged. But what Blackstone did do is inform LP advisory committees about the fees – and not once did LPs object, suggesting their tacit approval.

Which brings up another takeaway: the SEC appears willing to guide industry practice through enforcement action. It was once believed that the SEC would release an after-action report detailing its findings from a recently completed two-year sweep of private fund managers, which GPs could have used as a blueprint to avoid SEC enforcement action. But the feeling now is that highly publicized cases with mega-firms like the one against Blackstone, or, for instance, the case against KKR over broken deal expenses earlier this year, are the SEC’s preferred means to initiate industry-wide changes to best practice.

One LP told us that Blackstone was by no means the worst offender on fees and the attention ought to be more focused on those collecting egregious evergreen fees. Indeed, Blackstone itself has noted that historically it has “very rarely received any fees from portfolio companies following a full exit and we do not expect this practice to change in the future,” according to an exchange with a pension fund obtained by the New York Times.

But perhaps the most important takeaway is simply the SEC’s more aggressive approach to private markets. The regulator is demonstrating a willingness to penalize what it feels to be historic bad behavior, despite something being standard industry practice with reasonable disclosures being made – and clear steps being taken to improve them.

Compliance officers say that, before the days of Dodd-Frank, a violation like this would at most pop up in a deficiency letter. The fact the SEC levied a fine against Blackstone is even more surprising given the funds in question pre-date changes to the firm’s disclosure policies, which it started to improve in 2012 before the SEC investigation. This leaves compliance officers at other firms scrambling to find a way to address historic actions now being deemed unacceptable by the SEC to avoid enforcement action.

The final takeaway? These cases are just the start of what’s to come.

“The SEC is not limiting its focus and these issues exist at smaller [fund] levels too, but not to the extent of the larger funds,” says Richard Jaffe, co-head of the private equity practice group at Duane Morris. “This is going to be a continuing issue.”