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Eliot Spitzer Could Take on Private Equity Firms That Scam New York City

As Comptroller, Spitzer would have an obvious target for financial reform.

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Eliot Spitzer, now the top contender to be the next New York City Comptroller, has said he wants to use the office to pursue financial reform. He has a ready, obvious, and comparatively easy target: the private equity industry.

There is clear evidence that private equity (PE) firms have been scamming their investors for decades. Most of these investors are public pension funds, like the funds invested by New York City on behalf of its employees. These PE investors have been largely clueless as to how their money is being stolen. When they have sensed that something is wrong, they’ve taken a collegial approach, relying on exhortation and negotiation. Not surprisingly, the “let’s handle this among friends” strategy has not been effective.

Despite being stymied and despite ample evidence of large scale abuses, public pension PE investors have been reluctant to use their bully pulpits, band together effectively, or take PE firms to court. This broken status quo is a great opportunity for what Spitzer does best, which is to use both the law and the media to tackle powerful, predatory interests. This is one big reason why his candidacy has evoked horror and aggressive attacks from the financial elite.

Let’s start by examining the relationship between private equity firms and the New York City Comptroller.

The New York City employee pension system is one of the largest private equity investors in the U.S., with $8.3 billion invested in this strategy. Though a board of trustees is technically the fiduciary for each of the City pension funds, and the Comptroller has only one seat on each of those boards, in reality, the City Comptroller is, to an extreme degree, first among equals on all of the boards. The reason for his disproportionate influence is that all of the City pension funds are managed day-to-day by a combined staff, and those staff members are all employees of the New York City Comptroller, making him effectively their boss.

Moreover, the super-secret contracts that the NYC pension funds enter into with PE firms are held at the Comptroller’s office, as are the super-secret cash flows showing what the pension funds contributed to the funds and what they got paid out in return. It’s impossible to overstate the importance of the Comptroller’s access to PE fund contracts (known as limited partnership agreements or LPAs) and cash flows. PE firms accomplish much of their investor scamming via fees that are contrary to LPA terms and that they take from portfolio companies owned by the funds they manage. The PE firms also scam by charging the funds they manage for expenses that the LPA says should be paid by the PE firm itself.

I’ve seen a tiny bit of this first hand through my work as a hired gun to PE firms. One of the things that PE firms do is manage portfolio companies. While a small subset of PE firm do have their staff roll up their sleeves and play a meaningful operating role, for the overwhelming majority, their oversight consists largely of financial engineering, possibly changing some of the executives of the portfolio business, and pushing like crazy for cost cutting.

The PE firm babysitting typically includes periodic meetings with the top employees of the portfolio company, in which the PE staffers harass the portfolio company management over their progress towards targets the PE firm has set. I’ve seen the actual and projected monthly financial statements used as part of this exercise. They clearly included as a separate line item a management fee paid to the PE firm. This was over and above the “management fee” paid by investors.* Yet most investors would assume that fund-wide management fee would cover the supervision of the portfolio companies. My understanding is that this second level of fee skimming is not disclosed to the investors in the PE fund.