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

Continued from previous page

And this isn’t the only type of double-dipping that has taken place. In the 1990s, following the practice of then industry leader KKR, it was common for large PE funds to charge “transaction fees” for buying and selling companies, again over and above their management fees, even though they often hired an investment bank, which charged its own fees, to do the work. This was such an egregious abuse that even the normally complacent investors eventually roused themselves to push back.**

The sad truth is nobody who invests in PE looks closely at whether PE firms are complying with the fee and expense provisions of their agreements. Part of the reason is that the PE firm lawyers draft the terms in these LPAs to be almost incomprehensible. Another reason is, astonishingly, that PE investors have accepted the argument of PE firms that these contract provisions are a form of “trade secret.” Public pension fund investors have almost universally acceded to the demands of PE firms to exempt the LPAs and cash flow reports from state FOIA laws, which keeps the eyes of the press and the public off the documents.

This information lockdown prevents a worst-case scenario for scamming PE firms, that a mid-level accounting employee at a portfolio company would use public documents to compare the payments made to fund investors with what was taken from the portfolio company where the accountant works. State qui tam laws, which are designed to prevent precisely this type of abuse by awarding a portion of the government’s recovery to people who uncover fraud, would provide a powerful incentive for employees at portfolio companies to rat out their PE overlords. But that’s not going to happen as long as public pension fund PE investors keep the contracts and cash flows behind the FOIA wall. However, the New York City Comptroller has access to this critical information. Hence the freakout at the prospect that Spitzer might get the job.

How do we know that private equity firms are stealing from their investors? It turns out that the SEC has been surprisingly vocal, though unspecific, in recent public statements about the fraud it is finding in private equity. Historically, the SEC had basically no nexus with the private equity industry, as virtually no PE firms in the past were “registered investment advisers”. That meant that PE firms were not subject to SEC supervision or the regular compliance audits that all registered investment advisers undergo. However, Dodd Frank changed the law that allowed PE firms to avoid registration. Virtually all institutional PE firms were required to become registered investment advisers by early 2012, making them subject to regular SEC audits (known as examinations).

Within months of the SEC corralling the private equity industry into its registered investment adviser program and initiating examinations, SEC Commissioner Elisse Walter spoke on a conference panel about early findings of these examinations. For instance, the law firm Ropes & Gray dutifully reported the SEC’s emerging awareness of PE fraud to its clients:

…SEC Commissioner Elisse Walter indicated that the SEC, in proceeding with its “presence examinations” of newly registered private fund advisers, has already noted many instances of poor controls, often regarding fees and expenses. Commissioner Walter elaborated that the staff has noted instances where advisers miscalculate fees, improperly collect fees and inappropriately use fund assets to cover their own expenses. Commissioner Walter noted that SEC staff will continue to examine and question advisers income and fees.

Note that, according to Ropes & Gray, Commissioner Walter described these impermissible fee practices by PE firms as “poor controls,” rather than fraud or theft.  It will be key for the next NYC Comptroller – as well as the interested public – to hold the SEC’s feet to the fire, so that the Commission doesn’t give PE firms a pass based on a “we didn’t mean to steal” defense.