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

Continued from previous page

Shortly after the Walter panel discussion, Bruce Karpati Chief, SEC Enforcement Division’s Asset Management Unit, gave a speech where he further outlined findings of the new SEC examinations of private equity. Like Walter, he noted finding instances of illegal shifting of fees to investor funds and the charging of dubious fees to portfolio companies.

These petty frauds by PE firms should be low-hanging fruit for Spitzer. The critical questions he needs to ask all of the PE firms doing business with the city’s pension funds are:

1. What is everything of value you receive, either directly or indirectly, from the portfolio companies owned by the funds you manage?

2. What are all the charges you have imposed on the funds in which New York City pension funds are an investor?

Once he has the answer to these questions, Spitzer should compare the fees with the language of fund LPAs and figure out which ones are impermissible. PE firms will stonewall on the first question, claiming that they already disclose to investors all the fees that they are required to share with investors. Don’t get caught in this logical trap. It’s the fees that the PE firms don’t share with investors that they don’t disclose. If the PE firms drag their feet, Spitzer should not hesitate to wield the Comptroller’s subpoena powers.

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* Almost all funds provide for the right of the general partner to receive a management fee. While the media commonly describes the fees as “two and twenty” meaning a 2% annual fee and 20% of the profits (as defined), the 2% is the “rack rate” for management fees, meaning it’s the starting point for negotiations. Funds of less than around $500 million, particularly venture capital, can negotiate for and may obtain a higher fee.

Funds larger than $2 billion face enormous investor pressure to charge less than 2%. SEC filings for some of the biggest public funds indicate management fee levels in the neighborhood of 1.25%. Typically, the general partner does not get that level of management fees for the full life of the fund. Instead, the GP gets that rate for the duration of a fund’s “investment period”, the time during which the fund is expected to acquire a portfolio of investments.

Once the investment period ends, the management fee steps down. Using a 2006 KKR fund as an example, that rate through the tenth anniversary of the fund’s life is 0.75%. Unlike during the investment period, that percentage is applied only to the capital still invested in the fund, as opposed to the original fund size.

** We may return to this bit of history in later posts, since it’s revealing and the remedy was not straightforward. Suffice it to say that the resulting contractual provisions were drafted by attorneys for the private equity firms, and are sufficiently vague that skeptical insiders are not convinced they are as effective as most fund investors would like to believe.