Well, for 80% of the flights anyway.

Photographer: Daniel Acker/Bloomberg.

KKR's Investors Paid for a Lot of Wasted Flights

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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One nice thing about running a private equity firm is that you get to sit between investors who have money and companies who need it, and send both of them bills. This has made a lot of private equity managers rich, but it is also a constant source of friction.

Many investors in private equity funds dislike the fact that the private equity firms charge fees both to the funds (i.e. the investors) and to the companies, and after much complaining a norm has grown up that most of the fees paid by the companies are credited against the fees paid by the investors.  But the specific boundaries of what gets credited to whom are hazy and shifting, and controversies keep cropping up.

So today there's a Securities and Exchange Commission enforcement action alleging that Kohlberg Kravis Roberts & Co. misallocated some of its $338 million of broken deal expenses from 2006 to 2011. Maybe the first thing to notice here is that KKR had $338 million in broken deal expenses over six years. That is a lot of plane tickets to nowhere! ("Broken deal expenses include research costs, travel costs and professional fees, and other expenses incurred in deal sourcing activities related to specific 'dead deals' that never materialize," says the SEC.) KKR spent over $50 million a year just wasting its (and its lawyers') time on deals that didn't happen. Obviously that is part of the business, but it really hurts to see it quantified like that. No wonder KKR wanted to send the bill for its failures to someone else. 

And of course it could: The great thing about private equity is that KKR can bill everything to someone else. When it buys a company, the billing is straightforward enough: It bills its deal expenses to that company. But when it doesn't buy a company, there's no company to bill the expenses to, and of course KKR is not going to eat the expenses itself. So it bills them to the fund for which it would have bought the company, if it had bought the company.  That is explicitly part of KKR's agreement with its limited partners (investors): The limited partnership agreement for each of its funds "requires the fund to pay 'all' broken deal expenses 'incurred by or on behalf of' the fund 'in developing, negotiating and structuring prospective or potential [i]nvestments that are not ultimately made.'"

But when KKR buys a company, it doesn't buy it just for its funds. The funds usually put up most of the money, but "KKR may obtain additional capital necessary to complete the transaction from co-investors." The co-investors include, "separate co-investment vehicles or similar investment account arrangements," that is, separately managed accounts for big investors who negotiate their own individual deals with KKR. They also include "dedicated co-investment vehicles for its executives, certain consultants and others," KKR's former publicly traded partnership, and even occasionally KKR -- the management company -- itself. And they sometimes include additional money sourced directly from KKR's outside investors for specific deals. "From 2006 to 2011, KKR Co-Investors invested $4.6 billion alongside the $30.2 billion invested by KKR’s Flagship PE Funds."  

But while those co-investors got to participate in the deals that happened, they didn't pay their share of fees for the deals that didn't happen. They do now: In 2011, "KKR recognized during an internal review that it lacked a written policy governing its broken deal expense allocations," so it wrote one. The one it wrote went into effect in 2012, and was complicated:

In addition to committed capital co-investment vehicles, KKR’s new allocation methodology began in 2012 to allocate or attribute a share of broken deal expenses to KKR Partner Vehicles and other KKR Co-Investors. KKR’s new methodology considered a number of factors, including the amount of committed capital, the amount of invested capital, and the percentage of transactions in which KKR Co-Investors were eligible to participate given the Flagship PE Funds’ minimum investment rights.

If that methodology had gone into effect in 2006 instead of 2012, $17.4 million of broken-deal fees that were actually paid by the funds would instead have been paid by the co-investors. And so the SEC, in its enforcement action today, more or less pretended that the policy went into effect in 2006 and made KKR pay back $18.7 million to its funds.  It also fined KKR $10 million for not doing that in the first place.

It is a little hard to see what the SEC's theory is here. The order says that KKR "violated Section 206(2) of the Advisers Act, which prohibits an investment adviser, directly or indirectly, from engaging 'in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.' " What was the deceit? KKR didn't "disclose in the LPAs or related offering materials that it did not allocate or attribute any broken deal expenses to KKR Co-Investors," but it didn't say that it did, either. The limited partners in KKR's funds knew that they had agreed to pay "all" of the broken deal expenses, and they knew that there would be co-investors in KKR's deals; it strikes me as not an unnatural reading of the situation that the limited partners would be paying all the broken deal expenses and the co-investors would be paying none of them.

That may not be fair -- SEC enforcement director Andrew Ceresney says that "although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses" of the broken deals -- but it is not obviously fraud. (Nor is it obvious what the fair answer is: By my math, co-investors put up about 13 percent of the deal capital over this period and paid zero percent of the broken deal fees; the SEC settlement -- based on KKR's own current methodology --implies that they should have paid about 7 percent. )

But I guess that's a sort of a technical reading. Marc Wyatt of the SEC's Office of Compliance Inspections and Examinations said this last month:

Many managers still seem to take the position that if investors have not yet discovered and objected to their expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.

One of the most common and often cited practices in this area involves shifting expenses away from parallel funds created for insiders, friends, family, and preferred investors to the main co-mingled, flagship vehicles.

When you put it like that, it does sound pretty lame. Wyatt goes on to say: "This practice can be a difficult for investors to detect but easy for our examiners to test."  That seems to be the point here: Perhaps KKR's investors weren't literally defrauded or deceived about these expenses. The expenses were hiding in plain sight, somewhere deep in KKR's limited partnership agreements. But it does kind of look like the thing where, if you sat the investors down and explained it to them clearly, they would tell KKR to knock it off.

The usual way for the SEC to deal with that situation is to require managers to sit the investors down and explain things to them clearly. The SEC is a notable fan of disclosure, and is always happy to add new rules requiring more clarification. It is usually less interested in imposing its substantive notions of fairness on agreements between willing participants: It's typically an enforcer of disclosure obligations, not fiduciary obligations. But in the world of private equity, where limited partners have a long history of not noticing fees and then complaining bitterly once they figure them out, the SEC has started to fight the investors' battles for them.  Sneaky fees will always be one step ahead of disclosure requirements, or at least of investors' attention spans. So rather than trying to make private equity documents clearer, the SEC is just reading them on behalf of investors, and fixing the things that it finds unfair. It's a bit of a departure for the SEC, but I suppose someone had to check on private equity fees, and it wasn't going to be investors.

  1. More or less -- the common approach seems to be that the investors get the majority of the management, monitoring, deal, etc., fees (say 80 percent) and the private equity firm gets the minority (20 percent).

  2. Technically it does this billing by reducing the amount of other company fees it shares with its investors, so the investors bear 80 percent of the costs:

    KKR is reimbursed for broken deal expenses through fee sharing arrangements with its funds. Consistent with other LPAs during the relevant period, pursuant to the 2006 Fund LPA and the accompanying Management Agreement between KKR and the 2006 Fund, KKR shared a portion of its monitoring, transaction and breakup fees with the 2006 Fund. More specifically, KKR reduced its management fee by 80% of the 2006 Fund’s proportional share of those fees after deducting broken deal expenses. Accordingly, KKR received 20% of those fees, and economically bore 20% of broken deal expenses. The 2006 Fund in turn received 80% of those fees, and economically bore 80% of the broken deal expenses.

  3. This counts KKR's dedicated co-investment vehicles (for investors, KKR executives, the publicly traded partnership, its own balance sheet, etc.), but not investments syndicated directly to limited partners and other investors outside of the vehicles. (See paragraphs 14-15 of the SEC order.)

  4. The disgorgement math is:

    • $17,421,168 of broken deal expenses that the funds shouldn't have paid;
    • minus $3,255,200 that KKR already paid back to the funds in 2014;
    • plus $4,511,441 of interest.

  5. Err, 80 percent of them, due to the crediting mechanism; see footnote 2.

  6. Math is:

    • The funds invested $30.2 billion and the co-investors $4.6 billion over the relevant period; $4.6 billion is 13.2 percent of the $34.8 billion total.
    • KKR had $338 million in broken deal fees over that time, of which KKR paid 80 percent and the funds paid 20 percent.
    • "The $17.4 million represents the sum total of $22.5 million in broken deal expenses for the relevant period as calculated based on a methodology consistent with KKR’s post-2012 allocation methodology less the portion of those expenses borne by KKR pursuant to its fee sharing arrangements with the applicable funds." 
    • So $22.5 million divided by $338 million is 6.7 percent. Alternative math -- divide $17.4 million by (80 percent of $338 million) -- gets you 6.4 percent, so close enough.

    All of this ignores syndicated co-investors who invested directly in specific KKR deals rather than through dedicated KKR vehicles; see footnote 3. And part of the reason that KKR's vehicles for its own executives didn't pay broken-deal expenses is that "during the relevant period, these vehicles did not receive a share of monitoring, transaction or break-up fees," which (for the regular funds) were netted against the broken-deal costs. It's not clear what the fair way to treat either of those situations is. The SEC says that "The new allocation methodology is not a subject of this Order." 

  7. He also says: "Frequently, operational expenses, broken deal expenses, and even the formation expenses of the side-by-side vehicle are borne by investors in the main fund," which is pretty brazen.

  8. Consider its case against Patriarch Partners for mis-marking some investments. Jonathan Macey says: "The SEC alleges that Patriarch committed fraud. In reality, though, the case rests merely on allegations of violation of contract." That ... strikes me as sort of correct? But the SEC's theory seems to be that it would be hard for investors to figure out the contract violation, so the SEC will step in and do it for them, and call it "fraud."

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net