SEC Finds That Blackstone Charged Too Many Fees
Today the Blackstone Group agreed to pay $39 million to settle a Securities and Exchange Commission case charging that it ripped off investors over "monitoring fees"; $29 million of the settlement will go to the investors. It is a strange case: When you read in the SEC order about what Blackstone did, it does sound a bit like a rip-off, albeit a common one. But then when you read about what Blackstone disclosed -- basically, everything -- it is harder to figure out why the SEC is involved.
The Blackstone-advised private equity funds would buy companies, and then Blackstone would charge those companies "an annual fee in exchange for rendering certain consulting and advisory services to the portfolio company concerning its financial and business affairs." That monitoring fee would be paid to Blackstone (the company, i.e. in large part its managers and employees) rather than to the fund (i.e. to Blackstone's investors), though in effect half of it would go to the investors in the form of reduced management fees. So the fee created a conflict of interest: Every dollar paid to Blackstone would reduce the value of the portfolio company by a dollar, but would increase Blackstone's own revenue by about 50 cents.
But, you know, such is life. The root of the conflict is that Blackstone is both advising the private equity funds (and charging fees for finding them good investments and making them more profitable), and helping to manage the portfolio companies (and charging fees for consulting and advising). Those two jobs are conceptually distinguishable, and have some synergies, and in theory it is not at all crazy for Blackstone to do both of them, or to charge separate fees. Your model could be that Blackstone thought carefully about the value of the services it provided to the funds, and charged them for that value, and then thought carefully about the value of the services it provided to the companies, and charged them for that value. Even though ultimately the funds own the companies and all the money comes out of the fund investors' pockets.
The alternative model is that Blackstone just thought of as many fees as it could think of, and then charged them to whoever would pay them, without sweating too much how exactly it was earning those fees. That model gets some support from the SEC order. Here is what got Blackstone in trouble:
Prior to 2012, Blackstone monitoring agreements commonly provided for ten years of monitoring services and fees. Some of these agreements contained so-called “evergreen” provisions that automatically extended the life of the agreement for an additional term. The monitoring agreements between Blackstone and the portfolio companies also provided for acceleration of monitoring fees to be triggered by certain events. For example, upon either the private sale or IPO of a portfolio company, the monitoring agreements allowed Blackstone to terminate the monitoring agreement and accelerate the remaining years of monitoring fees, in some cases including additional renewal periods, and receive present value lump sum “termination payments.”
If you get paid the monitoring fees for years after you stop monitoring the company, and in a lump sum as soon as you stop, they don't look like actual fees for services. They look more like just another way to extract money from the company without anyone noticing.
Except that they weren't a way to extract money without anyone noticing, because Blackstone disclosed them copiously. As the SEC helpfully says in the order:
While Blackstone disclosed its ability to collect monitoring fees to the Funds and to the Funds’ limited partners prior to their commitment of capital, it did not disclose to the Funds, the Funds’ LPAC, or the Funds’ limited partners its practice of accelerating monitoring fees until after Blackstone had taken accelerated fees. The disclosures were made in distribution notices, quarterly management fee reports, and, in the case of IPOs, Form S-1 filings. By the time these disclosures were made, the limited partners had already committed capital to the Funds and the accelerated fees had already been paid. The LPAC of each Fund could have objected and arbitrated over the accelerated monitoring fees after they had been taken, but never did.
The LPAC is the Limited Partnership Advisory Committee, a group of limited partners that was supposed to review potential conflicts of interest. Blackstone told its investors that it was taking these fees -- after they'd signed up for the funds, sure -- and the investors never objected. They never objected because this was just how private equity operated. As Blackstone's Peter Rose explains:
This SEC matter arose from the absence of express disclosure in marketing documents, ten or more years ago, about the possible acceleration of monitoring fees, a common industry practice. Each accelerated fee was, however, as the SEC order acknowledges, disclosed when received and our Limited Partner Advisory Committee did not exercise its right to object.
I have to say, when you put it like that, it doesn't really sound bad at all? Obviously the marketing documents for a fund cannot explicitly disclose everything that Blackstone will ever do over the life of that fund. The point is to lay out some basic principles, to clearly disclose what Blackstone does when it does it and to have a way of resolving disputes that investors feel is fair. And that pretty much happened.
So what is going on here? The SEC seems to think that Blackstone failed to follow its fiduciary duties to its investors. It had a conflict of interest with them, and it charged them fees that it shouldn't have charged them, hoping that they wouldn't object. This is not a crazy theory at all: Sitting here in 2015, those fees do sound kind of bad! On the other hand it's not a slam-dunk either: Blackstone's own limited partners didn't think there was anything objectionable about the fees, and they were "a common industry practice."
But the thing is that the SEC is not really in charge of preventing conflicts of interest at private equity managers. You can tell from the "Violations" section of the SEC's order, which never mentions conflicts of interest or fiduciary duties or excessive fees. Instead it is about deception: It accuses Blackstone of engaging in a "transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client," and of making an "untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading, to any investor or prospective investor in the pooled investment vehicle." Those charges seem plainly wrong: The fees were disclosed repeatedly, and there is no real claim that any investors were deceived.
In June, the SEC settled another private-equity fee case with KKR, over the allocation of broken-deal expenses. That case was a bit like this one, in that KKR's disclosure actually seemed to have been accurate, but the SEC just thought that the fees were unfair. I cut the SEC some slack, though:
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.
That just doesn't seem to be true of this case. Blackstone did explain the monitoring fee acceleration to its investors, more or less clearly, when it accelerated those fees, and the investors did not tell Blackstone to knock it off. They were fine with it.
The subtext here is that they shouldn't have been. And that is, to be fair, a popular view. There is a widespread sense that private equity fees are too high and complex and rapacious, and that private equity limited partners -- many of them public pension funds -- do not do enough to monitor them. So Dan Primack has criticized Calpers for saying that "it doesn’t know the amount of profit-sharing fees it has paid to private equity managers," Scott Stringer has criticized New York City's pensions for overpaying for private equity, and Yves Smith has criticized limited partners for not demanding more information from their private equity managers. There is a sense that someone needs to step in and save private equity investors from themselves, and there is a sense at the SEC that it should be the regulator to do it. When we discussed the KKR case, I quoted this speech by Marc Wyatt of the SEC's Office of Compliance Inspections and Examinations, in which Wyatt said that "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." Again: Fee legitimacy is not a traditional core concern of the SEC.
As far as I can tell, this is a story of changing norms for private equity. Once upon a time, private equity was a sexy asset class that charged silly fees that were not subject to too much scrutiny by investors. (It was also a very well lawyered asset class that disclosed those fees reasonably clearly.) But as returns have gotten less exciting, and as outside observers have called on public pension funds to pay more attention to what they pay for investing advice, limited partners have realized that some of the fees they paid to private equity firms were pretty silly. One response has been to stop paying those fees: Even before this SEC case, Blackstone got more conservative about accelerating monitoring fees, presumably because that's what investors wanted. But another response has been for investors to regret that they ever paid the fees in the first place, and to attribute that regret not to their own failure to care but to the private equity firms' failure to disclose. There's an obvious emotional appeal to that result -- it's much better to blame sophisticated Wall Street fat cats for overcharging than to blame public pension managers for overpaying -- even though it doesn't quite fit the facts.
Okay, no look it's "three private equity fund advisers within The Blackstone Group," specifically Blackstone Management Partners L.L.C., Blackstone Management Partners III L.L.C., and Blackstone Management Partners IV L.L.C. But we can just say Blackstone.
There is also stuff about legal fees: Basically, a law firm charged Blackstone lower fees than it charged the funds. Really nobody cared about this at all; the SEC says:
In early 2011, Blackstone voluntarily ended its disparate legal fee arrangement with the Law Firm. In 2012, Blackstone disclosed to all limited partners, without any resulting complaints, that historical discounts offered to Blackstone exceeded discounts provided to the Funds.
The SEC doesn't say which law firm it was, and honestly the law firm should maybe have advised Blackstone that this wasn't the greatest idea?
From the order:
The monitoring fees paid by each fund-owned portfolio company to Blackstone are in addition to the annual management fee paid by the Funds’ limited partners to Blackstone. However, a certain percentage of the monitoring fees the portfolio companies pay to Blackstone are used to offset a portion of the annual management fees that the Funds’ limited partners would otherwise pay to Blackstone. The offset percentage, which was 50 percent for BCP III and is also 50 percent for BCP IV and BCP V, is set forth in each fund’s LPA or investment advisory agreement.
Really less, because it would in theory reduce Blackstone's management and performance fees. Similarly a dollar of monitoring fee is worth about 50 cents to investors, but reduces the value of their company by a dollar, meaning that its net effect is about negative 50 cents.
I have written sympathetically about this desire before:
I think you have to start with the fact that there was once a norm that private equity firms got to keep their doing-stuff-to-companies fees -- monitoring fees, consulting fees, whatever -- for themselves. That's not a crazy norm. Those are fees for work! The private equity firms do the work of monitoring or consulting or whatever. The limited partners don't do that. The LPs provide capital, and the reward for their capital is the profits when the business is sold. The reward for doing the work of supervising the business should go to the people who supervise the business.
My bias comes from the fact that I used to be an investment banker, which is all about doing tons of work for no fees, so I sort of root for the PE guys to charge lots of fees for their work.
To be fair, the SEC says, "In connection with most IPOs, Blackstone continued to provide consultancy and advisory services to the publicly traded portfolio company until the fund completely exited its investment," so it was providing some (unpaid?) services even after it accelerated the fees. So maybe the fees were rough justice. But "in a few instances, Blackstone accelerated monitoring fees beyond the period of time during which it held an investment in the company."
Who is? Well, the investors, who are supposed to sue in state court for breaches of fiduciary duty. The SEC is supposed to make sure the investors have enough information to know they're getting ripped off.
Consider this April case against BlackRock, which starts out sounding like it's about conflicts of interest, but which ends up really being about disclosure:
“BlackRock violated its fiduciary obligation to eliminate the conflict of interest created by Rice’s outside business activity or otherwise disclose it to BlackRock’s fund boards and advisory clients,” said Andrew J. Ceresney, Director of the SEC’s Division of Enforcement. “By failing to make such a disclosure, BlackRock deprived its clients of their right to exercise their independent judgment to determine whether the conflict might impact portfolio management decisions.”
There are also some other redundant charges, like the law making it illegal to "engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle," and the one about having written policies to prevent violations.
In fact, since the conduct at issue here, that disclosure has gotten clearer, still without the investors telling Blackstone to knock it off. From the SEC order:
In 2012, Blackstone enhanced the disclosures it makes after taking accelerated monitoring payments by explicitly identifying termination payments in reports distributed to limited partners and setting forth in detail the assumptions underlying the calculation of such payments.
To be fair, in 2014 Blackstone did change its practices to "not accelerate more than three years (equal to the approximate average post-IPO length of time before Blackstone has made full exits) of remaining monitoring fee payments in the event of an IPO." Perhaps (probably) that was in response to investors telling it to knock it off. But it took two years, which I read as a story of changing norms, not a story of shocked rejection as soon as they learned what was going on.
See the previous footnote.
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