Private Equity Firm Threatens To Shut Out Iowa Pension Over FOIA Request

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Over at Naked Capitalism, Yves Smith has penned a long post expounding on the practice of private equity firms dissuading public pension funds from complying with FOIA requests related to investment data – often with the threat of shutting out pension funds from future investment opportunities.

The post stems from yesterday’s Wall Street Journal report covering the same topic.

Here’s the Naked Capitalism post in full:

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By Yves Smith

A new story on private equity secrecy by Mark Maremont at the Wall Street Journal started out with a bombshell, that of private equity industry kingpin KKR muscling a public pension fund to deny information requests about KKR’s practices:

KKR & Co. warned Iowa’s public pension fund against complying with a public-records request for information about fees it paid the buyout firm, saying that doing so risked it being barred from future private-equity investments.

In an Oct. 28 letter to the Iowa Public Employees’ Retirement System, KKR General Counsel David Sorkin said the data was confidential and exempt from disclosure under Iowa’s open-records law. Releasing it could cause “competitive harm” to KKR, the letter said, and could prompt private-equity fund managers to bar entree to future deals and “jeopardize [the pension fund’s] access to attractive investment opportunities.”

The article also demonstrated, as we’ve pointed out earlier, than many investors are so cowed that they don’t need to be on the receiving end of overt threats:

Once public pension funds start releasing detailed information in response to public-records requests, “that’s the moment we’re done,” said Linda Calnan, interim chief investment officer of the Houston Firefighters’ Relief and Retirement Fund. “These are sensitive documents that managers don’t want out there.”

This risk, that private equity funds might exclude public pension funds that the general partners deemed to be insufficiently zealous in defending their information lockdown, has long been the excuse served up public pension funds for going along with these secrecy demands. As we demonstrated in May, the notion that the information that the funds are keeping hidden rises to the level of being a trade secret or causing competitive harm is ludicrous. We based that conclusion on a review of a dozen limited partnership agreements, the documents that the industry is most desperate to keep under lock and key.

But the only known instance of that sort of redlining actually taking place, as the Journal notes, took place in 2003 after CalPERS said it would start publishing limited data on financial returns as a result of a settlement of a Public Records Act (California-speak for FOIA) lawsuit. As we wrote in April:

Two venture capital firms, Sequoia and Kleiner Perkins, had a hissy fit and refused to let funds that would disclose their return data invest in them. Now this is of course terribly dramatic and has given some grist to the public pension funds’ paranoia that they’d be shut out of investments if they get too uppity. But the fact is that public pension funds overall aren’t big venture capital investors. And people in the industry argue that there was a obvious self-serving motive for Sequoia to hide its returns. Sequoia has launched a number of foreign funds, and many are believed not to have performed well. Why would you invest in Sequoia’s, say, third India fund if you could see that funds one and two were dogs?

So why has industry leader KKR stooped to issue an explicit, thuggish threat? Why are they so threatened as to cudgel an Iowa pension fund into cooperating with KKR and heavily redacting the response? Just as with the Sequoia and Kleiner Perkins case, it’s naked, and not at all defensible self interest.

Law firm Ropes & Gray, which counts Bain Capital among its clients, issued what amounted to an alarm to its private equity and “alternative investment” clients over an increase in inquiries to public pension funds about the very subject that the SEC had warned about in May, about fee and expense abuses, as well as other serious compliance failures. It’s a not-well-kept-secret that many investors were correctly upset about the SEC’s warnings, and some lodged written inquires with general partners as to what specifically was going on. We’ve embedded an unredacted example of one such letter at end of this post. It was the same one that CalPERS board member JJ Jelincic used to question investment consultants last month because the letter ‘fessed up to an abusive practice called evergreen fees.

Journalists like Maremont and interested members of the public have written public pension funds to obtain the general partners’ responses to these questionnaires. And this is a matter of public interest, since shortfalls in private equity funds, even minor grifting, is ultimately stealing from beneficiaries, and if the pension fund is underfunded, from taxpayers. Yet notice how Ropes & Gray depicts questions about what are ultimately taxpayer exposures as pesky and unwarranted intrusions:

We have recently observed a surge in freedom-of-information (“FOIA”) requests made by media outlets to state pension funds and other state-government-affiliated investment entities. Although the requests have so far concentrated on information related to private equity sponsors, they have also sought information about investments with other alternative investment fund sponsors. The requests tend to focus on information about advisers’ treatment of fees and expenses, issues raised as areas of SEC interest in a speech by an SEC official earlier this year. The requests may also ask for information concerning recent SEC examinations of fund managers. Many state-level FOIA laws exempt confidential business information, including private equity or other alternative investment fund information in particular, from disclosure. Nonetheless, record-keepers at state investment entities may reflexively assume that all information requested should be disclosed. But a prompt response, supported by the applicable state law, can help ensure that confidential information that is exempt from FOIA disclosure is in fact not released.

The sleight of hand here, which we’ve discussed longer-form, that merely asserting that something is confidential does not exempt it from disclosure. In fact, if you look at the examples from selected states that Ropes & Gray cites in its missive, states have tended to shield certain specific types of private equity information from disclosure, including limited partnership agreements and detailed fund performance information, but generally restrict other disclosures not on the basis of mere confidentiality but on trade secrecy or similar competitive harm, meaning the private equity firm’s competitors might learn something about the fund’s secret sauce if they obtained that information.

Please look at the first letter at the end of this post and tell me what if anything in it is so valuable that competitors might seek to copy it. Contrast that with a second letter from a Florida pension fund, from KKR that the Journal obtained and see how much is blacked out.

The fact is that the various FOIAs focused on getting at SEC abuses aren’t about protecting valuable industry intelligence, to the extent there really is any in any of their documents; it’s simply to hide their dirty laundry. The Wall Street Journal story reports how in Washington, Florida, and North Carolina, public pension fund officials have been acceding to private equity fund “concerns” and using strategies ranging from foot-dragging to woefully incomplete disclosure to outright denial to stymie inquiries.

The interesting thing about KKR’s exposure is that its defensiveness is likely due to how much scrutiny it is getting from the SEC. Maremont earlier exposed how KKR’s captive consulting firm KKR Capstone appeared to be charging undisclosed, hence impermissible fees to KKR funds. KKR has attempted to defend the practice by arguing that KKR Capstone isn’t an affiliate. We debunked that argument here.

Even though we have criticized the SEC for its apparent inaction on the private equity front, in terms of following through with Wells notices after describing widespread private equity industry malfeasance, we have been told that the agency is in the process of building some major cases against private equity firms. Given how many times KKR’s name has come up in Wall Street Journal, New York Times, and Financial Times stories on dubious private equity industry practices, one has to imagine that KKR would be a likely target for any action that the SEC would consider to be “major”.

This is an area where readers can make a difference. The one thing public pension funds, even one like CalPERS, are afraid of is their state legislature. Call or e-mail your state representatives. If you have the time and energy, also write to the editor of your local paper and the producers of your local television station. Tell them you’ve read in the New York Times and the Wall Street Journal (and if you are in California, the Sacramento Bee) about public pension funds refusing to provide information to members of the public about fees as well as widespread abuses that the SEC discussed at length in a speech this year. Tell them that the SEC has made it clear that private equity can’t be treated on a “trust me” basis any more. The time has come for more pressure on public pension funds to weight the public interest more strongly in dealing with these inquiries, and if needed, new legislation to force more accountability from private equity funds and their government investors.

CalPERS Board Asks Private Equity Consultants: Are “Investors Having Their Pockets Picked” By Evergreen Fees?

http://youtu.be/gn7XSqZZanU

Over at Naked Capitalism, Yves Smith has posted an extensive analysis of the October 13th meeting of CalPERS’ investment committee.

At the meeting, the committee heard presentations from three consultants: Albourne America, Meketa Investment Group, Pension Consulting Alliance.

The meeting gets interesting when one committee member asks the consultants about “evergreen fees”.

[The exchange begins at the 34:30 mark in the above video].

From Naked Capitalism:

The board is presented with three candidates screened by CalPERS staff. Two, Meketa Investment Group and Pension Consulting Alliance, are established CalPERS advisors. There’s one newbie candidate, Albourne America. Each contender makes a presentation and then the board gets a grand total of 20 minutes for questions and answers for each of them. This isn’t a format for getting serious.

To make a bad situation worse, most of the questions were at best softballs. For instance, Dana Hollinger asked what the consultants thought about the level of risk CalPERS was taking in private equity program. Priya Mathur asked if the advisors could do an adequate job evaluating foreign managers with no foreign offices. Michael Bilbrey asked how the consultants kept from overreacting to positive or negative market conditions.

One board member, however, did manage to put the consultants on the spot. The answers were revealing, and not in a good way. The question came from J.J. Jelincic, where he asks about a particular type of abusive fee, an evergreen fee.

Evergreen fees occur when the general partner makes its portfolio companies, who are in no position to say no, sign consulting agreements that require the companies to pay fees to the general partners. It’s bad enough that those consulting fees, which in industry parlance are called monitoring fees, seldom bear any resemblance to services actually rendered. Over the years, limited partners have wised up a bit and now require a big portion of those fees, typically 80%, to be rebated against the management fees charged by the general partners.

So where do these evergreen fees come in? Gretchen Morgenson flagged an example of this practice in a May article. The general partner makes the hapless portfolio company sign a consulting agreement, say for ten or twelve years. The company is sold out of the fund before that. But the fees continue to be paid to the general partner after the exit. Clearly, the purchase price, and hence the proceeds to the fund, will have been reduced by the amount of those ongoing fees, to the detriment of the fund’s investors. And with the company no longer in the fund, it is almost certain to be no longer subject to the fee rebates to the limited partners.

[…]

Jelincic describes the how the response said that the fees are shared only if the fund has not fully exited its investment in the portfolio company. Jelincic asks if that’s an example of an evergreen fee, and if so, what CalPERS should do about it.

Naked Capitalism on the consultants’ responses:

The response from Albourne is superficially the best, but substantively is actually the most troubling. The first consultant responds enthusiastically, stating that CalPERS is in position to stop this sort of practice by virtue of having a “big stick” as the SEC does. He says that other funds aren’t able to contest these practices.

The disturbing part is where he claims his firm was aware of these practices years ago by virtue of doing what they call back office audits. That sounds implausible, since the rights of the limited partners to examine books and records extends only to the fund itself not to the general partner or the portfolio companies (mind you, some smaller or newer funds might consent). But the flow of the fees and expenses that the limited partners don’t know about go directly from the portfolio company to the general partner and do not pass through the fund. How does Albourne have any right to see that?

But if they somehow really did have that information, the implication is even worse. It means they were complicit in the general partners’ abuses. If they really did know this sort of thing and remained silent, whose interest were they serving? It looks as if they violated their fiduciary duty to their clients.

The younger Albourne staffer claimed a lot of the fees were disclosed in footnotes and that most limited partners have been too thinly staffed or inattentive to catch them. That amounts to a defense of the general partners and if Albourne really did know about these fees, Albourne’s inaction.

However, The SEC doesn’t agree with that view and they have the right to do much deeper probes than Albourne does. From SEC exam chief Drew Bowden’s May speech:

[A]dvisers bill their funds separately for various back-office functions that have traditionally been included as a service provided in exchange for the management fee, including compliance, legal, and accounting — without proper disclosure that these costs are being shifted to investors.

For these fees to be properly disclosed, they had to have been set forth in the limited partnership agreement or the subscription docs for the limited partners, meaning before the investment was made, to have gotten proper notice. Go look at any of the dozen limited partnership agreements we have published. You don’t see footnotes, much the less other nitty gritty disclosure of exactly who pays for what. Not very clear disclosures after the limited partners are committed to the funds, to the extent some general partners provide them, do not constitute proper notice and consent.

Meketa was clearly not prepared to field Jelincic’s question and waffled. They effectively said they thought the fees were generally permissible but more transparency was needed. They threw it back on CalPERS to be more aggressive, particularly on customized accounts, and urged them work with other large limited partners.

Pension Consulting Alliance was a tad less deer-in-the-headlights than Meketa but in terms of substance, like Albourne, made some damning remarks. The consultant acted if evergreen fees might be offset, which simply suggests he is ignorant of the nature of this ruse. He said general partners are looking to do something about it, implying they were intending to get rid of them, but said compliance was inconsistent. Huh? If the funds intend to stop the practice, why is compliance an issue? This is simply incoherent, unless you recognize that what he is actually describing is unresolved wrangling, not any sort of agreement between limited and general partners that charge these fees on this matter. He also said he would recommend against being in funds that have evergreen fees. But there was no evidence he had planned to be inquisitive about them before the question was asked.

You’ll notice that all of the answers treat the only outcome as having CalPERS, perhaps in concert with other investors, be more bloody-minded about evergreen and other dubious fees. You’ll notice no one said, “Yes, you should tell the SEC this stinks. You were duped. You should encourage the SEC to fine general partners who engaged in this practice and encourage the SEC to have those fees disgorged. That would to put an end to this. Better yet, tell the general partners you’ll do that if they don’t stop charging those fees and make restitution to you. That’s the fastest way to put a stop to this and get the most for your beneficiaries.” Two of the three respondents said CalPERS is in a position to play hardball, so why not take that point of view to its logical conclusion?

But this is what passes for best-of-breed due diligence and supervision in public pension land. Imagine what goes on at, say, a municipal pension fund.

Read the entire Naked Capitalism post, which features more analysis, here.