Even thought the Biden Administration is rife with cronies and incompetents in important positions (Kamala Harris, Anthony Blinken, Javier Becerra, Pete Buttigieg…the mind boggles), Gary Gensler is showing what a capable and determined agency leader can do, even at a considerably weakened body like the SEC. As we’ll discuss, the SEC just published a simply brutal and badly needed set of proposed private equity disclosure requirements.

Even though these pending rules are subject to a 60 day public comments period, the SEC made its bloody-mindedness very clear. On a fast reading of the part of the rules that sets up the public comment, every one of the many questions I read where the SEC solicited further input were of the form: “Or should we twist the zip ties tighter by also requiring Y and Z?”

Gensler had indicated in a speech last November that he saw the SEC’s private equity oversight, established in Dodd Frank, as in bad need of improvement. As we wrote:

Gensler stated that he’s already tasked SEC staff to look into what we have described for years as a central abuse in private equity: that investors have no clue as to the total fees they are paying because private equity fund managers hoover all sorts of charges directly out of the portfolio companies in the funds. And they don’t even pretend these fees are for services rendered…

Gensler almost cutely asks whether fund managers know enough about their private equity fees, as if this question is even remotely in doubt. He then drives the knife in:

Together, those fees might add up to 3-4 percent in private equity and 2-3 percent per year in hedge funds…

That may not even be counting other fees that private funds collect from limited partners and portfolio companies. These can include consulting fees, advisory fees, monitoring fees, servicing fees, transaction fees, director’s fees, and others….

Hundreds of billions of dollars in fees and expenses are standing between investors and businesses…

Then Gensler reveals that he’s much more plugged in than his “aw shucks” setup reveled. He next goes after side letters….Without going into sordid details in his talk, Gensler makes clear he is not keen about side letters that lead to some investors getting a better financial deal than others…

That’s benign compared to what comes next. Gensler doesn’t like that investors have to rely on performance figures prepared by the general partners, who aren’t held to any standard as to how they run the numbers.

We saw this speech as a very hopeful sign that Gensler and the SEC were serious. But the the draft SEC rule is vastly more comprehensive and well thought out than we dared hope. We’ve embedded it at the bottom of this post. You can a good idea of its scope and careful crafting if you read the opening narrative, on pages 7-28. It gives an overview of the deficiencies that it seeks to address, the thrust of the rules, and additional questions about whether they should be “improved” in various ways, as in made more stringent.

In a matter of fact, understated manner, the SEC document makes clear that its enforcement regime has not succeeded in getting private equity fund managers to stop or at least considerably reduce their abuses. Recall that in 2014, then enforcement chief Andrew Bowden gave a peculiarly titled speech, Spreading Sunshine in Private Equity. The SEC has just started its initial examinations of private equity firms. Bowden said that the SEC had found serious abuses in more than half of the firms examines, including what in other circles would be called embezzlement. Bowden also said if anything the misconduct was more prevalent at the biggest firms, which was the reverse of what it found in other areas it regulated, where the crooked operators were normally boiler-room level.

This promising start quickly fizzled out. Yes, the SEC did engage in a series of enforcements actions, targeting common abuses like charging “termination of monitoring fees” which had never been contemplated in the fund agreements, and hauling up big name firms like Apollo, KKR, and Blackstone. However, this amounted to enforcement theater. The SEC acted as if “one and done,” citing particular firms for an isolated abuse, when all the big players were certain to have engaged in many others, and then acting as if everyone would shape up, was either craven or willfully blind. Bowden immediately turned to giving speeches on how private equity firms were obviously upstanding and wanted to do right. He then gave a speech at Stanford at a private equity conference where went on far too long about how he wanted his son to work in private equity and an audience member immediately said he wanted to hire him. Bowden left the agency in three weeks.

This SEC letter, by contrast, makes clear that the agency has ample evidence in its files of continued abuses by private equity fund managers. It does not mention a particularly egregious general strategy: of admitting in the annual disclosure documents, the Form ADV, that the private equity fund managers are violating their contracts with investors. Admitting a contractual violation does not cure it, but the private equity barons appear to believe they can create their own alternative reality. And until Gensler showed up, that belief looked to be correct.

That context will hopefully enable readers to appreciate the seriousness of some of the SEC’s findings:

The Commission also has pursued enforcement actions against private fund advisers for practices that have caused private funds to pay more in fees and expenses than they should have, which negatively affected returns for private fund investors, or resulted in investors not being informed of relevant conflicts of interest concerning the private fund adviser and the fund. Despite our examination and enforcement efforts, these activities persist….

This lack of transparency regarding costs, performance, and preferential terms causes an information imbalance between advisers and private fund investors, which, in many cases, prevents private bilateral negotiations from effectively remedying shortcomings in the private funds market. We believe that this imbalance serves only the adviser’s interest…

We also have continued to observe instances of advisers acting on conflicts of interest that are not transparent to investors, provide substantial financial benefits to the adviser, and potentially have significant negative impacts on the private fund’s returns…In addition, private funds typically lack governance mechanisms that would help check overreaching by private fund advisers….

As you can see, the proposals and the nitty gritty of both the suggested rule themselves and the many many issues where the SEC is soliciting input are extensive. And the amusing part is that the SEC is planning to hoist the industry on a transparency petard. It’s going to be hard to see the private equity industry try to come up with rationales for not giving information that any private businessman investing his own money would demand, like an explanation of how his money was spent, whether he hired any relatives or college buddies and what his deal with them was, and detailed performance accounting. In fact, the private equity industry runs a risk if they try to make too much of a stink that the great unwashed public may realize that lots of government pension dollars are going into investments with dreadful accounting and lots of grifting and self dealing.

And how can the industry claim harm when these additional disclosures will be made only to investors and the SEC? Saying it will hurt them is tantamount to admitting they don’t want the full scale of their cheating exposed.

The SEC is prepared to hear the usual whining about how this will all cost to much. But they’ve asked for data and concrete examples. And given the grotesque profitability of the private equity industry, it will be hard for them to try to poor mouth.

Another factor in the SEC’s favor, as they allude to in the letter, is that investors have been asking for more disclosure for years and made no progress. A group of thirteen major trustees many years back wrote the SEC asking for it to assist them with getting more information about fees and costs. The toothless and captured Institutional Limited Partners Association has proposed a fee disclosure template which has gone nowhere. Industry benchmarking firm CEM pointed out that at least half of the private equity fees and costs were not disclosed, and investors that kept dogging the general partner did get some more, but far from comprehensive, additional detail.

The tone of the proposed new rules is very firm on matters like disclosing portfolio-company level fees, forbidding fees for services not rendered, reporting on compensation to affiliates (broadly defined, but here I think the SEC should go even wider and pick up family members of principals and officers) and disclosing the breaks that other fund investors get in side letters.

The SEC is also calling for extensive changes in fund reporting: quarterly disclosure, as discussed above, of detailed fees and costs, including all those tricky portfolio company fees. The agency also wants to stop fund managers from shifting costs more onto some funds than other and crack down on fiduciary duty waivers.

Yet another major push is to standardize performance reporting so that investors can compare funds on an apples to apples basis. Some of the requirements may seem basic yet are essential, such as mandating computation of returns from inception and requiring them to be reported without the use of fund-level borrowing, aka subscription lines of credit, which occurs in addition to borrowing at the portfolio company level. Before and after reporting will also give investors an idea of the magnitude of fund-level borrowing, which is hidden from them now.

This section gives an example of the sort of basic information investors often don’t get now:

The proposed rule also would require an adviser to provide a statement of contributions and distributions for the illiquid fund. We believe this would provide private fund investors with important information regarding the fund’s performance because it would reflect the underlying data used by the adviser to generate the fund’s returns, which, in many cases, is not currently provided to private fund investors. Such data would allow investors to diligence the various performance measures presented in the quarterly statement.

And some activities will be barred. From the SEC’s press release:

The proposals also would prohibit all private fund advisers from engaging in several activities, including seeking reimbursement, indemnification, exculpation, or limitation of liability for certain activity; charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services and fees associated with an examination or investigation of the adviser; reducing the amount of an adviser clawback by the amount of certain taxes; charging fees or expenses related to a portfolio investment on a non-pro rata basis; and borrowing or receiving an extension of credit from a private fund client.

And this reform will produce a final side benefit. One of the big problems with private equity investing as practiced now is that the staffers at places like CalPERS engage in a substantial amount of pretend work, in the form of due diligence and oversight theatrics. With grossly inadequate disclosure, too much of the inspection and supervision winds up being meeting with private equity masters of the universe, being on the receiving end of their storytelling and evasion, and going on junkets in the form of investor-paid trips to glamorous destinations where they eat lavish meals and get top tier entertainment (Elton John was a recent example).

Now, with all this data, being on the private equity team will entail real work, as in going through all this new data and reviewing it on a comparative basis. Even if the limited partners fob a lot of the analysis off on third parties, they’ll still need to review the findings and make decisions based on them and not their delusion that they can assess the character of these sociopaths. This new data heavy lifting, and more detail about actual costs and returns might finally take some of the fake glamour out of private equity.

Finally, if you live in California, New York, Vermont, Pennsylvania, Virginia, Rhode Island, North Carolina, South Carolina, Missouri, Wyoming, or the District of Columbia, please look at the 2015 letter embedded in this post from senior pension trustees in your state or city. It lists their titles so it should be easy to find who the current office holder is and how to contact him.

Even with the incumbents in these offices changing, their pension fund duties have not. I strongly urge you e-mail the current office holder. The message should call their attention to how their predecessor was deeply concerned about how the SEC had found widespread misconduct in private equity and they lacked the information to do much about it themselves. They had joined with other prominent government pension trustees to ask the SEC for more disclosure. The SEC has now launched a major initiative to do just that. Ask them to show they back this initiative, at the very least by writing the SEC to express formal support. They can e-mail [email protected]. Advise them to put “File Number S7-03-22 ” in the subject line.

We have found in the past that state officials normal consider private equity to be so far removed from the concerns of voters that a surprisingly small number of letters gets their attention. So writing will make a difference.

And NC readers can also write the SEC. Even if it is a simple note to the effect, “The technical details are beyond my ken, but it’s clear the SEC’s initial private equity oversight didn’t go far enough, so it’s gratifying to see the agency take this important matter up again with such an detailed and apparently very carefully thought out set of rule changes.” Even if you can’t say much more than that, articulate “atta boys” will help.

And thanks again!

00 Proposed SEC Private Fund rule February 2022