SEC Official Describes Widespread Lawbreaking and Material Weakness in Controls in Private Equity Industry
At a private equity conference this week, Drew Bowden, a senior SEC official, told private equity fund managers and their investors in considerable detail about how the agency had found widespread stealing and other serious infractions in its audits of private equity firms.
In the years that I’ve been reading speeches from regulators, I’ve never seen anything remotely like Bowden’s talk. I’ve embedded it at the end of this post and strongly encourage you to read it in full.
Despite the at times disconcertingly polite tone, the SEC has now announced that more than 50 percent of private equity firms it has audited have engaged in serious infractions of securities laws.
These abuses were detected thanks to to Dodd Frank. Private equity general partners had been unregulated until early 2012, when they were required to SEC regulation as investment advisers.
Bowden heads the SEC’s examinations unit, and his rap sheet was based on his two years of experience in auditing private equity firms. As bad as embezzlement and other sharp practices are, at least as troubling is the revelation that the limited partners have been derelict in their duties. They’ve agreed to terms in their relationship with the general partners to make it easy for the general partners to abuse the investors. The general partners can steal from their limited partners because the limited partners are asleep. The LPs have failed to negotiate for contractual protections when they have the most leverage, prior to investing, and they’ve been unwilling or unable to monitor their investments effectively once they’ve handed over their money. Note that the industry was warned about this possible outcome; it corresponds to the worst scenario, ” A Broken Industry,” in a 2011 paper by Harvard Business School professor Josh Lerner.
Bowden pointed out that private equity is unique among the investment advisers the SEC supervises. The general partners’ control of portfolio companies gives them access to their cash flows, which the GPs can divert into their own pockets in numerous ways. Naked Capitalism readers may recognize that this arrangement is similar to the position mortgage servicers are in: they control the relationship with the funds source, and they are also responsible for records-keeping and remitting money to investors. And as we’ve chronicled at considerable length, servicers have shown remarkable creativity in lining their wallets and investors have been unable to discipline them.
Bowden described some of the ways that general partners can filch:
[A] private equity adviser is faced with temptations and conflicts with which most other advisers do not contend. For example, the private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services … or to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company … or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment.
Translation: private equity provides uniquely lucrative temptations and opportunities to steal from investors. Yet, perversely, limited partners have blinded themselves to these risks. For over 30 years, their relationship has been been shrouded in secrecy, a “trust me” operation. As Bowden noted, “Lack of transparency and limited investor rights have been the norm in private equity for a very long time.” Even worse, limited partners defend the general partners’ obsession with secrecy and reflexively reject requests for information even when it isn’t confidential.
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