Still Lackin Transparency
by Timothy Bernstein, Analyst, NewOak NewOak is an independent financial services company, which provides strategic counsel and services around structured credit, complex asset valuation, enterprise risk, and regulatory compliance. Reprinted with permission. Visit newoak.com.
Quietly released to the public this month was a report published by the Management Funds Association (MFA) on the five-year impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act on the alternative investment industry.
The MFA, a trade group that describes itself as “the voice of the global alternative investment industry,” was extremely complementary of the legislation’s impact, heralding a new regime of “increased transparency” in the alternative space, a segment of the financial industry that includes hedge funds and private equity firms. “The Dodd-Frank Act,” the report states up front, “has changed the way our financial and capital markets function and brought forth a new economy that is more regulated, more transparent, and more reliant on alternative investment vehicles like hedge funds to provide capital.”
Still Lacking Transparency
Though Dodd-Frank has made significant inroads toward increased transparency in the alternative investment sector, transparency with respect to private equity (PE) funds remains an exception.
In both the reporting of the specific nature of assets under management, as well as the fees charged to investors, private equity falls short in some aspects. Currently, the Securities and Exchange Commission does not require a PE firm to report to the authorities on individual companies within the firm’s portfolio.
The lack of transparency surrounding information—such as the amount of leverage on a company and its debt structure—can have material consequences for the firm’s investors. A study of pre-crisis bankruptcy rates among PE-owned companies found that the yearly rate of default was twice as high as it was for publicly traded companies. Furthermore, PitchBook recently reported that the median range of debt used by PE firms in their acquisitions was a 6.9 – 8.2 times EBITDA (earnings before interest, taxes, depreciation and amortization) multiple.
By contrast, joint guidelines from the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (OCC) identify debt levels of over six times EBITDA as “raising concerns for most industries.” However, since the OCC issued the guidelines for banks, and not companies, PE firms have avoided having a harsher regulatory light shone on potential overleveraging. Private equity fund investors do have a higher risk appetite than banks and public equity investors in order to achieve higher returns.
Investor Costs and Regulatory Ambiguity
There is also the industry’s widespread failure to disclose the full extent of investor costs. As The New York Times reported in May, PE firms often charge investors for transaction fees, legal costs and taxes, all of which go beyond the more standard management fees charged based on total assets invested and a percentage of profits.
As the Times reported, a recent analysis from a Toronto consulting firm estimated that “more than half of private equity costs charged to United States pension funds were not being disclosed.” It is certainly true that acquiring and managing private companies is an involved process which requires extensive due diligence, restructuring, and legal expenses.
These expenses are born by the investors with private equity firms, which select the funds and managers based on their historical net performance. Those investors deserve to know what they are paying for. Regulatory ambiguity, as related to possible breaches of ethics, plays a significant role here.
The Governmental Accounting Standards Board declares that investment-related costs are to be reported as expenses if they are “separable from investment income and the administrative expense of the pension plan.” In other words, PE firms can essentially decide at their own discretion which of these fees to report, essentially leaving investors in the dark.
One practice that has inspired special rancor is the murky “monitoring fee” that PE firms charge to the companies they own. Even more egregiously, the fee is often the result of a multi-year contract into which the acquired company must enter with its buyer, and which remains in effect even if the PE firm sells it before the contract ends (at which point the firm receives the remainder of the money owed to it in one lump sum).
To top it off, such fees are tax deductible, meaning that if you’re reading this as a citizen of the United States, the nation’s PE firms owe you a thank-you note. As with hedge funds, it can be tempting to disregard duplicitous activities in private equity as a set of problems that affect only the rich. However, as the MFA report happily discloses, institutional investors like pension funds, charities and college endowments “now represent nearly two-thirds of the industry’s assets under management.”
Despite the post-crisis attention focused on America’s big investment banks, the current regulatory regime needs to be improved to ensure a higher standard of transparency in the PE industry. In fairness, it is true that many top PE firms have been gradually increasing their transparency, partially due to demand by institutional investors. Hopefully, the rest will follow suit.