SEC Official Claims Over 50% of Private Equity Audits Reveal Criminal Behavior

– SEC Official Claims Over 50% of Private Equity Audits Reveal Criminal Behavior (Liberty Blitzkrieg, May 12, 2014):

Last week, Yves Smith of Naked Capitalism penned a fantastic piece leveraging a talk by SEC official Drew Bowden. Mr. Bowden heads the SEC’s examinations unit, and at a private equity conference he explained that “more than 50 percent of private equity firms it has audited have engaged in serious infractions of securities laws.” What is so incredible about the talk, is that while Bowden goes into details of shady practice after shady practice, he ultimately admits that the SEC isn’t being particularly aggressive with the private equity industry because “we believe that most people in the industry are trying to do the right thing, to help their clients, to grow their business, and to provide for their owners and employees.”

Yes, go ahead and read that again. The industry regulator is assuming that private equity firms are trying to do the right thing, despite the fact that audits demonstrated to a tune of greater than 50% the opposite to be true.

Private equity managers are some of the savviest people in finance and they know exactly what they are doing. What the SEC is basically admitting, is that private equity firms are also “too big to regulate” and, of course, “too big to jail.” After all, every single person at the SEC is likely angling for a big payday at a PE firm via the revolving door. Of course they aren’t going to regulate.

Meanwhile, if you are just an average citizen, you will be prosecuted to the fullest extent of the law if you commit even the most minor infraction. This sort of behavior led to the death of prodigy Aaron Swartz, the incarceration of political prisoner Barrett Brown, a swat team raid on a young kid in Peroia, Illinois for a parody Twitter account, the firing of a constriction worker for not paying for a $0.89 soda refill. This list goes on and on. Yet private equity crimes, which likely run into the billions collectively, are treated with kid gloves. As I have maintained many times before, this is how the social fabric of a society dies.

From Naked Capitalism:

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.

He went on to describe some of the common fee skimming models. For example:

Some of the most common deficiencies we see in private equity in the area of fees and expenses occur in firm’s use of consultants, also known as “Operating Partners,” whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not independently afford.

Here’s how this scam works. PE firms raise funds by showing prospective investors a strong team of professionals who are going to find attractive companies to buy and manage them. The limited partnership agreement, which is the contract between the private equity firm and the investors, typically says that the private equity firm has to pay for the wages of people working on the fund’s behalf. However, unbeknownst to the investors because it was never disclosed, part of the PE firm “team”, usually the members that work with portfolio companies, are actually being paid as independent contractors. The private equity firm then bills most or all of these sham independent consultants to the portfolio companies with whom they interact.

Most troubling of all is that we have reports from industry insiders that Bowden failed to mention the most egregious forms of stealing, which may cost investors billions of dollars annually. As we understand it, the SEC is on to a couple of large-scale scams perpetrated by some of the biggest firms.

The SEC may be pulling its punches because it may be uncertain about what to do with the rot it has found. Side by side with the the unprecedented, detailed litany of numerous forms of lawbreaking and bad conduct, Bowden was also peculiarly deferential, which gave his speech a schizophrenic feel. For instance:

Some questioned why we would show our hand in this way, to which there’s a simple and sensible answer. We believe that most people in the industry are trying to do the right thing, to help their clients, to grow their business, and to provide for their owners and employees. We therefore believe that we can most effectively fulfill our mission to promote compliance by sharing as much information as we can with the industry, knowing that people will use it to measure their firms and to self-correct where necessary. Put another way, we are not engaged in a game of “gotcha.”

So you see, an average citizen gets locked up for life, yet a private equity partner is given the benefit of the doubt and, at worst, asked politely to change behavior by the SEC.

State legislators need to understand what is going on here. They have granted public pension funds and public endowments across the U.S. the exorbitant privilege of secrecy in private equity investing, even to the point of making these contracts virtually the only ones that are exempt from state-level Freedom of Information Act laws.

State legislators need to understand what is going on here. They have granted public pension funds and public endowments across the U.S. the exorbitant privilege of secrecy in private equity investing, even to the point of making these contracts virtually the only ones that are exempt from state-level Freedom of Information Act laws.

I recently wrote that private equity will deservedly emerge as the financial industry’s major villain in the next crisis. I detailed why in my post, Leaked Documents Show How Blackstone Fleeces Taxpayers via Public Pension Funds, which is a must read in the context of the article above.

Full article from Naked Capitalism can and should be read here.

In Liberty,
Michael Krieger