A recent article in the June 30, 2016 edition of The Wall Street Journal by Norm Champ titled “An Iniquitous Raid on Private Equity” highlights the latest intrusion by the SEC on the freedom of private equity managers to arrange their relationships with their portfolio companies. In an enforcement action against a private equity firm called Blackstreet, the SEC sought restitution, interest and penalties for charging a transaction fees in connection with the buying and selling of portfolio companies. The SEC characterized part of the problem in its own press release as follows: “Blackstreet operated outside of the funds’ documents by using fund assets to make political and charitable contributions and pay entertainment expenses.” The enforcement action was settled for $3.1 million. It was not enough that Blackstreet was registered with SEC as an investment advisor under new rules spawned by Dodd Frank. The enforcement action claimed that Blackstreet had acted as a broker dealer in connection with the buying and selling of portfolio companies and as such needed to be registered with SEC as a broker dealer.
This logic is so flawed that you have to ask what is the political motivation? Did Blackstreet principals say something bad about our President? Did they contribute to conservative causes? Did they finance the Benghazi movie? One thing is for sure in Chevy Chase, these guys did not contribute to the right political party? Had they made charitable contributions to the Clinton Foundation from Fund assets we may have had a different view of entertainment expenses?
Business Model for Private Equity
The business of private equity is buying, improving and selling its portfolio companies. The private equity firm serves as the general partner and exclusive manager of a limited partnership that owns the portfolio company. GPs act for the passive owners who risk general liability if they engage in management activities. So the GP is really the owner’s representative and the exclusive party to exercise all of the functions of ownership including buying and selling. Under this logic a private condo developer who pays himself a commission for selling a condo unit instead of hiring a real estate broker should be a broker dealer.
Transaction Fees Are Common
Transaction fees are often assessed by a General Partner when the resources of the private equity firm are devoted to the buy or sell effort. For example, the creation, supervision and updating of a data room is often a collaboration between the managers of the portfolio company and employees of the General Partner. Depending on who does what, it may be appropriate to outsource many one-time services incident to a sale to the private equity firm rather than having a management team do it for the first time. It is not unusual for the GP to charge a fee for the avoided costs to the portfolio company. It is rare, however, for the GP to act as a financial advisor in the purchase or sale. It is a principal and a surrogate for the owner not an agent. If it is charging a transaction fee in connection with a buy or sell it would most often be in the context of providing outsourced services that are not within the expertise of the management team or the case where a preemptive, unsolicited offer is too good to pass by and an intermediary is not required.
The best example is tuck in acquisitions where the transaction was sourced by the GP and the transaction size is too small to engage an investment banker to sift through the selling memorandum, due diligence materials, legal documents, escrows and post-closing responsibilities. Most of our portfolio company managers have little or no experience with acquisitions and they completely outsource the heavy lifting to us. If we charge a transaction fee, it would usually be significantly less than an investment banker would charge for many times more work than they are trained to do. This is not a broker dealer activity but rather additional work by the GP that is an avoided cost to the portfolio company and its owners in the limited partnership.
Bad Actor Creates Bad Precedent
The fund formation documents typically permit the GP in its capacity as a fiduciary (investor interest first) to charge reasonable transactional and portfolio monitoring fees whenever it is providing outsourced services to the portfolio company that they cannot provide themselves. Those outsourced functions are numerous: treasury, corporate development (inbound and outbound), financial reorganization, financial modeling and feasibility analysis, quarterly governance preparation, litigation management, administration of escrows and post-closing working capital, exit preparedness, stock option plan administration, organizing and oversight of committees of the advisory boards, CEO performance reviews, and hiring and supervision of recruiters for key personnel. None of these functions are broker dealer functions. I know because I worked for a broker dealer and owned a broker dealer. Broker dealers do not act as management surrogates nor do they serve as the fiduciary representatives of the limited partner owners who are prohibited from acting for themselves.
The SEC is run by a woman who understands these things. Mary Jo White is well respected for the work she did in the private sector. For 10 years, she was chair of the litigation department at Debevoise & Plimpton, whose “core practices” and expertise are focused on the success of Wall Street financial firms. The fact that Senator Elizabeth Warren thinks she is doing a lousy job is an endorsement of her leadership effectiveness. Giving her the benefit of the doubt, you must ask if something else is motivating a bad legal intrusion. The answer is found by investigating the reputation of Murry Gunty who is the general partner of Blackstreet. He was alleged to have rigged the balloting for the prestigious Harvard Business School Finance Club in his favor and might be on the SEC’s ten “most wanted” list because of subsequent ethical slips. This decision may be more about a bad man than the bad activity, but it certainly does not warrant bad legal precedent.
And there is always the most logical explanation in Washington DC- politics as usual.
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