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Investors take aim at private equity’s use of private jets

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A $2.7bn private equity manager, named after the Monomoy lighthouse in the Nantucket Sound, was forced to return almost $2m to its investors after US regulators decided last year that it had failed to provide “full and fair disclosure” about costs that were ultimately paid by clients.

Monomoy Capital pledges to help its clients navigate “rough waters” but numerous similar examples of private equity managers exploiting opaque fees and expenses to boost their own profits are making investors feel queasy.

Investors say they routinely find themselves billed for extra costs, such as the hiring of private jets, in addition to the standard “two and 20” — a 2 per cent annual management fee and 20 per cent performance fee — charged by the managers of private equity groups, known as general partners or GPs.

“Expenses are the biggest cause of misalignment between GPs and their clients,” said an investor running a multibillion-dollar private equity portfolio.

Public criticisms of private equity managers by institutional investors remain extremely rare. Most large investors are reluctant to speak out in case they damage their own reputations as fiduciaries — guardians of their clients’ money — and because they worry that they will be quietly excluded from joining new funds raised by private equity managers.

But now, rule changes might be coming down the track.

The Institutional Limited Partners Association, a trade body, is urging US regulators to force private equity managers to report all of the fees and expenses which they charge in a clear and consistent format to investors.

“I have made allocations to more than 50 PE funds and there are a dozen where it is unclear what is being charged as an expense, even with the help of an external auditor which we hire to try to verify the information provided by our GPs,” said the private equity investor.

Michael Frerichs, the state treasurer of Illinois who oversees a $430m private equity portfolio, appealed in October to the US Congress to pass “new rules and sensible reforms” so that a “dangerously unregulated” part of the capitalist system would not cause further damage to institutional investors, businesses and workers.

Clear and standardised fee and expense disclosures by private equity managers, which either own or invest in 8,000 US companies, would “drive better decision making” among investors, said Frerichs, a former Democratic member of the Illinois senate.

Assets overseen by private equity managers have grown rapidly over the past decade to $4.5tn and the contracts signed by investors allow GPs to take additional fees for sourcing deals, salaries for advisers and expenses for regulatory and compliance filings.

A quarter of investors are paying for administrative expenses for private equity managers, such as in-house legal services, accounting and computer software, according to ILPA.

The legal costs to set up new private equity funds have more than doubled since 2011, a bill that is also paid by investors who are also having to stump up for new expenses such as cyber security services for GPs.

KKR, the world’s second largest private markets manager by assets, has reported that it earned $480m in capital market fees and a further $152m in “additional fees” including monitoring and transaction fees in 2020.

“These fees include services provided by KKR which its portfolio companies are encouraged to use. They accounted for 30 per cent of KKR’s fee related revenue last year,” said Eamon Devlin, a private equity lawyer.

Ludovic Phalippou, a professor of finance at Oxford Saïd Business School, said that the expenses heaped on to investors at the discretion of GPs shows that the alignment of interests between private equity managers and their clients is “completely crooked”.

“It is amazing that it is down to GPs to decide how much they get paid after the contract with the investor is signed. This is effectively what happens when a GP can choose what to invoice as an expense,” he said.

Demands by investors for improvements in transparency standards led ILPA to create a new cost reporting template in 2016 for fees and expenses which the association says is “gaining traction”.

“All investors should have the transparency necessary to validate their fees and expenses with managers. Regulation can help achieve this,” said Chris Hayes, general counsel at ILPA.

But a significant minority of GPs remain reluctant to provide more information to their clients.

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Only 60 per cent of the US private equity funds raised since 2017 have used the ILPA cost template or a similar reporting framework, according to Colmore, a specialist data provider.

“Fee templates based on the ILPA guidelines are now standard features of the services of fund administrators and software providers. We are moving to the point where ILPA type reporting standards will apply to all new PE funds,” said Ben Cook, the chief executive of Colmore.

Gary Gensler, chair of the Securities and Exchange Commission, said in October that he supported reforms to enhance fee disclosures by private funds.

“Every pension fund investing in private funds would benefit if there were greater transparency and competition,” said Gensler.

His comments follow blistering criticisms by the SEC last year which rebuked private equity managers for overcharging investors and secretly favouring their own interests and those of high-paying clients over other customers in clear contravention of existing regulations.

Private equity managers are obliged to observe a fiduciary duty to act in the best interests for their clients. But most funds are domiciled in Delaware and the Cayman Islands where local laws permit GPs to dilute or eliminate key parts of their fiduciary duties. Investors pay for these contractual changes which weaken their own legal protections and strengthen the hand of GPs.

Nearly 48 per cent of institutional investors reported modifications or reductions in the fiduciary duties specified in PE funds where they made new allocations over the past 12 months, particularly in the North America and Asia-Pacific regions, according to ILPA.

“This goes to the very heart of the issue of the alignment between the GP and investors in a private equity fund,” said Chris Hayes, general counsel at ILPA.

The association is lobbying the SEC to tighten the rules so that the fiduciary standards that apply to GPs are not weaker than those covering other types of investment advisers, such as mutual fund managers.

Not everyone thinks that PE needs to change how it operates.

“Transparency and accountability are important but it’s worth remembering that investors understand that PE is an expensive asset class . . . investors have demonstrated that they’re willing to pay those costs in exchange for the returns they are able to obtain,” said Igor Rozenblit, founder of the Iron Road Partners consultancy to private market managers, and a former SEC regulator.

But Phalippou cautions that regulators will have to step up their supervision of GPs to ensure that they “play by the rules” as opaque, complex private equity strategies move deeper into the investing mainstream.

“At the moment, investing in PE is like walking into a jungle. All you can hope is that the lions will be friendly,” he says.

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