PE Panorama: SEC flexes its muscles at PE players

07 July 2014   Category: Asia, Global   By Paul Mackintosh

Reports in the Wall Street Journal indicate that the US Securities and Exchange Commission (SEC) is using the expanded powers of oversight over private equity firms granted to it in 2010 to investigate supposed sharp practices over group-purchasing programmes, where the general partner (GP) uses the scale and collective bargaining power of its portfolio companies to secure purchasing discounts with suppliers. In some cases, reportedly, the GP also picks up commissions from these purchases, and the SEC is focusing on whether or not those commissions are then shared with the fund's limited partners (LPs). Leading firms such as Bain Capital, Blackstone Group, Kohlberg Kravis Roberts and TPG Capital are cited in the coverage.

In principle, a better business deal for portfolio companies ought to mean better performance and ultimately better returns for investors. But the issue of internal charges and other mechanisms for securing extra comeback from investments for GPs has long been a sore point with LPs. It would be unfortunate if they gained the impression that GPs were still trying to work out new ways to get around the regulations and take more revenue away from both their investees and their investors.

The Institutional Limited Partners Association (ILPA) principles were supposed to have fixed all this. The ILPA pulled these together in the aftermath of the global financial crisis (GFC) in 2008 to resolve the problems that its members were having once the private equity boom of the mid-2000s came off the boil and innate difficulties in the GP/LP relationship grew more pronounced. The 2.0 version of the principles contains extensive guidance on fees. “Management fees should be based on reasonable     operating expenses and reasonable salaries, as excessive fees create misalignment of interests”, the principles state, continuing: “Transaction, monitoring, directory, advisory, exit fees, and other considerations charged by the GP should accrue to the benefit of the fund”.

Predictions that LPs would use the rebalancing of relationships after the GFC to unwind the established 2-and-20 compensation structure of private equity proved unfounded. Most LPs now report that they are happy with this breakdown – so long as the GPs deliver the investment outperformance that they are supposed to. Private equity's recent performance spike, with some attractive and consistent returns to investors, ostensibly reassured all parties in the ecosystem that GP/LP interests were still effectively aligned and that issues around the structure of the asset class had been successfully worked out. Perhaps this is just the SEC using its newfound power a little too vigorously. For the industry's sake, one hopes so.