WASHINGTON -- Private equity firms are routinely ripping off their clients, harming pension funds, universities and charitable foundations, according to a top government regulator with the Securities and Exchange Commission.
"When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50 percent of the time," Andrew J. Bowden, director of the Office of Compliance Inspections and Examinations, said Tuesday, according to a transcript. "This is a remarkable statistic."
In his bold speech before a New York private equity conference, Bowden laid out a host of improper schemes that the Securities and Exchange Commission has found to be rampant in the sector. Private equity firms have dodged nearly all of the new rules included in President Barack Obama's 2010 Dodd-Frank financial reform law, but managers of larger firms now have to register with the SEC as formal investment advisers and are subject to periodic reviews.
In December, the House passed a bill that would repeal the section of Dodd-Frank requiring private equity managers to register with the SEC. Although the bill received just 36 Democratic votes, seven of its 13 co-sponsors were Democrats, including Wall Street-friendly Reps. Jim Himes (D-Conn.) and David Scott (D-Ga.). The bill is unlikely to be voted on in the Senate.
After examining over 150 private equity advisers, Bowden said that the SEC found that private equity managers frequently charge improper hidden fees to investors and misrepresent major consulting expenses.
"We have seen that these temptations and conflicts are real and significant," Bowden said.
Private equity firms raise money from investors -- pension funds, hedge funds and other sources of capital -- and use it to takeover private companies. Most private equity critics focus on problems with the way private equity firms manage these businesses. One common strategy involves raiding the company's assets while loading it up with debt, eventually forcing the company into bankruptcy. While creditors get burned and workers are laid off, the private equity manager rakes in cash.
But Bowden's speech focused on the other side of the business -- how private equity managers relate to the investors who give them money in the first place. Bowden devoted special attention to consulting arrangements where private equity managers give investors the impression that the private equity firm itself is footing the bill. In fact, Bowden said, managers are often charging the fees to the companies they manage. Instead of coming out of the manager's fee, it comes out of the company's profit -- which ultimately belongs to investors.
Bowden also took issue with "monitoring fees" -- money that private equity managers charge to serve on the board of directors and function as advisers to the companies they control. But private equity firms often orchestrate payments to ensure that investors are charged these fees for several years after the private equity firm has ceased performing these functions.
"This sort of arrangement has the potential to generate eight-figure, or in rare cases, even higher fees," Bowden said. "There is usually no disclosure of this practice at the point when these monitoring agreements are signed."
Bowden also said that private equity managers often charge undisclosed administrative fees, or simply violate their investment agreements by charging fees beyond what the arrangement allows. Companies also overstate their investment prowess in marketing materials by relying on bogus valuation metrics. Often, according to Bowden, firms will tell investors they use one method for calculating the value of their investments, while using a different methodology to justify rosier figures.
Bowden is no bomb-thrower. He came to the SEC in 2011 after 17 years with Legg Mason, where he had ascended to executive director of its capital management unit. Now known as ClearBridge, the fund has almost $100 billion in assets under management.
When critics have taken issue with the ethics of some private equity management decisions, the industry typically invokes the traditional business lobby line that whatever is good for its bottom line is good for America. The Private Equity Growth Capital Council -- an industry PR and lobbying shop -- has focused much of its messaging around the idea that many public interest groups like pension funds and university endowments end up benefitting from private equity's sometimes-ruthless strategies. Bowden took this line head-on.
"I'm often asked: Why is [the SEC] spending resources on private funds? Investors in hedge funds and private equity funds are 'big boys' that can take care of themselves. Why not devote more resources to helping 'mom and pop' investors?" Bowden said. "'Mom and pop' are much more invested in these funds than people realize. [Private Equity Growth Capital Council] states it best: 'Private equity investment provides financial security for millions of Americans from all walks of life. The biggest investors in private equity include public and private pension funds, endowments and foundations, which account for 64 percent of all investment in private equity in 2012.' To the extent private equity advisers are engaged in improper conduct, it adversely affects the retirement savings of teachers, firemen, police officers, and other workers across the U.S."
A spokesperson for the PEGCC said that the organization is not commenting on Bowden's speech.
The full text of Bowden's remarks is available here.