Whistle-blower tries to shed light on private-equity transaction fees

In 2007, Texas-based utility TXU agreed to the largest leveraged buyout ever: a $48 billion sale to Kohlberg Kravis Roberts & Co., TPG and Goldman Sachs. Since then, however, the renamed Energy Future Holdings has piled up $18 billion in losses, while revenue has dropped by nearly half. Buckling under a monstrous $44 billion debt load dating back to the LBO, the company is negotiating with creditors in an effort to fend off bankruptcy.

KKR, TPG and Goldman all face substantial losses if Energy Future succumbs to bankruptcy. Still, they already have a little something to help numb their pain: Back when the deal closed, KKR and TPG each pocketed a $107 million “transaction fee,” according to a regulatory filing. Goldman got $80 million.

These nifty payouts are an important reason why private equity is perhaps the most lucrative game on Wall Street. In the past 10 years, private-equity firms have collected $2 billion in transaction fees, which essentially are bonuses the firms take for conducting their business of buying, managing and selling companies.

Now a senior private-equity insider is trying to shine light on these little-known payments, which can constitute a sizable slug of revenue at the firms. The insider filed a whistle-blower complaint earlier this year with the Securities and Exchange Commission in which he contends that private-equity firms are violating federal securities law because they are acting as unlicensed brokers when they collect transaction fees.

“This is one of the most black-and-white examples of a securities violation that I can recall,” said the insider’s attorney, Jordan Thomas, who helped establish the SEC’s whistle-blower program and is now a partner at Labaton Sucharow. “The widespread, systematic and flagrant nature of these violations is likely to be deeply troubling to the new, more aggressive SEC under Chairman Mary Jo White’s leadership.”

Because the whistle-blower’s complaint hasn’t been made public by the SEC, Crain’s New York Business agreed to not disclose his name. His complaint already seems to have sparked debate within the agency, where officials recently have begun speaking publicly on the wisdom of subjecting private-equity firms to stricter regulation. An SEC spokesman wouldn’t comment.

Private-equity firms manage some $3.3 trillion for pension funds, endowments and other institutions. They are facing scrutiny from Congress over why their earnings are taxed at lower rates than ordinary income. In addition, shareholders in companies sold to private-equity firms recently were allowed to proceed with a suit alleging some firms colluded to depress acquisition prices. And amid middling returns in recent years, the industry has struggled to justify the fees it charges fund investors — typically equal to 2% of assets under management and 20% of investment gains, plus various transaction and other fees.

“There is an increasing awareness about fees charged by private-equity firms. It is definitely something people are talking about,” said Gregory Brown, a professor of finance at the University of North Carolina’s Kenan-Flagler Business School.

HARD TO REGULATE
Transaction fees, the subject of the whistle-blower’s complaint, would be difficult for the government to regulate, Mr. Brown said. He noted that the fees are set by sophisticated parties on both sides of the negotiating table.

Besides, if transaction fees were ended, private-equity firms would likely find other ways to collect similar sums. “It’s sort of like squeezing a balloon,” Mr. Brown said.

For the whistle-blower, the stakes are high. If his complaint results in SEC penalties against private-equity firms, he’d stand to collect up to 30% of the proceeds. But it could be a tough argument to win.

The actual victims of high transaction fees are hard to identify. Energy Future Holdings isn’t gasping for breath because it paid KKR, TPG and Goldman $300 million in transaction fees at the closing of its LBO years ago. Rather, its problems are related to the rise of fracking, which depressed the natural-gas prices that private-equity buyers had expected would climb and help the company boost revenue and service its debt.

Even if transaction fees are a minor factor in the financial troubles of overly indebted companies, private-equity firms often seem reluctant to disclose them. Energy Future’s $300 million transaction fee wasn’t revealed until five months after it was paid, when the utility released its annual report. Mr. Thomas said his client has reported that many private-equity firms decline to disclose the existence of such fees before deals close, a practice that allows them to extract cash from their targets without investor approval.

Some of the larger transaction fees over the years include a $260 million payment to KKR for its $28 billion buyout of First Data back in 2007, according to a regulatory filing. The same year, KKR and Goldman shared a $75 million transaction fee when they bought Dollar General. A year later, Bain Capital Partners and Thomas H. Lee Partners split an $87.5 million fee when they closed the $18 billion buyout of Clear Channel Communications.

SIGNIFICANT CASH
More recent LBOs have featured transaction fees, too. Clayton Dubilier & Rice took a $40 million payment when it closed its $3.2 billion acquisition of Emergency Medical Services in 2011. Bain Capital took $17 million for its $1.8 billion acquisition of retailer Gymboree in 2010.

None of the private-equity firms would comment.

Although transaction fees are dwarfed by the sums private-equity firms make from money-management fees or from selling companies through initial public offerings, they can represent a nice chunk of cash.

KKR recorded nearly $100 million in gross transaction-fee revenue last year, or more than a sixth of all fee revenue generated in its private-equity division. The firm has recorded $360 million in such fees in the past three years. Blackstone Group generated $100 million in net transaction-fee revenue last year, or about an eighth of its private-equity revenue, and the firm has collected $305 million in such fees during the past three years.

The whistle-blower’s argument that transaction fees are illegal rests on some finer points of Wall Street regulation. He contends that firms that collect transaction fees must be registered with the government as “broker-dealers,” much like Goldman Sachs’ or JPMorgan Chase’s securities divisions. Broker-dealers have their sales practices and conflict-of-interest disclosures examined by the SEC or the Financial Industry Regulatory Authority every year or two.

Private-equity firms, however, usually are regulated as “investment advisers.” The rules governing how brokers and advisers must treat customers aren’t the same, but perhaps the most important difference is that oversight of advisers is much less rigorous. A now-former SEC commissioner said in a speech earlier this year that investment advisers can expect to be examined by the SEC only once every 12 years because the agency is short-staffed.

“Effectively, what the private-equity industry has been doing is operating a multibillion-dollar business — one which most Americans’ college and retirement savings depend upon — without a business license,” Mr. Thomas said.

The private-equity industry strenuously disagrees with that view.

“The services provided by private-equity fund sponsors to their affiliated funds and portfolio companies are investment-advisory services. Layering broker-dealer regulations on private equity will be of no meaningful benefit to investors and would levy significant costs on private-equity firms,” said Steve Judge, CEO of the Private Equity Growth Capital Council.

Still, SEC officials seem to be listening to the whistle-blower.

“Given the significant consequences of acting as an unregistered broker-dealer and the increased attention being given to this issue by the SEC staff, private-fund advisers should consider reviewing their practices to determine whether any activities that may be approaching or crossing the line would require broker-dealer registration,” David Blass, the chief counsel of the SEC’s division of trading and markets, suggested in a speech last April.

(Aaron Elstein is senior reporter at sister publication Crain’s New York Business)