And why would they, really? Photographer: Daniel Acker/Bloomberg
And why would they, really? Photographer: Daniel Acker/Bloomberg

A couple of weeks ago, Andrew Bowden of the Securities and Exchange Commission gave a speech about private equity fees. It was pretty punchy, for an SEC speech. Especially punchy were the bits about "operating partners," which the SEC views as a way for private equity firms to get paid fees without sharing them with their limited partners.1

Private equity firms buy companies with their limited partners' money, do things to them, and eventually re-sell them at (one hopes) a profit. The LPs pay the private equity firms for finding and buying and re-selling the companies, and the companies pay the private equity firms for doing the things (consulting, monitoring, operational improvements, whatever). The LPs worry about double-counting, and about just overpaying the private equity firms, so the partnership agreements provide that the fees that the portfolio companies pay to the private equity firms have to be shared with the LPs.

On the other hand, fees that portfolio companies pay to outside consultants do not have to be shared with the limited partners. I bet you can figure out what happens!

Or you can just read today's Wall Street Journal article about what happens at KKR, which is delightful.2 KKR & Co., the private equity firm, has a ... thing ... called KKR Capstone. I guess you could call it an "affiliate," as KKR has, repeatedly, but it's not. Technically. According to KKR, anyway.

The investing giant said it incorrectly listed the unit, KKR Capstone, as a subsidiary in a 2011 annual report. Several KKR-controlled public companies erroneously described Capstone as a KKR "affiliate" in regulatory filings. And statements on investor calls identifying Capstone's top executive as a KKR partner weren't "technically correct," an official of the private-equity firm says. Similar mentions of the Capstone executive as a partner by KKR co-founder Henry R. Kravis, KKR said, were a "collegial reference."

Kravis didn't want to hurt Capstone's feelings by calling it "an unaffiliated entity that licenses the KKR name and happens to provide consulting services only to KKR portfolio companies." And, sometimes, KKR just plum forgot that this entity is not a subsidiary or affiliate of KKR. It's an understandable confusion, since KKR consolidates Capstone for accounting purposes, meaning that as a matter of accounting Capstone is part of KKR.3

But it's not an affiliate. Why is that important?

Big investors now routinely demand a share of fees private-equity firms charge their portfolio companies — often 80% to 100% — arguing that the charges drain companies bought with their money. Investors generally don't collect fees directly, but use them to offset a portion of annual management fees they would otherwise owe private-equity firms.

When raising $17.6 billion for its 2006 fund, KKR agreed to share 80% of a range of fees collected by its management company or any "KKR affiliate."

So if KKR Capstone -- an entity that works only for KKR, that works with 90 percent of KKR's portfolio companies, that is advertised as a key part of KKR's operations, that is consolidated with KKR for accounting purposes, that has employees who participate in the KKR carry pool, and that has KKR right in the name -- is an "affiliate" of KKR, then KKR has to give its limited partners 80 percent of its ($30+ million a year) revenue.4 If not, not. You can see why KKR's vote is for not! You can also see why KKR has the occasional Freudian slip on this point. It sure looks like an affiliate.

How shady is this? Yves Smith thinks very shady. From Bowden's speech, you get the impression that the SEC agrees. And the Journal quotes an investor being surprised and upset to learn that Capstone is not part of KKR (and that he's not getting its fees). I think it's a reasonable bet that in, say, three years, KKR Capstone will not be operating in the same way that it is now.

How should we understand what is going on here? I think you have to start with the fact that there was once a norm that private equity firms got to keep their doing-stuff-to-companies fees -- monitoring fees, consulting fees, whatever -- for themselves. That's not a crazy norm. Those are fees for work! The private equity firms do the work of monitoring or consulting or whatever. The limited partners don't do that. The LPs provide capital, and the reward for their capital is the profits when the business is sold. The reward for doing the work of supervising the business should go to the people who supervise the business.

That's a very loose argument. Obviously, there are conflicts of interest, since the private equity firm is effectively on both sides of negotiating those fees. So the fees were probably excessive in relation to the amount of work that they paid for. But, you know. You go into private equity to get rich. Of course the fees were excessive.

But then the rules changed, and again you can understand why. I mean, you can understand it on two levels. One, there was a perception that the fees were excessive and created a conflict between the private equity firms and their investors, and that sharing the fees was a fairer and more correct outcome. But, also, two, private equity is a market, partnership agreements are (sort of) negotiated, and these fees are just a price term. If general partners want to charge fees, and limited partners don't want to pay them, they negotiate, and whoever has more negotiating power wins. That's not a matter of rightness, it's a matter of supply and demand. In recent funds, big investors cared enough, and had enough leverage, to negotiate to get most of those fees -- in KKR's case, 80 percent of them.

But while the contracts changed, the facts that created the original norm didn't. Monitoring or consulting or whatever is still work, and the norm in finance5 is that the people who do the work should get most of the profit from it. Investment banking boutiques tend to pay north of 50 percent of revenue to their employees. Twenty percent seems very light.

So you can see why someone sitting at KKR would say, wait, it is unfair that we're doing all this operational consulting for our portfolio companies, but we can only get 20 percent of the fees. And why they would think up a way around that, a way that technically works but sure looks like a violation of the spirit of the contract.6 Because they're not thinking about the spirit of the contract. The norms of their industry long predate these contracts. The contracts violate the spirit of the industry, so evading the spirit of the contract seems, in some important sense, like fair play.

This strikes me as a parable of financial regulation. You have a business, and it develops standard practices and expectations and norms of conduct. Then people outside the business decide that those practices are shady or risky or whatever, and so they write rules to change the practices. But the people inside the business like those practices. They are used to them. They seem like the right practices. The new rules seem like a weird and unnatural impediment to doing things the way you're supposed to do things. The outsiders who wrote the rules don't really understand how the business works. This is an annoyance -- they wrote rules that don't reflect how the business works! -- but also an opportunity, because you can evade the rules in ways that are not apparent to those outsiders. And so you do. Because you just want to get back to the old way of doing things, the way you thought was right.

Obviously, the old way of doing things makes you more money, so it's easy enough to explain these evasions as the result of "greed." But greed is a very boring explanation for anything; most people would rather have more money than less money. KKR's Capstone adventures can give you a thicker sense of what sorts of rules get gamed, and why, and how the games work. And why, when outsiders eventually do figure out the games, they tend to look so awful.

1 Again, punchy for the SEC:

Some of the most common deficiencies we see in private equity in the area of fees and expenses occur in firm’s use of consultants, also known as “Operating Partners,” whom advisers promote as providing their portfolio companies with consulting services or other assistance that the portfolio companies could not independently afford. The Operating Partner model is a fairly new construct in private equity and has arisen out of the need for private equity advisers to generate value through operational improvements. Many limited partners view the existence of Operating Partners as a crucial part of their investment thesis when they allocate to private equity funds, largely because the Operating Partner model has proven to be effective.

Many of these Operating Partners, however, are paid directly by portfolio companies or the funds without sufficient disclosure to investors. This effectively creates an additional “back door” fee that many investors do not expect, especially since Operating Partners often look and act just like other adviser employees. They usually work exclusively for the manager; they have offices at the manager’s offices; they invest in the manager’s funds on the same terms as other employees; they have the title “partner”; and they appear both on the manager’s website and marketing materials as full members of the team. Unlike the other employees of the adviser, however, often they are not paid by the adviser but instead are expensed to either the fund or to the portfolio companies that they advise.

There are at least two problems with this. First, since these professionals are presented as full members of the adviser’s team, investors often do not realize that they are paying for them a la carte, in addition to the management fee and carried interest. The adviser is able to generate a significant marketing benefit by presenting high-profile and capable operators as part of its team, but it is the investors who are unknowingly footing the bill for these resources. Second, most limited partnership agreements require that a fee generated by employees or affiliates of the adviser offset the management fee, in whole or in part. Operating Partners, however, are not usually treated as employees or affiliates of the manager, and the fees they receive therefore rarely offset management fees, even though in many cases the Operating Partners walk, talk, act, and look just like employees or affiliates.

2 The article, I mean. Views will differ about the delightfulness of what happens at KKR.

3 According to the Journal, KKR claims that Capstone is not an "affiliate" but a "variable interest entity." Here's KKR's 10-K on VIEs:

KKR consolidates all VIEs in which it is considered the primary beneficiary. An enterprise is determined to be the primary beneficiary if it has a controlling financial interest under GAAP. A controlling financial interest is defined as (a) the power to direct the activities of a variable interest entity that most significantly impact the entity's business and (b) the obligation to absorb losses of the entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity. The consolidation rules which were revised effective January 1, 2010, require an analysis to determine (a) whether an entity in which KKR has a variable interest is a VIE and (b) whether KKR's involvement, through the holding of equity interests directly or indirectly in the entity or contractually through other variable interests unrelated to the holding of equity interests, would give it a controlling financial interest under GAAP.

So KKR apparently has "the power to direct the activities" of Capstone, and has "the right to receive benefits from [Capstone] that could potentially be significant" to it.

4 That KKR presentation is by way of Yves Smith at Naked Capitalism. The (conservative) $30+ million a year number comes from the Journal's claim that Capstone's consulting fees "constitute the bulk of the roughly $170 million in such fees KKR reported as revenue over the past three years."

5 But nowhere else, haha, finance is a Marxist workers' paradise.

6 And of course there are asymmetries of information and attention and sophistication that let KKR get around the spirit of the contract fairly easily.

To contact the writer of this article: Matt Levine at mlevine51@bloomberg.net.

To contact the editor responsible for this article: Tobin Harshaw at tharshaw@bloomberg.net.