While mutual fund investors are assured equal treatment under the federal securities laws, private equity funds are the Wild West—industry practice is to grant certain investors secret preferences which may be harmful to others. Regulators and law enforcement are looking into flagrantly illegal “side letter” agreements which pay investors aware of fraud to not tell unsuspecting others.
When you invest in a mutual fund registered with the Securities and Exchange Commission, you can be reasonably certain that you and all other investors in the fund will be treated comparably. Sure, investors who have purchased different share classes in the same fund may pay greater or lesser fees but the availability of lower-cost shares is plainly disclosed in the prospectus and all investors in a given share class pay the same costs. All investors in a mutual fund own a proportionate share of the same investment portfolio, and have identical redemption rights, as well as equal access to information about the fund’s investments.
Private equity funds which are not registered mutual funds offer none of these protections. There are no prospectuses for these funds, and their appalling (evolving) private offering documents matter-of-factly disclose that different investors in the fund may pay different fees, participate in different investment opportunities, enjoy different rates of return and redemption rights, as well as have varying degrees of access to information about fund investment strategies and portfolio holdings. It is impossible from the offering documents for investors to divine whether they will be treated better or worse than others because the terms of each investor’s participation are secret, known only to him.
For fiduciaries overseeing other people’s money, private equity’s disparate treatment of investors, abusive industry practices and alarming lack of transparency should be deal-breakers. To the contrary, pensions in recent years have dramatically increased their allocations to private equity funds—either because they don’t understand the dangers lurking in the shadows or simply don’t care as long as above-market returns are promised (which will supposedly reduce severe pension underfunding).
The most that private equity offering documents disclose is that certain unnamed individuals, including industry insiders, friends and family of the manager, “may” be treated better than others. That’s bad enough but, as we’ll see, flagrantly illegal secret arrangements are not unheard of.
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Whenever you encounter disclosure that a fund manager “may” treat you unfairly, you should naturally assume he will do so—otherwise why would he have reserved the right? Which begs the question: Why would any sane investor who receives advance warning of unequal treatment proceed?
When a manager tells you “friends and family” may receive preferences, he’s letting you know: You are not his friend… and he is not yours.
Securities and pension regulators have paid little attention to the “side letter” agreements private equity funds enter into with investors granting preferential treatment. It’s no secret that these agreements exist—the practice of entering into them is disclosed in offering memoranda and is openly discussed throughout the industry. As a result of increasing institutional investor domination of private equity, and the regulation applicable to these investors, it is now standard practice in the industry for each investor to demand its own side letter. As a consequence, there has been a proliferation of the number of side letters being negotiated with investors, as well as the kinds of arrangements and provisions included in them.
The irony of all this frenetic side dealing is that today every institutional investor who has cut a secret deal with a private equity fund apparently believes (i.e., is probably told so by the fund manager) that he is getting a better deal than the others! Indeed, pension fiduciaries have a legal duty to ensure plans are being treated fairly and that others are not profiting at the plan’s expense. Since pension fiduciaries are never permitted to see all side agreements, there’s simply no way they can fulfill their legal duties when investing in these funds.
While it is common knowledge that side letters proliferate, the only real secret is how ugly these agreements can actually be.
Most disturbing of all the agreements I’ve reviewed are those which specifically provide that fees will be waived for, or compensation paid to, investors who agree to remain in a private equity fund, not pursue fraud claims and not tell the other investors about the fraud. That is, investors who are aware of fraud are compensated for keeping other unsuspecting investors in the dark (as they and the fund manager continue to profit from the fraud) and for not blowing the whistle to regulators.
As a former SEC attorney, I believe such side letter agreements arguably aiding and abetting fraud raise grave regulatory, even criminal concerns and I have made my findings known. As long as private equity firms continue to oppose transparency, granting certain investors secret preferences which blatantly disadvantage the others, there is no way any investor can be assured his assets are being managed with integrity and in compliance with applicable law. The real questions for private equity are: Why can’t private equity funds operate with full transparency, treating all investors equally? Who would win and who would lose if all the secrets were to unfold?
For more information on how to protect your pension, see Who Stole My Pension?