A series of ethical slip-ups within some of the country’s more prominent pension funds could have powerful transformative effects on the private equity industry, should the Securities and Exchange Commission get its way. A proposal published in August by the regulator suggests a sequence of reforms to the ways in which pension funds and third-party deal brokers interact—and has become a hot topic for private equity players in opposition to the proposed rules.
The SEC’s proposal, if adopted, would forbid private equity funds from using third-party placement agent services to solicit investment dollars from state and municipal pension plans, thus bringing to a halt the widely practiced use of such agents. The proposal would also block political contributions from parties seeking investments from those government entities, a shadowy, but not altogether uncommon, practice among private equity firms. “There are just a few small players in the country that have the political connections to do this,” says Charles Eaton of placement house C.P. Eaton Partners. “If the SEC bans political contributions, we would be happy to see these two-bit finders go away.”
The use of placement agents has become commonplace in private equity, with 54 percent of PE firms using their services in 2008, up from just 40 percent two years previously. The agents, who deduct their fees from the firms themselves, are responsible for a large portion of the investment that has flowed through private equity in recent years—illiquid “alternative assets,” which include PE deals, composed about 18 percent of U.S. pension fund assets at the end of last year.
The SEC’s major objective in its controversial proposal is to staunch the prevalence of “pay to play” tactics that have marred the PE landscape in recent years, with the ban on placement agents a largely secondary, but no less crucial, aspect of the proposal. “Pay to play” refers to the use of political donations (or, as in some notable cases, even more blatant financial offerings) on the part of third-party solicitors to curry the favor and investment dollars of state and municipal pension funds, which, nationally, hold $2.2 trillion in assets.
“Private equity is already laying lifeless as it is. If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities.” -Paul Denning, private equity firm Denning & Co.
The SEC reasons that by stopping third-party placement agents, as well as explicitly forbidding political contributions within the investment advisory sector, there will be less of an opportunity for the kind of shady politically linked financial deals that have as late been an embarrassment for the private equity industry. As the SEC announced its proposal, “Investment advisers that seek to influence the award of advisory contracts by public entities, by making or soliciting political contributions to those officials who are in a position to influence the awards, compromise their fiduciary obligations.”
The most infamous breach of such obligations between funds and the solicitors that seek to win their business is that which was uncovered earlier this year in relation to the New York state pension fund. A pair of aides to former New York Comptroller Alan Hevesi are alleged to have funneled millions—including $30 million straight to the pocket of Hevesi consultant Hank Morris—in fees from companies that won pension investment from the state fund. “Morris was essentially masquerading as a placement agent,” says Paul Denning of private equity firm Denning & Co., who notes that Morris’s standards of professional conduct were much lower than industry standard. “Our hit rate is like 7 or 8 percent, whereas Morris’ guys were at 100 percent. There were no standards.”
The SEC’s reasoning in its efforts to stomp out pay to play is multifaceted, and largely supported by the private equity community. The effects of pay to play are harmful to pension funds and independent brokers alike—and are more a matter than mere reputation. Qualified advisors and the advisory community at large are hurt when certain parties can simply buy the business of those funds whose investment dollars they seek, leading funds to invest in companies that may not be an ideal match. The pension plans themselves will pay higher fees to compensate for the corrupt advisor’s expenditures—and the advisor has a greater ability to squeeze other monetary rewards out of the pension fund. And, of course, the actual beneficiaries of the pension fund—state and municipal workers—aren’t happy to know that their retirement dollars were pushed in inappropriate investments, especially if these investments underperform.
“The important thing from the funds’ point of view is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.” -Charles Eaton, placement house C.P. Eaton Partners.
“The ultimate goal of the SEC’s proposal is to protect public funds from abuse,” says Richard Marshall, counsel at Ropes & Gray. “But the question is whether the approach that they’re taking with this proposal will help public plans or hurt them.” Indeed, the critics of the SEC proposal have come out in droves during the document’s 60-day comment period, with many claiming that such changes will damage an already-fragile private equity climate. “Private equity is already laying lifeless as it is,” says Denning. “If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities. It’s also going to hurt those newer funds that don’t have the access to capital that the big guys have.”
Many critics have pointed out that the banning of placement agents is going to have a disparate effect across the PE field, with smaller firms bearing the brunt of the damage. Because the proposal allows a loophole—placement agents are allowed if they have an exclusive relationship with the capital-raising firm—it will be those smaller firms, who cannot afford in-house fundraisers and must outsource, that will suffer. “The rule has an asymmetry,” says Marshall. “And the question is, does this give an unfair advantage to the largest entities?” There is also the fact that placement agents do indeed offer a valuable service to smaller private equity or venture capital groups that don’t have the necessary professional contacts to get an audience with large pension funds, all of which are constantly besieged by deal proposals. “The important thing from the funds’ point of view,” says Eaton, who has spurred a Washington lobbyist group to attempt to stymie the bill, “is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.”
But the regulatory proposal, however unpopular, isn’t without precedent. A similar pitch, made under Arthur Levitt’s SEC in 1999, would have placed a two-year ban from accepting pension fund fees on investment firms that used third-party placement agents. The 1999 proposal died, but, ten years later, numerous pay to play scandals have forced regulators to consider the harsher measures of its latest proposal. Though the egregious abuses allegedly committed in New York were the most highly publicized, they were by no means singular, with similar cases having been brought to trial in New Mexico, Connecticut, Illinois, Ohio, Florida, Alabama, North Carolina, and other states. The sheer volume of wrongdoing mandates some degree of policy change, says Marshall. “There have been a number of speeches that have been given that have identified this issue as a priority for the SEC. Clearly, the SEC will adopt something.” What remains to be seen—and what depends highly on the influence exerted by private equity groups and their attendant lobbyists—is just what kind of balance can be struck between fair play and a balanced, self-correcting market. The risk of overreaction, says Eaton, could wreak havoc within the industry: “We’re praising the SEC for coming to grips with pay to play, but we’re saying that if you go so far to ban the entire industry, you’re going to have a lot of unintended consequences.”