By Matt Levine
There is a genre of Securities and Exchange Commission enforcement action in which someone starts an investment fund, raises money from investors and then blows that money — or some of it, anyway — on personal expenses. A feature of this genre is that the SEC lists the personal expenses in some detail, because they are funny. Really anyone’s personal expenses, pulled from their context in life and placed into the context of an SEC enforcement action, will be funny. “I can’t believe this dope spent investor money on bagels, whiskey and in-game purchases on his phone,” I’ll laugh, as though there were other things to spend money on. But also, people who steal from their investment funds tend to spend the money on certain kinds of expense, and those expenses just read funny. If you catered to people running crooked investment funds, you could run a very profitable steakhouse, or a Ferrari dealership, or like eight strip clubs. You’d have a harder time with a used bookstore.
But when a senior partner at Apollo Management allegedly takes money from Apollo’s investors to spend on his personal expenses, the SEC is blandly abstract:
From at least January 2010 through June 2013, a former Apollo senior partner (“Partner”) improperly charged personal items and services (collectively, “personal expenses”) to Apollo-advised funds and the funds’ portfolio companies.
In certain instances, the Partner submitted fabricated information to Apollo in an effort to conceal his conduct. In other instances, the personal expenses on their face appeared to have a legitimate business purpose.
Hhmm. What sort of personal expenses could “on their face appear to have a legitimate business purpose”? We will never know, because the SEC keeps everything strictly business. It itemizes each time that the partner was “verbally reprimanded” for doing this (more than once!), but never mentions the name of even one establishment where the partner blew some investor money. (He paid Apollo back, and ultimately “Apollo and the Partner executed a formal separation agreement,” which is a pretty polite way to go.)
It’s almost like there are two genres of SEC enforcement action: The funny ones against two-bit Ponzi schemers, and the Very Serious ones against big firms.
Today’s SEC action against Apollo is Very Serious, at least in the sense that Apollo agreed to pay $52.7 million to settle it. The improper expensing is just a small part of it, though; the main problem is that Apollo charged its portfolio companies accelerated monitoring fees without adequately disclosing to investors that it would do that. The SEC takes that very seriously, though I am a little meh on it. We talked about it last year, when the SEC fined Blackstone Group $39 million for the same thing; it is part of a broader SEC crackdown on the private-equity industry’s habit of charging whatever fees it can get away with.
The basic idea is that private-equity firms charge their portfolio companies a “monitoring fee” for … monitoring them? It seems silly to insist on a reason. They charge the monitoring fee to get more money. They could charge portfolio companies a Fee For Being Nice Guys, and the portfolio companies would cheerfully pay up. The way private-equity firms work is that they buy portfolio companies with money provided by their limited partners (pensions and other big institutional investors), and then run those companies on behalf of the limited partners. So the private-equity firms are the (effective) owners and managers of their portfolio companies. They can send a portfolio company a bill, and then send themselves back some money. The guy sending the bill is also the one paying it, but with the limited partners’ money. You can monitor, or you can not monitor, but either way you charge a monitoring fee, because the emphasis in “monitoring fee” is solidly on the word “fee,” not the word “monitoring.”
The way you know that is that the portfolio companies were supposed to pay the monitoring fees for 10 years. But the portfolio companies often were sold or went public before the 10 years were up. And when that happened, they had to pay the rest of the monitoring fees anyway in a lump sum. So Apollo got paid the same monitoring fee for not monitoring as it did for monitoring.
This all sounds like a racket, and it is a racket, but to be fair it is a well-known racket of private-equity investing, which is that the private-equity firms keep dreaming up amusing fees to charge to their investors and portfolio companies, and the investors keep discovering those fees, and each time they chuckle appreciatively and say “I tip my hat to you, Apollo, really well played old chap, charging those monitoring fees for not monitoring.”
I mean, that’s what I would do, but it’s not my money. Actually the limited partners don’t much like this sort of thing, which is why, for instance, Apollo rebates most of its monitoring fees back to the limited partners by reducing the management fees it charges them, though usually not by the full amount of the monitoring fees. (So if Apollo charges a portfolio company $100 in monitoring fees, it will reduce the management fees it charges the investors who own that company by, say, $65.)
And while Apollo both disclosed to investors at the outset of its funds that it planned to charge portfolio companies a lot of random fees,and specifically disclosed the accelerated monitoring fees each time it took them, the SEC still finds that disclosure unsatisfactory, because Apollo didn’t specifically mention the accelerated monitoring fee thing at the beginning of each fund’s life:
While Apollo disclosed its ability to collect Special Fees to the Funds and to the Funds’ limited partners prior to their commitment of capital, it did not adequately disclose to the Funds, the Funds’ Advisory Boards, or the Funds’ limited partners its practice of accelerating monitoring fees until after Apollo had taken accelerated fees. The disclosures were made in distribution notices, reports to the Advisory Board, and, in the case of IPOs, Form S-1 filings. By the time these disclosures were made, the limited partners had already committed capital to the Funds and the accelerated fees had already been paid.
And then their only recourse was to complain about it. Which honestly isn’t nothing, as recourses go? This was a repeated game: The limited partners are big institutional investors, and Apollo kept raising new funds. And as the limited partners find silly new fees, they seem to be pretty successful at squashing them, or at pushing the private-equity firms to credit those fees against their management fees, reducing the overall cost to the limited partners. The SEC’s accelerated-monitoring-fee cases are basically just an acceleration of this process: The limited partners would eventually have cracked down on accelerated-monitoring-fee thing, but the SEC can shut it down faster and more completely.
But as a disclosure problem, the accelerated-monitoring-fee stuff feels a little thin. It was disclosed. Sure, Apollo didn’t emphasize the silliness of taking monitoring fees for not monitoring companies, but it didn’t exactly hide it either. It feels like the SEC is more offended by the silliness than by the disclosure.
Anyway, there’s one other thing that Apollo did that the SEC didn’t like, and it’s my favorite:
In June 2008, Apollo Advisors VI, L.P. (“Advisors VI”) – the general partner of Apollo Investment Fund VI, L.P. (“Fund VI”) – entered into a loan agreement with Fund VI and four parallel funds (collectively, the “Lending Funds”). Pursuant to the terms of the loan agreement, Advisors VI borrowed approximately $19 million from the Lending Funds, which was equal to the amount of carried interest then due to Advisors VI from the Lending Funds. The loan had the effect of deferring taxes that the limited partners of Advisors VI would owe on their respective share of the carried interest until the loan was extinguished. Accordingly, the loan agreement obligated Advisors VI to pay interest to the Lending Funds until the loan was repaid. From June 2008 through August 2013, when the loan was terminated, the Lending Funds’ financial statements disclosed the amount of interest that had accrued on the loan and included such interest as an asset of the Lending Funds. The Lending Funds’ financial statements, however, did not disclose that the accrued interest would be allocated solely to the capital account of Advisors VI.
The SEC is again concerned that this is a failure of disclosure, but I am more interested in it as a triumph of imagination. Apollo’s managers got paid in part with carried interest, a share in the appreciation of their portfolio companies. Carried interest is — notoriously — taxed at favorable rates, compared to other forms of compensation. But why pay yourself your carried interest, and incur a 15 percent tax rate, when you can instead lend yourself your carried interest, and put off paying taxes for five years? You get the money now, and can spend it now, but you don’t have to pay taxes until later. Of course the downside is that you have to pay interest on the loan, but that isn’t really so bad because you pay the interest to yourself. It’s such a nice little trade that I’m surprised that Apollo got in trouble for inadequately disclosing it. It almost seems like they should have bragged about it.
- Nah, we might know one day. The partner is not named or charged in today’s SEC action, but the SEC’s release says that the investigation is continuing, so maybe there’ll be a sequel with more detail.
- Strictly, Apollo was fined for having “failed reasonably to supervise Partner,” insofar as he kept racking up fake expenses and they kept not firing him for it.
- Present-valued, though:
For example, upon either the private sale or IPO of a portfolio company, the monitoring agreements allowed Apollo to terminate the monitoring agreement and accelerate the remaining years of monitoring fees, and receive present value lump sum “termination payments.”
- To be fair, when the portfolio companies IPOed, Apollo might still monitor them:
In most instances, Apollo terminated the monitoring agreement upon a portfolio company IPO and accelerated monitoring fee payments while the Funds maintained a significant ownership stake in the company. In connection with most IPOs, Apollo continued to provide certain consultancy and advisory services to the publicly traded portfolio company until the fund completely exited its investment. However, in some instances, Apollo accelerated monitoring fees beyond the period of time during which it held an investment in the publicly traded portfolio company. In other instances, Apollo provided services for periods longer than the period for which it received accelerated monitoring fee payments.
- From the SEC order:
Pursuant to the terms of the monitoring agreements, Apollo charges certain portfolio companies monitoring fees in exchange for rendering certain consulting and advisory services to such portfolio companies concerning their financial and business affairs. The monitoring fees paid by each fund-owned portfolio company to Apollo are in addition to the annual management fee paid by the Funds’ limited partners to Apollo. However, a certain percentage of the monitoring fees the portfolio companies pay to Apollo is used to offset a portion of the annual management fees that the Funds’ limited partners would otherwise pay to Apollo. The offset percentage, which generally is 65% to 68% for the relevant Funds, is set forth in each Fund’s LPA or investment advisory agreement. Certain limited partners of ANRP receive higher offset percentages – from 80% to 100% – pursuant to side letters.
The Funds’ LPAs and other disclosure documents authorize Apollo to collect certain “Special Fees” related to its negotiation of the acquisition and financing of portfolio investments. These Special Fees include, among others, consulting fees, advisory fees, and transaction fees. For example, the Funds’ LPAs and Private Placement Memoranda generally provide that Apollo is entitled to receive “[a]ny consulting fees, investment banking fees, advisory fees, breakup fees, directors’ fees, closing fees, transaction fees and similar fees . . . in connection with actual or contemplated Portfolio investments.”
That covers a lot of ground!
- Though I don’t doubt for a second that it’s common practice.
- The top capital-gains rateas of 2008. It’s now 20 percent, which I guess would have been one reason not to defer it.
By the way: Nice work taking out your carry in June 2008!