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The Private Equity Limited Partnership Agreement Release: The Industry’s Snowden Moment

The private equity industry kingpin, KKR, systematically took advantage of its credulous investors.

Last week, the Wall Street Journal released an important story that chronicled how the private equity industry kingpin KKR systematically took advantage of its credulous investors via taking questionable charges through its related company KKR Capstone. That story depended critically on the Wall Street Journal obtaining the terms of the investment from a 2006 KKR limited partnership agreement so that it could ascertain whether the investors had authorized these charges. Readers may recall that the private industry heretofore has kept these contracts under lock and key, insisting zealously that they be kept in the strictest confidence possible by those who obtain access to them.

We’ve published 12 private equity limited partnership agreements (LPAs), including the KKR limited partnership agreement that key to the Wall Street Journal’s story, in a searchable format that you can view here and here. We obtained the documents through the Pennsylvania Treasury’s public e-contracts library. Until now, it appears virtually no one knew that they had been made public. And you can be sure that if anyone associated with the private equity industry had recognized what had occurred, they would have shut this window immediately.

It is hard to overstate the significance of Pennsylvania’s release of these private equity limited partnership agreements. This development will change the industry forever. Even a superficial reading of these documents shows that investors and policy-makers were naive to treat private equity general partners as deserving of the blind trust they had placed in them.

Trade Secret? What Trade Secret?

For decades, private equity (PE) firms have asserted that limited partnership agreements (LPAs), the contracts between themselves and investors, should be treated in their entirety as trade secrets, and therefore not subject to disclosure under Freedom of Information Act laws in any jurisdiction. These private equity general partners argued that the information in their contracts was so sensitive that it needed to be shielded from competitors’ eyes, otherwise their unique, critically important know-how would be appropriated and used against them. In particular, PE firms have made frequent, forceful claims that their limited partnership agreements provide valuable insight into their investment strategies. The industry took the position that these documents were as valuable to them as the formula for Coca-Cola or the schematics for Intel’s next microprocessor chip.

Now that we can look at the actual language in limited partnership agreements, we can see what any sophisticated user of legal instruments would guess: the PE firm lawyers describe the strategy in the broadest, most general terms to give the private equity fund as much latitude as possible. For example, here is the investment strategy language from the KKR 2006 Fund:

2.1 Objectives The objective and policy of the Partnership are to invest in (i) Securities of Persons formed to effect or which are the subject of management buyouts or build-ups sponsored by the General Partner or any Affiliate thereof and (ii) Securities of Persons the investment in which the General Partner reasonably expects to generate a return on investment commensurate with the returns typically achieved in previous KKR-sponsored buyouts, build-ups and growth equity investments.

Claiming this statement is a trade secret is analogous to the U.S. Navy claiming classified status for the fact that it operates ships on oceans.

Moreover, if you read the balance of section 2.1 (“Objectives”), you see that that most of the remainder of the paragraph deals with the goal of tax avoidance, with 195 words in the paragraph dedicated to this issue. When KKR claims the limited partnership agreement is a trade secret, it’s not hard to surmise that these tax games are a big part of what they are really trying to hide. But now that we can look across a series of limited partnership agreements, it’s clear that the tax strategies are highly parallel across funds. To the extent that there is anything distinctive, it’s in minor details relating to the implementation of the tax scheme, and not its objective or design.

The closer you look, the harder it is to find information in the LPAs that even approaches a bona fide trade secret. Could it be the management fee? Platinum Equity Capital Partners III says in its LPA (p. 158) that the management fee during the commitment period is equal to “0.4375% per quarter”. At the same time, in its publicly-available Form ADV Part 2 (p. 4), the firm discloses that “Platinum Equity Capital Partners III, L.P., together with its Parallel Funds, is subject to a Management Fee of up to 1.75% [annually] of committed capital…” (1.75% = 0.4375% X 4). So, apparently that’s not the trade secret either.

Key person terms are another provision of LPAs that PE firms have asserted rise to trade secret status. The idea behind a “key person” provision is that certain individuals are critical achieving the sought-after investment returns and the investors thus depend on their expertise and experience. The agreements provide that if any of these “key persons” depart or otherwise can no longer work for the private equity firm, the limited partners can stop contributing capital to a fund or even force its dissolution.

Let’s look at Milestone Partners IV, where in section 3.2(h), you can see that both John P. Shoemaker and W. Scott Warren are defined as the sole “key persons”. Are we supposed to be surprised by this? Both Shoemaker and Warren are described on the firm’s website as Milestone’s sole managing partners. So there is nothing really a secret about this either, nor is it easy to see how disclosure of Shoemaker’s and Warren’s key person designation, even if it were previously a secret, would hurt Milestone upon disclosure.

So what might be the reason for such stringent efforts to maintain secrecy? We described one reason why private equity firms are keen to keep limited partnership agreements confidential last year:

This information lockdown prevents a worst-case scenario for scamming PE firms, that a mid-level accounting employee at a portfolio company would use public documents to compare the payments made to fund investors with what was taken from the portfolio company where the accountant works. State qui tam laws, which are designed to prevent precisely this type of abuse by awarding a portion of the government’s recovery to people who uncover fraud, would provide a powerful incentive for employees at portfolio companies to rat out their PE overlords. But that’s not going to happen as long as public pension fund PE investors keep the contracts and cash flows behind the FOIA wall.

How realistic is that scenario? Two days ago, the New York Times’ Gretchen Morgenson quoted a high-level SEC official discussing the practices of PE firms: “In some instances, investors’ pockets are being picked.” So, it’s reasonable to suspect obscuring this “pocket picking” is a major reason why general partners insist on keeping LPAs hidden.

Tax Dodging

A cursory look shows that the KKR, TPG, and Platinum LPAs all contain management fee waiver provisions (see language relating to “Increased Capital Amount” in KKR; “Waiver Election Amount” “Waiver Contribution” and “Waiver Earnings” in Platinum; 6.02(c)-The Management Company may “elect to waive all or a portion of the Management Fee…” “for a number of quarterly periods determined by the Management Company” in TPG). We have written extensively about this tax dodge, whereby PE firms con their investors into enabling a scheme that allows private equity general partners to convert what would otherwise be ordinary income into capital gains. The PE firms purportedly “waive” their management fees in return for supposedly receiving additional carried interest compensation. This is similar to telling your boss not to give you the raise he’s offered, but to buy you Yankees season tickets with the money instead, and claiming that the transaction is tax free.

The IRS has been grumbling for some time that it’s on to this maneuver and takes a dim view of it. In April, a high-ranking official made a speech intimating that the IRS is finally clamping down. Regulations will be issued shortly that will clarify that, under existing law, fee waivers are do not achieve the claimed tax result. Somebody needs to ask the investors in the KKR, TPG, and Platinum funds how they justify cooperating with this scheme in light of the IRS’ vocal disapproval.

The LPAs also reveal potentially illegal efforts for the funds and their investors to hide arcane but important forms of income called “UBTI” (“Unrelated Business Taxable Income”) and “ECI” (“Effectively Connected Income”). The idea behind both UBTI and ECI is that tax exempt investors should not be able to hide behind their tax-free status to operate businesses that would have a competitive advantage because the profits aren’t taxed. As a result, UBTI federal tax is assessed on U.S. non-profits and ECI federal tax on foreign investors in U.S. funds to level the playing field.

One of the few ways that limited partners have pushed back against the general partners is that the limited partners have demanded and won a de facto fee reduction via the sharing of general partner transaction and monitoring fees with limited partner investors (as we’ve also discussed, the degree to which there actually were any services rendered is open to question). But for the limited partners to take their partial rebate of these fees would clearly constitute UBTI/ECI absent any special maneuvering to avoid the tax.

PE firms long ago came up with the idea of crediting these rebates against the management fees otherwise owed by investors, rather than writing checks to investors. The argument for why these management fee offset arrangement doesn’t implicate UBTI/ECI gets fairly arcane, but the key point is that the PE firms take the position with the IRS that “Hey, we’re not sending the investors checks, so it’s not UBTI/ECI.”

Now that we can scrutinize LPAs, however, we see that some do call for checks to go back to the investors. For example, on p. 158, Section 3.02(d) TPG’s limited partnership agreement says:

(d) On a cumulative basis, the Management Fee due in respect of each Limited Partner (including any additional Limited Partner) shall be reduced by an amount equal to one hundred percent (100%) of such Limited Partner’s share of Net Fee Income, if any, B-3 received by the Management Company, any Principal or any Affiliate of the Management Company, in each case in connection with such Person’s activities as a representative, or on behalf, of the Partnership. To the extent that the amount referred to in the preceding sentence exceeds the Management Fee due in respect of such Limited Partner, such excess shall be carried forward and, if not previously applied against such Management Fee, shall (notwithstanding paragraph 4.02(d) of the Partnership Agreement) be paid by the Management Company (or its Affiliate) to such Limited Partner upon liquidation of the Partnership [emphasis added].


What this complicated section provides for is that TPG will roll forward any management fee credits that can’t be applied in a given period because the management fee has already been reduced to zero. If any remain at the end of the fund life, the investors get a check. So, rather than there being the potential for payment issuance in any particular accounting period, TPG has pushed the accounting around so that any check is issued just once, at the end of the fund life. But it’s the same either way, and the key point is that the practice pretty much destroys their argument that these payments are not subject to UBTI/ECI tax. Other of the LPAs have this same feature (see, for example, Palladium at p. 100 section 4(b))

Tricky, Tricky Language

Some of the language in these documents is so sneaky that, if the investors’ lawyers didn’t flag it in the legal review process, they are arguably guilty of malpractice. And, if their lawyers did point it out, yet the investors ignored the problem, one can only ask: What were they thinking?

We’ll offer just one very disturbing example of how the PE firms use language to mislead, from the “Definitions” section of the KKR 2006 Fund LPA. A careful reading reveals that all of the following are defined terms: “KKR”, “Affiliate”, and “KKR Affiliate”. Critically, “KKR Affiliate” is much narrower than what “KKR” and “Affiliate” mean when defined separately. And KKR clearly understood that what was and wasn’t an affiliate was key to its KKR Capstone fee-hogging activity. As we noted in our analysis of the Wall Street Journal story on KKR Capstone, whether or not the SEC goes after KKR on this matter hinges on whether it accepts KKR’s tortured defense.

The term “Affiliate” has the meaning that readers of corporate agreements would expect and refers to bothentities and individuals. A “KKR Affiliate” refers only to entities controlled directly or indirectly by KKR.

This distinction matters a great deal. Section 6.3.1(b) appears to provide the fund investors with the critical protection they need against various forms of fee skimming that both KKR entities and their executives might otherwise be free to pursue with the fund’s money or the money of portfolio companies:

The General Partner, KKR and the KKR Affiliates will not engage in any transaction with the Partnership or any Portfolio Company or subsidiary thereof unless the terms of the transaction are on an arm’s-length basis and no less favorable to the Partnership or such Portfolio Company than would be obtained in a transaction with an unaffiliated party…

What is clearly intended here is for investors to read the term “KKR Affiliates” as synonymous with “Affliates” of “KKR”. But that’s not what it means. If it did mean “Affiliates” of “KKR”, the restriction would prevent KKR executives from having side businesses that they could force the fund or the portfolio companies to hire for purported “services”. This is not a hypothetical situation. We documented that Tony James, the COO at Blackstone, has just such a business that is active in industries in which Blackstone owns portfolio companies. The investors no doubt believe they got a restriction on related party activities, but Blackstone’s agreements almost certainly contain similar language which permits this sort of abuse.

The Snowden/NSA Analogy

For decades, the NSA kept its domestic spying activities under wraps, claiming that it served as a wise and responsible steward of the powers with which it had been entrusted. Similarly, the private equity industry has insisted for decades that none of the usual SEC and FOIA transparency requirements should apply to its activities, but that the general partners should be trusted to comply with the law and treat investors fairly.

Snowden’s documents revealed that much of the NSA’s domestic spying is arguably illegal, and that a primary objective of the secrecy surrounding it was to shield the NSA from accountability and oversight, since that would curb the scope of the agency’s actions. The private equity industry now finds itself in much the same situation, albeit in this case, there’s no Snowden-like insider who chose to break institutional rules and give confidential information to journalists. Here, a public pension fund had simply made them public and it took a surprisingly long amount of time for anyone to notice.

Nevertheless the uncomfortable analogy to the NSA’s fetish with secrecy remains. Here the exposure of key documents reveals the private equity industry’s claims that the general partners obey the law are false. Instead, critical elements of their scams and violations of public interest depend on their being hidden from view.

The document release also reveals what dupes the investors have been. The SEC has already reached that conclusion, stating in a recent speech that investors have done a poor job of negotiating agreements so that they protect their interests and have done little if any monitoring once they’ve committed to a particular fund. As we’ll chronicle over the next few days, anyone who reads these agreements against the disclosures that investors are now required to make to the SEC and the public in their annual Form ADV can readily find numerous abuses, which range from bad-faith dealing to potentially criminal conduct. And remember, investors have far more detailed information, and also can ask the general partners questions if they detect practices that look sus.

But rather than live up to their fiduciary duties, pension funds that have invested in private equity funds haven’t merely sat pat as they were fleeced; even worse, they’ve been staunch defenders of the private equity industry’s special pleadings.

The private equity industry’s obsession was never about competing effectively. It was a self-serving ploy to shield the documents from scrutiny, since third parties might ferret out how private equity firms increase their already substantial profits at the expense of complaint, clueless investors. And as we’ll discuss in more depth, quite a few general partners have been both relentless and shameless in how they’ve gone about it.

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