On its fourth anniversary, has Dodd-Frank begun to bite?

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The financial crisis of 2008-2010 threatened the nation's financial stability and caused families to lose trillions of dollars in household wealth. Many large financial institutions, driven to the brink of bankruptcy by greed, fraud and irrational exuberance, were bailed out by the government at taxpayer expense.

In the years preceding the crisis, rules that had successfully protected the financial system since 1930 were rolled back and lax enforcement prevailed for those that remained in place. Regulators, led by Alan Greenspan at the Federal Reserve and Robert Rubin and Larry Summers at the Department of the Treasury, had promulgated the view that sophisticated players in financial markets cared more about protecting their reputations than about lining their pockets, so there was no need to regulate them. The financial collapse demonstrated just how wrong it was to let bankers, hedge fund wheeler-dealers and private equity titans police themselves.

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Chastened by the crisis and the backlash by Americans of every political persuasion against Wall Street, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. The law provides stronger regulation of finance and, for the first time, regulates private equity firms.

Before Dodd-Frank, the general partners in private equity funds, who make all decisions, were exempt from the Investment Advisers Act of 1940. Most claimed an exemption by limiting the number of investors and meeting other criteria. Dodd-Frank repealed this exemption. Since August 2012, advisers to private equity and hedge funds with $150 million or more in assets under management in the U.S. are subject to the Investment Advisers Act and must register with the Securities and Exchange Commission (SEC). In addition to requiring the registration of private equity fund general partners, the act requires these general partners to comply with fiduciary responsibilities to fund investors, and limits the performance fees they charge.

Under Dodd-Frank, general partners of private equity funds must report basic organizational and operational information such as size, types of services, fund investors, fund employees and potential conflicts of interest. These reporting requirements are modest, however, in comparison to the information that publicly traded companies must provide, and are kept confidential by the SEC. This ensures that private equity transactions remain private and transparency remains an issue. It appeared that private equity had watered down the regulations affecting them, substantially limiting SEC oversight. Many observers, including my co-author, Rosemary Batt, and myself, were skeptical that this would have much effect on how private equity firms do business.

Early on, however, Carlo di Florio — director of the SEC's Office of Compliance Inspections and Examinations (OCIE) at the time the Dodd-Frank regulations went into effect — signaled his office's intention to monitor private equity fund advisers. Speaking at a private fund compliance conference in May 2012, di Florio laid out what his office would be looking for.

The SEC, he told his audience, would monitor private equity fund advisers to be sure they implemented appropriate written policies and procedures. The SEC would also examine whether private equity advisors met their fiduciary responsibilities to investors "by fairly allocating fees and expenses, clearly disclosing them, and reporting them completely, accurately and in a timely manner." In addition, the SEC would ensure that private equity firms identify, disclose and mitigate potential conflicts of interest. Potential conflicts might arise from exaggerating returns on previous investments; misallocating investment opportunities and fees; highlighting only successful portfolio companies; or extending a fund's life in order to accrue management fees.

Despite this clear warning, issued three months before the Dodd-Frank provisions affecting private equity firms went into effect, the industry was taken aback by the results of the SEC's monitoring of fund advisers' activities. Two years later at the private fund compliance forum, Andrew Bowden, the current director of the OCIE, shocked his listeners when he reported on the insights gleaned from monitoring private equity firms. Bowden pointed to the vagueness of many limited partnership agreements with fund investors that enabled advisers to charge fees to portfolio companies and require payment for expenses that could not have reasonably been contemplated by investors in private equity funds. The SEC, he reported, had identified this type of misbehavior and possible violations of law in more than half the cases it has examined.

The largest failings are associated with fees that private equity firms charge portfolio companies for advice on business operations — advice that investors believe is provided by private equity firm employees. This creates a backdoor means of collecting fees that investors are not aware of. Even more egregious is causing portfolio companies to sign contracts for monitoring services that extend long past the time that the private equity fund owns the company. The sale of the portfolio company triggers a huge payout on the contract for services that will never be provided. This arrangement, as Bowden observed, "has the potential to generate eight-figure, or in rare cases, even higher fees" — without the knowledge of private equity investors.  

Apparently many private equity firms will miss no opportunity to enrich themselves, no matter how small. The SEC is now investigating whether undisclosed kickbacks that private equity firms receive for steering portfolio companies to group purchasing services represent a conflict of interests between the best interests of the portfolio company and the payoff to the private equity firm. The kickbacks are modest in comparison, with payouts for monitoring services. Blackstone, for example, is reported to have received approximately $7 million between 2011 and 2013 in such kickbacks — a little more than one-tenth of 1 percent of its $6 billion income from fees during those three years.

Bowden is hopeful these revelations will improve the behavior of private equity firms and will help the industry grow. It may be, however, that these revelations are only the tip of the iceberg. The SEC will have to go beyond its current mandate before investors in private equity funds and employees and creditors of portfolio companies can have confidence in the private equity business model. Under Dodd-Frank, the SEC is charged with collecting information on potentially systemic risks. The SEC does not currently require fund managers to report on individual companies in private equity fund portfolios — the amount of leverage loaded onto the company, the company's role as an economic anchor in the community in which it is located, and the risk that the company will default on its loans. As with information collected in the examinations of private equity fund advisers conducted to date, such information would improve transparency and increase the SEC's ability to monitor systemic risk.

The SEC is also concerned with ensuring that the culture of private equity firms is conducive to effective risk management and overseeing risk-based compensation systems. To this end, it might consider actions similar to those taken by bank regulators to reduce risk by limiting the amount of debt loaded onto a company to six times earnings (EBITDA). It might also take action to rein in risk-based pay of private equity partners, who currently have incentives to make risky bets on companies with other people's money, reaping the rewards when those bets pay off but suffering no consequences when they go sour.

Appelbaum is a senior economist with the Center for Economic and Policy Research and co-author, with Rosemary Batt, of the book Private Equity at Work: When Wall Street Manages Main Street.