The head of the SEC's examination unit, Andrew Bowden, created a furor last May when he described the widespread lawbreaking that the SEC was uncovering in its first examinations of private equity firms, now that virtually all were required by Dodd Frank to register as investment advisors. For one type of abuse alone, allocation of fees and expenses, Bowden stated that the SEC had found "violations of law or material compliance failures" in more than half the firms examined. Let's not put too fine a point on this: the SEC said that most firms were stealing from investors, either by accident or design. Bowden confirmed that view, later telling the New York Times' Gretchen Morgenson that "investors' pockets are being picked."
But after this unusually tough and detailed talk, the SEC went into retreat. Reports from speeches and statements by Bowden at private equity conferences and in interviews showed him making conciliatory remarks that were disturbingly inconsistent with the level and range of wrongdoing his unit had unearthed. The disparity was so striking that it went well beyond a walkback; we called it a coverup last September and an example of enforcement cowardice in October. The agency appeared to be hoping, unrealistically, that if it merely told investors that there was gambling in Casablanca, that they'd shut it down on their own. This position looked naive given that Bowden himself had pointed out, in May, that the agreements between investors (the "limited partners") and the private equity firms (the "general partners") were vague on many critical points, which gave the general partners far too much latitude for misconduct. If the limited partners were willing and able to stop these abuses, they would have done so long ago.
One possible explanation of this striking reversal could be that private equity kingpins, who are often substantial political donors, told Congresscritters to call the SEC dogs off. Remember that the SEC is the lone financial regulator whose budget comes from Congressional appropriations, as opposed to fees and fines. Congressmen have not hesitated to threaten the SEC with budget cuts when they've deemed it to be stepping on important donors' toes.
However, the reason for the apparent reversal appears to be far more troubling. Bowden's previous appearances have been industry conferences, not open to the public, and not recorded. But an event earlier this month was taped, and the picture that emerges is disturbing.
At a minimum, Bowden reveals himself to be captured to an embarrassing degree. His remarks about the industry aren't merely fawning; a former Goldman staffer called them "fellating". Even worse, Bowden comes uncomfortably close to the line of offering to play the revolving door game at an unheard-of level of crassness, putting his son, and by implication himself, into the job market at an industry conference.
Bowden, along with Erin Schneider of the SEC's enforcement staff in its San Francisco office, senior private equity investment professionals Sarah Corr from CalPERS and Margot Wirth of CalSTRS, and John Monsky, general counsel of private equity firm Oak Hill, appeared on March 5 at a conference at Stanford Law School, Emerging Regulatory Issues in Private Equity, Venture Capital, & Capital Formation in Silicon Valley. In a sign of undue chumminess, the moderator, former SEC commissioner and Stanford law professor Joseph Grundfest, didn't see fit to disclose that he is a board member of KKR.
If you watch the entire segment, you'll see that much of it surrounds who is and is not subject to SEC registration (venture capital firms are generally exempt, while private equity "buyout" firms with over $100 million in assets are subject), how the regulators try to judge intent and severity of misconduct (with the caveat that really poor processes for protecting investors can be as bad as malfeasance), how limited partners try but too often fail to get the information they'd like, and how the SEC allegedly has enforcement actions in the pipeline.
But the revealing part came in response to the final query in the Q&A section.
Questioner: It seems that one of maybe the unintended consequences of the new regulatory regime seems to be that it favors the scale economies of a large fund versus a smaller fund because of the fixed cost of compliance. Also, because there's with the transaction fee offsets, there's kind of less money there for the smaller funds to afford groups like operating partners and people like that. And it would seem that one of the consequences could be you will find over time less innovation, less creation of smaller GPs to the favor of the larger GPs because the economics because the economics of the industry because of all these fixed costs and changes in transactions are favoring the larger GPs. I'm interested from an LP perspective how you view that.
As as aside, it's hard to have much sympathy with this "compliance costs money" complaint. Any long-only asset manager with $150 million in assets under management faces similar compliance obligations, yet has a vastly less rich fee structure than private equity. Moreover, it's true across the entire asset management industry, and not just in private equity, that there are very large returns to scale at the individual fund level. So even though the question was not directed at him, Bowden was correct to interject and take issue with what amounts to whining about profits. But look at how he makes that response:
Bowden: Let me throw my two cents in, which is this is something I ran into for like 25 years in the industry. So when I was in the industry and I'd be on panels like this, a lot of the older people would talk about growing regulation, 'cause it has increased, right, over the last couple of decades, I don't think there's any two ways about it, and they'd sort of lament and say, I have money to get out of the business, there's too much regulation, it's not worth it any more.
And even when I was in the industry, I'd always look at them and say, like, "What are you talking about? This is the greatest business you could possibly be in. You're helping your clients."
I think if you look at McKinsey studies, the average asset manager, I'm not even talking about private equity, the average asset manager has margins of 25 or 30 percent. Like what, who else out there is in a business that's that good? And I reckon, it's sort of interesting for me for private equity in terms of all we've seen, and what we have seen, where we have seen some misconduct and things like that, 'cause I always think like, to my simple mind, that the people in private equity, they're the greatest, they're actually adding value to their clients, they're getting paid really really well, you know, if I was in that position, the one thing I would think to myself as I skipped to work was like just "Let's not mess it up. You know, this is the greatest thing there, I'm helping people, I'm doing OK myself."
And so my view on the small ones is, I still think this is one of…I tell my son, I have a teenaged son, I tell him, "Cole, you want to be in private equity. That's where to go, that's a great business, that's a really good business. That'll be good for you."
So for me personally, as we share our opinions…
Questioner [interrupting] I'd love to hire your son, by the way. That's a deal.
This is disturbing on multiple levels. First, even though Bowden and industry loyalists will depict this response as a successful attempt at levity at the end of a dry panel, Bowden's tone and his word choice say a lot more is at work. There's a nose-against-the-toy-store window quality to his awe of private equity industry profitability. The words come tumbling out of his mouth, with Bowden at points not even finishing a thought before he rushes off to the next. He can barely contain his enthusiasm and admiration. Rest assured that this is not his normal speaking style; see his measured, composed discussion of conflicts of interest at 1:24:20 by way of contrast.
I'd be put off by this level of gushiness in a prospective service provider, say an attorney or an accountant. It's cringe-making coming from a regulator.
And remember, unlike banking, where all the regulators are prudential regulators, and thus actually do have to worry whether regulatory costs and burdens hit industry profits too much (over time that can hurt capital levels and thus put institutions at risk), the SEC has no such conflicts in its mandate. The SEC is tasked strictly with protecting investors and the integrity of markets. For instance, when it regulates broker-dealers, it cares about whether the firms' customers are at risk of losing money, and not about lender or shareholder exposures. So while it might be politic to take the position that the SEC is not out to get the firms it regulates, it has no business acting as if it were a booster.
But even worse is the way, in what was the closing remark on this panel, that Bowden effectively dismisses the work his exam group has done. The abuses, which include what amounts to embezzlement, are "some misconduct" by an industry that Bowden repeatedly depicts as "the greatest". This is a textbook example of what I've called the "big producer syndrome," when a high-performing individual or unit is given undue latitude and misconduct goes undetected or is ignored. This is precisely the sort of thing that regulation is meant to stop. Yet Bowden is presenting, unabashedly, precisely the "nothing that terrible can be happening if the results look so good" mindset that allows bad behavior to grow into organizational cancers.
Moreover, Bowden's belief in the industry's "adding value" and "helping people" is based on having taken a very big swill of industry Kool-Aid. He twice parrots the position that private equity firms are a boon to their clients and the economy overall. He might want to make more study of the industry, or even reread his speech from last May, before acting as a PR agent.
The most extensive, careful study of the private equity industry, Eileen Appelbaum's and Rosemary Batt's Private Equity at Work, based on a bending-over-backwards-to-be-fair reading of academic research and numerous case studies, finds pervasive problems with the private equity model, the biggest being that it extracts from creditors, taxpayers, pension funds and employees. Their book also, contrary to Bowden, cites considerable academic evidence that private equity does not deliver returns adequate to cover for its risks. That's before you get to the fact that it uses a valuation method, IRR, which is widely criticized as unduly flattering.
Appelbaum's and Batt's reservations were confirmed by the CalPERS's panelist Sarah Corr earlier in the Q&A, who pointed out that CalPERS has cut its allocation to private equity. That is apparently the result of private equity failing to meet CalPERS' benchmarks over the last one, three, five, and ten year periods. If CalPERS, which can negotiate the best terms and has better deal access to funds than anyone, can't get great results out of private equity, how can other investors expect to do better?
But the icing on the cake was the overly-eager, overly-long discussion of how Bowden really wants his son Cole to work in private equity. Even though Bowden can brush his remarks off a joke, there are some words you just can't unsay. As a Congressional staffer who looked at the segment put it, "It looks like he's soliciting a bribe." And the private equity questioner, in the same bantering-but-maybe-not manner, seized immediately on the opportunity to do a favor for an influential regulator.
Bowden's most attractive career option, assuming he does not move into a more senior role at the SEC first, would be to join a private equity firm as a chief compliance officer. The fact that Bowden made such an unabashed statement of his real loyalties, to his future meal tickets, is a strong and troubling sign that this sort of cozying up is a non-issue at the Mary Jo White's SEC. Bowden was hired during her tenure and presumably reflects her priorities. Recall that White is trying, with mixed success, to make a good appearance while doing as little as possible to rock the boat of powerful incumbents.
Zephyr Teachout, in her celebrated book on corruption, depicted it as public officials putting private interest over the general good. Bowden, who clearly sees himself as an upstanding person, is nevertheless a textbook case by virtue of how deeply captured he is, and his refusal to scrutinize the comfortable, career-advancing assumptions that have worked so well for him.