SEC investigates ‘favoritism’ for LPs providing debt for deals

This specific issue falls under the category of “favoritism,” which is explained as “favoring certain clients or funds or favoring certain investors without proper disclosure,” according to a January 2014 SEC presentation.

One example under “favoritism” in the presentation was “improperly giving mezzanine/lending business to favored investors.” The agency also cited primary commitments made to support a secondary or co-investment business.

Sources confirmed the SEC has been taking an active look at GPs that use LPs as mezzanine lenders, but it’s not clear if the agency has singled out specific firms. Judith Burns, a spokeswoman for the SEC, declined to comment.

Sources stressed that the practice is not inherently wrong. The SEC wants to make sure all LPs in a fund are aware that certain LPs have the benefit of an enhanced relationship with the GP, sources said. This is also the case for co-investments — the SEC wants to make sure all LPs in a fund understand which LPs get offered co-investments and why.

“The SEC doesn’t really care who the PE firm picks for borrowing, but does care a lot about improper disclosure and the fact that some LPs have been getting better deals than others without it being disclosed,” said a source with knowledge of the practice.

One concern is a firm with a large insurer as an LP will give that institution the first look at its deals and potentially choose to work with the insurer even if it’s not offering the best price, the source said.

This becomes especially relevant for firms who have a hard time raising their next fund. Getting a big institution as an early investor in the new fund can help illustrate to other LPs in the market that the fund has a significant name behind it, the source said.

However, two sources argued firms choose lenders for each deal and don’t promise business based on LP relationships. They also questioned how disclosure around these relationships could be enhanced considering firms choose lenders with each deal. Disclosure would have to be made to every LP each time a deal closes, they said. 

Some big insurance companies look for LP relationships as a way to bolster their mezzanine businesses — much like big investment banks enter LP relationships with large funds to try and get a slice of their deals.

Mezzanine is like “crack cocaine” to insurance companies because of the yielding nature of the investment, said one insurance company private equity official. “All insurance companies want yield, and mezzanine pays you a 10 or 11 percent coupon, when your bonds are giving you 3 percent. To be able to get cash yield for an insurance company is huge.”

Lenders involved in middle-market mezzanine lending include Babson Capital, an indirect, wholly owned subsidiary of Massachusetts Mutual Life Insurance Co and Northwestern Mutual Life Insurance Co, according to financial documents outlining their investments, as well as New York Life Insurance Co, through its subsidiary GoldPoint Partners.

GoldPoint, for example, touts its “Core Partners” program, which is focused on creating returns through limited partnership investments, and “a source of high quality, proprietary deal flow for the direct equity co-investment and mezzanine business.”

GoldPoint declined to comment.

Some insurance companies avoid providing mezzanine financing to GPs if they are limited partners in the GPs’ funds. One private equity professional at an insurance company that doesn’t provide mezzanine lending said the situation can be rife with conflict. “If I’m supplying mezzanine and the deal goes bad, I have to sit in the room and negotiate against my sponsor who I think is a great sponsor,” the insurance professional said. “You get into an adversarial relationship if things go bad. You are now not aligned.”