The US Primaries And The Private Equity Industry by Sebastien Canderleauthor of Private Equity’s Public Distress
What is it about American elections that helps revive the rant against private equity practices? As the primaries are underway, once again the generous tax treatment of PE fund managers’ income and the asset-stripping nature of some of their aggressive practices have received significant media coverage. Hillary Clinton has already vowed to close the carried interest loophole that allows PE professionals to pay less tax than middle-income earners. Even free-market advocate Donald Trump has suggested raising the tax rate applied to hedge fund and PE professionals’ carried interest. Had we hibernated for the last four years, we could be mistaken for thinking that Mitt Romney is still running for the Republican nomination and that his past involvement in LBOs is the main bone of contention. It is a safe bet that things will get back to normal once the presidential election is out of the way, so powerful is the private equity industry’s lobby in Washington.
But what is also topical at the moment is the SEC’s crackdown on fees charged by private equity groups, not always with the full consent or knowledge of their institutional investors, the Limited Partners. For years, Warren Buffett has explained that expensive, high-end money managers (not specifically PE managers but also hedgies) add little value and actually generate lower returns than your average low-fee index fund. Buffett is in the process of winning his decade-long bet against Protégé Partners, with Buffett’s selection of a Vanguard index fund apparently well-ahead of Protégé’s choice of five funds of hedge funds. No doubt, in private equity, fees have been equally value-destructive but it is difficult to assess their real impact. The reason has become clear in recent months when we discovered that even leading Limited Partner CalPERS does not know the amount of fees it gets charged by its General Partners in any given year. If CalPERS has no idea, we can venture a guess that few others do. It seems that LPs do not bother to keep track of the various commissions General Partners extort from them.
Step in the regulators. The SEC recently fined two of the sector’s largest GPs for, allegedly, overcharging their Limited Partners and/or for failing to disclose clearly and in advance what these commissions relate to. In June and October of this year, KKR and Blackstone paid $30 million and $39 million respectively to settle charges from the US financial regulator. Already rumours point to further settlements in the not so distant future. It is only a matter of time before regulators in other countries, least of all the UK’s Financial Conduct Authority, follow the SEC’s path.
Nevertheless, the SEC’s manoeuvres are surprising. The argument heard from regulators and trade associations all those years was that LPs were savvy institutional investors that could take care of themselves, implying that they did not need financial authorities to step in to defend their interest. The SEC seems to have changed its mind. Either that or it realised that it is not the LPs’ interest that needs protecting but that of the end-investors: the individual pensioners, the holders of bank savings accounts, and the subscribers to life insurance products. Fees charged on these people’s assets gradually gnaw at the gains generated on their investments. We are back to Buffett’s argument about fund managers charging exorbitant fees with little added benefit to investors.
Which rather begs the question: what is the reaction of limited partners in all this? We can presume that they feel slightly embarrassed by the recent public admission that they do not have a clue how much they are being charged by the PE fund managers they pledge their capital to. The recent call by California’s State Treasurer John Chiang for legislation on fee disclosure was well received by CalPERS, so perhaps LPs will take advantage of the support they are getting from regulators and legislators to start protecting the interest of the end-investors. Something they should have done long ago.
If GPs are happy to overcharge for their services and LPs could not be bothered to put things right, we can understand why the regulators had to step in. But that raises another question. For the last four decades the sector has operated under a light-touch regulatory framework and all parties involved had assumed that there were enough bells and whistles, checks and balances, to keep GPs honest. If the latter have misbehaved when charging fees, what else have they been up to? It might be worth investigating. After they have closed the small matter of fee overcharging, regulators can tackle issues like tax avoidance, tax evasion and what else. It is amusing what companies get up to when loosely supervised.
Maybe it is time for US presidential candidates to stop the rhetoric and get serious about introducing the private equity world to a tax and regulatory framework worthy of the name. Do we really want to wait till the 2019 primaries, or worse, the next financial crisis before acting? If the worst fears that the scandal around fees is the tip of the iceberg prove correct, authorities must act to protect capitalism from this tiny minority of shy-on-disclosures rent-seekers.
Sebastien Canderle is a consultant, a university lecturer in private equity, and the author of Private Equity’s Public Distress