Fees, Fees And More Fees: How Private Equity Abuses Its Limited Partners And U.S. Taxpayers by Center for Economic and Policy Research
“One nice thing about running a private equity firm is that you get to sit between investors who have money and companies who need it, and send both of them bills. This has made a lot of private equity managers rich.” — Matt Levine1
Executive Summary
The private equity industry receives billions of dollars in income each year from a variety of fees that it collects from investors as well as from companies it buys with investors’ money. This fee income has come under increased scrutiny from investigative journalists, institutional investors in these funds, the Securities and Exchange Commission (SEC), the Internal Revenue Service (IRS), and the tax-paying public. Since 2012, private equity firms have been audited by the SEC; as a result, several abusive and possibly fraudulent practices have come to light.
This report provides an overview of these abuses — the many ways in which some private equity (PE) firms and their general partners gain at the expense of their investors and tax-payers. Private equity general partners (GPs) have misallocated PE firm expenses and inappropriately charged them to investors; have failed to share income from portfolio company monitoring fees with their investors, as stipulated; have waived their fiduciary responsibility to pension funds and other LPs; have manipulated the value of companies in their fund’s portfolio; and have collected transaction fees from portfolio companies without registering as broker-dealers as required by law. In some cases, these activities violate the specific terms and conditions of the Limited Partnership Agreements (LPAs) between GPs and their limited partner investors (LPs), while in others vague and misleading wording allows PE firms to take advantage of their asymmetric position of power vis-à-vis investors and the lack of transparency in their activities.
In addition, some of these practices violate the U.S. tax code. Monitoring fees are a tax deductible expense for the portfolio companies owned by PE funds and greatly reduce the taxes these companies pay. In many cases, however, no monitoring services are actually provided and the payments are actually dividends, which are taxable, that are paid to the private equity firm.
The Problem
Private equity firms charge their portfolio companies monitoring fees that can cost the company millions of dollars each year. The practice itself is fraught with conflicts of interest. The monitoring fee is stipulated in the Management Services Agreement between the private equity firm and a portfolio company that it controls. The PE firm has representation on the portfolio company’s Board of Directors that approves the agreement, and fees are paid directly to the PE firm.
Abusive Fee Allocation and Expense Practices Include:
- Double-dipping: PE firms have been found to directly charge the limited partner investors in their funds for back office expenses that should have been covered by the 2 percent annual management fee that the limited partners already pay.
- Failure to share monitoring fee income: PE firms are paid monitoring fees directly by the portfolio companies for consulting and advisory services they ostensibly provide. In many cases, they are required to share a portion of this fee income with their limited partner investors, but have failed to do so. In other cases, where they have shared fee income, LPs do not receive an accurate accounting of the fee income and are unable to assess whether they have received their fair share.
- Using consultants to avoid sharing fees: Monitoring fees are supposed to cover advisory services that PE firm professionals provide to portfolio companies. But some firms hire outside consultants instead and bill their services to the portfolio company. In cases where outside consultants are used, PE investors do not receive the fee income they would otherwise be entitled to. Moreover, the profits of the PE firm are increased because the salaries of the executives providing advice have been shifted to the portfolio company. In addition, fees paid by portfolio companies for advisory services are tax deductible, so the entire scheme is subsidized by taxpayers.
Private Equity – Money for Doing Nothing
Beyond basic fee and expense allocation abuses, more egregious ones include “accelerated monitoring” and “evergreen” fees.
- “Accelerated monitoring” fees are fees for services never rendered. Here, the Management Services Agreement (MSA) (signed by the portfolio company and the PE firm) stipulates that the company must pay the annual monitoring fee to the private equity firm for a given time period, perhaps 10 or more years — regardless of when the private equity fund sells the company. If the PE fund sells the company in five years, as is often the case, the portfolio company must nonetheless pay off all the remaining monitoring fees in one lump sum — for services it will never receive.
- “Evergreen” fees are accelerated monitoring fees, charged to a portfolio company, that automatically renew each year. An initial 10 year agreement automatically renews each year for 10 years. When the company is sold, it must pay for 10 years of services it will never receive.
Transaction Fees and Acting as a Broker-Dealer
The transaction fees collected in the course of a leveraged-buyout of a portfolio company by a PE fund have the potential to create a conflict of interest. Because PE general partners receive a fee for every transaction they execute, they may be motivated to carry out transactions that generate substantial fee income for themselves without regard to whether that transaction is in the best interest of the limited partners in the PE fund. These fees provide an immediate cash windfall to the GP, regardless of how well or poorly the investment performs.
Because of these potential conflicts of interest, securities laws require that anyone engaged in the business of securities transactions register as a broker-dealer and be subject to increased scrutiny and transparency. A whistleblower lawsuit filed in 2013 identified 200 cases of leveraged buyouts (LBOs) in which the private equity general partner had failed to register as broker-dealer, but the SEC has taken no action on these cases even though it has flagged this activity as a potential violation of securities laws.
Waiver of Fiduciary Responsibility
Some Limited Partnership Agreements specifically state that private equity firms may waive their fiduciary responsibility towards their limited partners. This means that the general partner may make decisions that increase the fund’s profits (and the GP’s share of those profits — so-called carried interest) even if those decisions negatively affect the LP investors. This waiver has serious implications for investors, such as pension funds and insurance companies, which have fiduciary responsibilities to their members and clients. These entities violate their own fiduciary responsibilities if they sign agreements that allow the PE firm to put its interests above those of its members and clients.
SEC Enforcement
Despite the mounting evidence of private equity abuses and potentially illegal behavior, SEC enforcement actions have been minimal, with only six actions against PE general partners between 2014 and 2016. In 2014, the SEC targeted two small private equity firms — Lincolnshire Management and Clean Energy Capital — for infractions that were relatively minor. In 2015, KKR paid $30 million to settle an enforcement action for misallocating expenses in failed buyout deals; Blackstone paid $39 million to settle charges of improper fee allocation; Fenway Partners paid modest fines for failing to share fee income with investors; and Cherokee Investment Partners paid minimal fines for inappropriate expense charges. The SEC allowed the PE firms in these cases to pay fines with no admission of guilt.
Limited Partners Have Failed to Challenge the Status Quo
Despite growing evidence of fee manipulation by private equity GPs and major media exposés in recent years, pension funds and other limited partners have been unable or unwilling to challenge the improper or illegal behavior of PE firms. They remain in the dark about how much private equity firms collect from their portfolio companies. They are not privy to the contracts between PE firms and portfolio companies, and fees are paid directly to the PE firm without passing through the PE fund. As a result, LP investors cannot determine whether portfolio company fees are reasonable or excessive and whether they have received their fair share. Some investors, e.g., CalPERS, under pressure from media and public scrutiny, have insisted on receiving information on the amount of carried interest they paid to their PE partners. But information about portfolio fee income remains largely unavailable.
In January 2016, the Institutional Limited Partners Association (ILPA) finally released a template for private equity fee reporting that requires standardized reporting of fees, expenses, carried interest, and all capital collected from investors and portfolio companies. While this would provide the kind of transparency that is needed, its implementation is voluntary. The only state that has taken action to remedy private equity’s lack of transparency is California, where in 2016, legislation was introduced to require PE firms to report all fees and expenses charged in relation to their LP agreements, including portfolio company fees.
Tax Compliance and Private Equity
Private equity firms have a long history of taking advantage of tax avoidance schemes: carried interest taxed as capital gains even though it is essentially a profit sharing performance fee; locating many of their funds in tax havens like the Cayman Islands; and making excessive use of debt, which lowers tax liabilities via the tax deductibility of interest payments. Less well known are some of the other tax strategies used to further reduce the taxes that private equity firm partners and portfolio companies pay: management fee waivers and improper monitoring fee expenses.
- Management Fee Waivers: In a management fee waiver, the private equity fund’s GP “waives” part or the entire annual management fee that the LP investors pay — typically 2 percent of capital committed to the fund. In exchange, the general partner gets a priority claim on profits earned by the fund. This turns the ordinary income the GP would have received for providing management services into capital gains income — thereby reducing the tax rate on this income from up to 39.6 percent to 20 percent. These waivers may be legal if the conversion of the fee income to profit income involves real risk, but private equity waivers are typically structured so that no risk is involved, and as such are most likely a violation of the tax code. In July 2015, the IRS proposed new rules to clarify the intent of the tax code provisions governing fee waivers. Recent reports suggest that the IRS has belatedly begun auditing the use of fee waivers by GPs. While this is a welcome development, the statute only allows recovery of back taxes, penalties, and interest for the past three years of improper waiver activity — a small fraction of the tax savings PE partners have claimed.
- Disguising Dividends as Monitoring Fees to Avoid Taxation: Under the U.S. tax code, if a portfolio company pays monitoring fees to a private equity firm, the company gets to deduct the fees from its income tax liability. But to qualify as a tax write-off, the fee payment must be intended as compensation for services actually rendered. Many Management Services Agreements between a PE firm and its portfolio company, however, do not specify the scope or minimum amount of services the PE firm will provide. And several indicators suggest that often, no services are actually provided. Rather, the monitoring fees are essentially a disguised dividend paid to the PE firms. In these cases, characterizing the payments as monitoring fees and using this expense to reduce tax liabilities is a violation of the tax code. Despite mounting evidence that many of these fee payments are in fact disguised dividends, it appears that the IRS has not investigated this issue. Lack of transparency in these agreements makes it impossible to estimate the millions of dollars in lost tax revenue.
Taxing Carried Interest
Carried interest is the share of the profits that private equity GPs receive when they sell or exit a portfolio company. It is taxed at the capital gains rate of 20 percent rather than at the ordinary income rate of up to 39.6 percent. However, a growing consensus has emerged — among industry players as well as critics — that carried interest is simply a form of profit sharing, or performance-based pay, which private equity GPs receive as a result of managing PE fund investments. Carried interest does not represent a return on capital that GPs have invested because nearly all of the capital in the PE fund is put up by the fund’s limited partners. Given that general partners put up only one to two percent of the capital in a fund, they should be entitled at most to capital gains treatment for one to two percent — not 20 percent — of the fund’s profit.
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