From All Sides, Pressure Mounts Over Private Equity Fee Practices

The IRS, SEC, and 13 state pensions have all moved to force private equity firms to fully disclose fees, pay taxes on them, and repent to clients when they don’t.

It started with KKR. On June 29, the US Securities and Exchange Commission (SEC) charged the private equity giant with violating its fiduciary duty by charging clients for its own expenses on failed deals.

As the summer draws to a close, it has become clear that the SEC was only the first of more than a dozen powerful public entities to voice the same accusation: Private equity’s fees practices are unfair, sometimes illegal, deeply opaque, and tilted too heavily in favor of general partners at the expense of investors.

KKR agreed to pay a $10 million fine for its actions—a small sum relative to the attention the case drew from asset owners and KRR’s fellow private equity firms. The terms of the settlement did not require KKR to admit to or deny the charges. When reached by CIO following the fine’s announcement, a spokesperson said, “KKR is firmly committed to upholding the highest governance and transparency standards, and we remain dedicated to continually enhancing our practices on behalf of our fund investors.”

The SEC secured $19 million in client reimbursements in addition to the $10 million penalty. This was not enough to satisfy a coalition of 13 major state retirement systems. Together, on July 21, comptrollers and treasurers representing funds for New York, California, Virginia, Missouri, and many other states sent an open letter to SEC Chair Mary Jo White urging the regulator to tighten disclosure rules for the asset class.

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Limited partners, they argued, often could not determine if the fees charged were legitimate. The SEC had to force transparency on private equity firms, these powerhouse clients argued, indicating that their managers weren’t going to open up voluntarily.

“Complexity, combined with a lack of industry disclosure best practices, has led to an uneven playing field for state fiduciaries seeking to report private equity fees fully,” the coalition wrote.

New York City’s Comptroller Scott Stringer put it more bluntly. “It’s time to take the detective work out of how private equity managers report their fees,” he said. “Billing practices are cryptic at best and many partnership statements are so vague they could be considered purposefully opaque.”

The final US public entity to throw its weight behind the issue was the most powerful—at least in the volume of assets under its control and notorious gangsters it has sent to jail.

On July 23, the Internal Revenue Service (IRS) proposed new regulations to combat the common private equity strategy of waiving management fees for a greater portion of profits earned. As a result, these managers pay capital gains tax on roughly 2% of their assets under management as opposed to standard income taxes. For the IRS, that represents a 50% haircut on revenue from management fees, assuming the current 20% federal capital gains tax and a manager earning more than $432,201—which is essentially all of them.

In keeping with the tone set by the SEC and coalition of public plans, the IRS made clear its displeasure with private equity’s fee-shifting. The 44-page proposal, widely covered by mainstream and financial publications alike, arrived under the title, “Disguised Payments for Service.”

Amid this blizzard of criticism in the last few months, private equity firms themselves had tended to remain quiet.

The venture capital (VC) sector boasts the highest number of consistently outperforming fund managers, according to Preqin.

Nine groups recorded top-quartile performance for all their funds currently operating in the sector, the data firm said.

New York-based Pittsford Ventures’ six VC funds were all top quartile, Preqin found, while California’s Sequoia Capital had four top-quartile products. A further seven groups had a trio of top performers each.

Six buyout-focused managers also achieved 100% top quartile performance from their funds. These included London-based Inflexion and Austin, Texas-based Vista Equity Partners, which both had four out of four products in the top quartile.

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Preqin collated performance data from buyout, VC, mezzanine, real estate, infrastructure, and natural resources funds. The lists included only active managers with at least three funds in similar strategies, and firms that had been raising cash from investors within the past six years.

Measuring performance on funds launched before 2013, Preqin found 19 firms currently running three products or more in a sector had achieved top quartile performance each time.

In private real estate, Carmel Partners, Centennial Holdings, and Embarcadero Capital Partners achieved this feat, while Latin America Enterprise Fund Managers was the only group to have all its funds in the top quartile in the natural resources sector.

In contrast, infrastructure groups found it the most difficult to produce consistent top returns. The best performing group was Harbert Management Corporation, with three of its four funds in the top 25%. However, its fourth product was bottom quartile, giving an average quartile ranking of 1.75. Only one other infrastructure investor—Energy Spectrum Capital—managed an average quartile ranking below 2.00, Preqin found.

The US dominated the most consistent firms, with 15 of the 19 members of the 100% group based in America. In total, US firms made up 42 of the 55 companies named in Preqin’s research.

Most Consistent Buyout Managers