We’ve been chipping away at the bigger implications of information exposed via the release of a dozen private equity limited partnership agreements. The SEC warned in May that investors, as in limited partners, had done a lousy job of negotiating these documents and weren’t so hot at monitoring the general partners either. We wrote earlier about a major tax problem for the limited partners, and we’ve since come across information from an expert that works for private equity funds that confirms our original reading, which we will discuss in due course.
But the more interesting question is: How did supposedly sophisticated investors sign up for investments that have tax liability bombs in them? This seemingly arcane but actually important tax problem illustrates how utterly outmatched private equity limited partners are by the general partners and their top-tier hired guns.
This tax problem, called UBTI, for “unrelated business taxable income,” comes about, perversely, as a result of the limited partners showing a rare bout of wanting to act like responsible investors and reduce the various fees that general partners charge over and above their management fees and carried income (the famed “2 and 20,” for the prototypical formula of 2% in management fees and 20% in carry, or upside fees*).
Mind you, private equity is a great way to get rich quickly, as the desperation of MBAs to join these firms attest. But many general partners seem unable to resist the temptation, um, opportunity presented by the fact that they have the true wealth of America, its operating businesses, in their hands. So on top of already-handsome compensation, they charge other fees to investors. The biggest are “transaction fees” paid for buying and selling companies (charged when possible to the portfolio company itself) which are in addition to fees paid to investment banks for doing the actual work) and consulting fees to the portfolio companies for overseeing them (which begs the question of what the management fees are for).**
One might wonder why investors put up with all of this skimming in the first place. They short version is that in the 1980s, when private equity was more descriptively called “leveraged buyouts,” the top players made extraordinarily juicy returns. Corporate America was full of overly diversified companies trading at conglomerate discounts. On top of that, many had over fat corporate headquarters. Making money in leveraged buyouts in those days was like shooting fish in a barrel, provided you were willing to go to war via a hostile takeover. A few simple bits of financial engineering, in terms of breaking the companies up, selling and leasing back corporate headquarters, and purging the layers between the operating staff and the C-level, yielded large gains. With such seemingly assured profits, investors were eager to participate in LBO funds and the general partners could dictate terms. The industry leader, KKR, was unabashed about taking as many fees as it could, most notably in the form of “transaction fees” it took for itself on top of ample merger & acquisition fees and financing fees its funds paid to Wall Street firms, as well as “monitoring fees” which were consulting fees paid to the general partner or affiliates by the portfolio companies.
After many LBOs went bankrupt in the 1990-1991 recession, LBO firms had trouble raising new funds. The industry picked up again in the mid-later 1990s, but the returns weren’t as juicy in the early days. Over time, the level of these fees became so significant that the normally-complacent investors roused themselves and demanded reductions.
In a typical commercial context, you would assume that if a buyer said, “I’m not paying that type of charge any more” that the levy would simply be prohibited or the two sides would compromise on a new level. But the general partners were successful in steering the limited partners to a resolution that kept transparency at a minimum, which gives the general partners considerable leeway in gaming the new arrangement.
We’ll continue with the example of transaction fees, although similar issues apply with other types of fees subject to this arrangement. The new arrangement was that the general partners would continue to charge the fees as before, but a portion would be rebated back to the limited partners. That portion has increased over time as the limited partners continue to be unhappy about the fees they are paying. 80% is a good working number, and most rebates fall in the 60% to 100% range.
Now you can see obvious problems about that structure. Without any reference point for the fees, the general partners can simply raise their charges to offset the rebates (if they are less than 100%). The better solution would have been to demand that the general partners produce their fee schedule and have that be subject to review against a third party standard (for instance, the fees on the schedule could not exceed x% of fees charged by a specified universe of investment banking firms for comparable services). But negotiation and verification of these fees would be work, and most of the limited partners are mainly in the business of determining asset allocations and investing in index funds, so this sort of monitoring isn’t something that they are inclined to assign to themselves.
Moreover, the use of a rebate, as opposed to a straight-up haircut, ceiling, or negotiated schedule, then triggered the possible tax problem for tax exempt investors, and a majority of investors in private equity (public and private pension funds, endowments, foundations) are tax exempt. This is where the UBTI and its twin “ECI” (effectively connected income) come in. As we explained in a previous post:
The idea behind both UBTI and ECI is that tax exempt investors should not be able to hide behind their tax-free status to operate businesses that would have a competitive advantage because the profits aren’t taxed. As a result, UBTI federal tax is assessed on U.S. non-profits and ECI federal tax on foreign investors in U.S. funds to level the playing field.
One of the few ways that limited partners have pushed back against the general partners is that the limited partners have demanded and won a de facto fee reduction via the sharing of general partner transaction and monitoring fees with limited partner investors (as we’ve also discussed, the degree to which there actually were any services rendered is open to question). But for the limited partners to take their partial rebate of these fees would clearly constitute UBTI/ECI absent any special maneuvering to avoid the tax.
So what was the maneuvering? Rather than get a cash refund, the investors took the rebate in the form of a reduction of the management fees, the prototypical 2% a years (although it often drops to a lower level in the later years of a fund’s life). That way, the tax-exempt investors could take the position that they were getting a reduction in fees, as opposed to participating in income earned by the general partner. Astute readers can no doubt see how this tax finesse already works to the advantage of general partners: if the transaction and monitoring fee rebates exceed the management fee, the limited partners don’t get the full rebate.
As we indicated in our earlier post, some investors have woken up to the issue that they are being shortchanged by this rebate structure. It appears have won the further concession that if there were rebate credits left when the fund was to be wound up, the general partner would make a payment to the limited partners. As we indicated in our earlier post, sending money means the payment would trigger UBTI/ECI. We recently found an article (which we have embedded at the end of this post) by James Schell, the head of the private equity practice at Skadden Arps, one of New York’s leading law firms. Schell and his two junior associate co-authors confirm our conclusion that these tax tricks have gone outside what the IRS views as kosher.
Here is where Schell, the Skadden private equity practice head, confirms our reading about the tax issue here with respect to transaction and monitoring fees, which he calls “advisory fees”:
Advisory fees that are sometimes paid by a Portfolio Company for advice rendered by the General Partner or one of its affiliates would clearly be UBTI because these fees are paid for services rendered.
As we noted in our original post, the potential tax liability here causes PE firms to seek to “launder” the portion of these fees that they share with LP investors by crediting the sharable amounts against the LPs’ management fees, rather than writing checks to the LPs:
As Schell puts it:
The Fund’s organizational documents will provide that all fees of a certain nature earned with respect to the Fund’s capital be earned by the Management Company and not the Fund. The Management Company, in tum, agrees to reduce its Management Fees by all or some portion of such other fees earned by it. Typically, the Management Fees is not reduced below zero for any year, such that any transaction or other similar fees earned by the Management Company in excess of Management Fees payable are retained by the Management Company. As a result of this arrangement, the Tax-Exempt Partner is not in receipt of fees that could be characterized as UBTI but, instead, receives some or all of the benefit of such fees through an offset to Management Fees otherwise payable by it.
In other words, the PE industry’s position that fee sharing does not trigger UBTI relies on this argument that LPs face uncertainty about whether they will actually get all of the rebated fees.
Again, Schell agrees with our analysis:
Typically, the Management Fees is not reduced below zero for any year, such that any transaction or other similar fees earned by the Management Company in excess of Management Fees payable are retained by the Management Company. As a result of this arrangement, the Tax-Exempt Partner is not in receipt of fees that could be characterized as UBTI but, instead, receives some or all of the benefit of such fees through an offset to Management Fees otherwise payable by it.
Note that Schell’s argument relies on the premise that excess credits, meaning fee income over and above what is applied to reduce LPs’ management fee to zero, are retained by the private equity firm (what he calls “the Management Company”). In our original post, we claimed that PE firms take the posture that””Hey, we’re not sending the investors checks” because people like Schell have advised them that refunding excess credits to LPs clearly implicates UBTI.
As Schell puts it, avoiding UBTI hinges on the simple fact that:
Thus, for example, the Tax-Exempt (Limited) Partner generally is not entitled to receive any transaction fees in excess of Management Fees payable by it.
Now we get to the rub, which is that, in many cases limited partners and totally contrary to Schell’s implicit tax advice, LPs are entitled to receive any transaction fees in excess of Management Fees payable by it. As we noted in our original post:
Now that we can scrutinize LPAs, however, we see that some do call for checks to go back to the investors. For example, on p. 158, Section 3.02(d) TPG’s limited partnership agreement says:
(d) On a cumulative basis, the Management Fee due in respect of each Limited Partner (including any additional Limited Partner) shall be reduced by an amount equal to one hundred percent (100%) of such Limited Partner’s share of Net Fee Income, if any, B-3 received by the Management Company, any Principal or any Affiliate of the Management Company, in each case in connection with such Person’s activities as a representative, or on behalf, of the Partnership. To the extent that the amount referred to in the preceding sentence exceeds the Management Fee due in respect of such Limited Partner, such excess shall be carried forward and, if not previously applied against such Management Fee, shall (notwithstanding paragraph 4.02(d) of the Partnership Agreement) be paid by the Management Company (or its Affiliate) to such Limited Partner upon liquidation of the Partnership [emphasis added].
What this complicated section provides for is that TPG will roll forward any management fee credits that can’t be applied in a given period because the management fee has already been reduced to zero. If any remain at the end of the fund life, the investors get a check. So, rather than there being the potential for payment issuance in any particular accounting period, TPG has pushed the accounting around so that any check is issued just once, at the end of the fund life. But it’s the same either way, and the key point is that the practice pretty much destroys their argument that these payments are not subject to UBTI/ECI tax. Other of the LPAs have this same feature (see, for example, Palladium at p. 100 section 4(b))
Now why does this matter? It isn’t simply that the limited partners let the general partners steer them down a path for how to reduce the transaction and monitoring fees that they paid that looked like a “less fuss” option but would operate to the advantage of the general partners, and when they realized that, going further down that path has triggered a tax risk.
This example shows how experts like Schell steer the IRS into not investigating issues that they might otherwise examine.
When you boil it down, Schell is making an argument, with presumably the IRS as his primary audience, that the general practice of how precisely transaction/monitoring fees are shared makes them immune from UBTI. However, in claiming that fee credits are limited to the amount of management fees paid, he is positing a scenario that is contrary to the fact that many cases where LPs can get a check for the otherwise unapplied credits.
Unfortunately, it is common for high-power tax lawyers to argue for the legality of otherwise questionable tax practices by assuming that particular conditions are in place when they don’t actually occur in many real world situations. The IRS reads the articles and, because its believes the often-false assumptions, accepts the legal analysis for why a practice is legal. In fairness, some tax lawyers may not realize that their clients don’t realize that their client have stepped outside the implementation requirements necessary to support the tax argument. But in many cases, the lawyers must know that they are engaged in disingenuous advocacy disguised as scholarship.
*Note that these fees scale down somewhat on bigger funds, but not as much as the industry would have you believe. A 2011 survey found that management fees continue to average 2%, save for funds over $1 billion, where the average management fee is 1.71%.
** Some private equity funds, like Hellman & Friedman, don’t charge these ancillary fees, and others, most notably Frostman & Little in its heyday, made their low ancillary fees a point of differentiation. But crudely speaking, most funds charge these additional fees at a full rate.