The scandal over CalPERS’ and CalSTRS’ failure to track private equity “carry fees” has the industry worried enough that it is offering up ludicrous rationalizations.
Perversely, the fact that private equity mouthpieces have escalated so quickly to strained arguments, particularly over a new, nothingburger threat, is a good sign. It shows both how threatened private equity firms are by the prospect of having their economics exposed, and how utterly incapable they are of making any sort of credible case for their long-standing secrecy practices.
By way of background, we broke the story on CalPERS’ failure to monitor its “carry fees” in early June. A mere month later, CalPERS was in full retreat. It was contacting all of its private equity managers to have them give the giant pension fund all the historical data on the “carry fees” CalPERS had paid on funds the general partners managed.
As an aside, “carry fees” are the largest fees that private equity limited partners like CalPERS pay across their private equity programs, unless they have the misfortune to invest only in really dodgy funds. In the prototypical fee schedule of “2 and 20,” 2% is the annual management fee (which typically scales down later in a fund’s life) and 20% is the participation in profits, usually after beating an 8% hurdle rate.
We’re also starting to put “carry fees” in quotes, since the term is a misnomer. It implies, incorrectly, that private equity firms have a “carried interest”. This term is also widely misdefined in layperson investor guides, a sign of the effectiveness of private equity propaganda efforts.
A true “carried interest” occurs when an investor allows another party to borrow from them in order to acquire a stake in the venture. Borrowing to obtain your participation means that the party with a true “carried interest” is at risk of loss. They eventually have to repay the lender the full amount borrowed, irrespective of whether the investment works out. If the borrower is the promoter, as the private equity funds are, a true “carried interest” exposes him to loss and thus aligns his incentives with those of his funders.
By contrast, the upside fees that private equity and hedgies extract from investors are a profit participation, or what the IRS calls a “profits interest”. This profits interest is yet another example of how private equity general partners structure their relationship with limited partners to be “heads I win, tails you lose” arrangements.
As we described in our last post on the running “carry fee” disclosure battle, a group of state Treasurers, all of whom are public pension trustees or board members, wrote a letter to SEC Chairman Mary Jo White asking her to Do Something to improve private equity fee and expense disclosure. Remember, even the formidable Elizabeth Warren, who has been thumping Mary Jo White regularly via press stories, long and carefully documented letters, and grilling in Senate testimony, can barely get her to budge. Do you seriously think a lone letter by state Treasurers is going to move her to act?
We discussed at some length why this letter was an a clumsy effort to shift responsibility for these Treasurers’ failure to do their jobs onto the new kid on the block, the SEC:
The SEC does not have the authority to order more frequent fee and expense disclosures. The information that the investors receive now is what they have obtained in their negotiations at the time they invest…
These limited partners have chosen, for decades, to give private equity general partners a blank check by allowing them to use the portfolio companies purchased with the limited partners’ monies as piggy banks, with virtually no checks or oversight. Critically, the limited partners have no right to see the financial statement of the portfolio companies, nor do they get information about transactions or business arrangements between the portfolio companies and parties related to the general partner and its owners, employees, and affiliates….
The elected officials who are asking the SEC to intervene on their behalf are all board members or trustees of pension funds that have agreed to sign remarkably one-sided agreements with private equity general partners. So why, pray tell, have they sat pat and allowed this sort of thing to go on?
Yet the private equity funds seem so desperate to combat any discussion of greater disclosure, even blatantly self-serving efforts by elected officials that are destined to go nowhere, that they now feel compelled to trot out new arguments against more transparency via favored mouthpieces. The arguments made are so intellectually bankrupt that they demonstrate that the private equity industry has no valid defenses for its secrecy regime.
Yesterday, Private Equity Manager (PEM) published an editorial on the “carry fee” contretemps titled, “Split the debate in half”. It’s available online only to subscribers but a private equity investor sent me the full text. Amusingly, the article fails to mention that the “carry fee” disclosure brouhaha was kicked off by CalPERS board member JJ Jelincic asking whether CalPERS tracked “carry fees” in a public board session and getting the “dog ate my homework” excuse that not only didn’t CalPERS do that, but it couldn’t. That falsehood kicked off an avalanche of bad press and a rapid volte face by CalPERS.
But you hear nary a word of that from PEM; readers are inaccurately told that the pressure for disclosure resulted from industry bodies revising their reporting templates.
Here are the key sections:
Conflating carried interest reporting with that of general fees and expenses only muddies the transparency debate….a coalition of state officials are now urging the SEC to mandate standardized fee disclosures by force.
I have to interrupt. You gotta love the hyperventilating “by force”. Back to the article:
But allow us to unpack what’s happening here from a more technical standpoint with respect to reporting (which is of higher interest to the finance and administrative team).
To begin, consider this: what does it mean exactly to report carried interest? It’s a question few are asking, despite most agreeing with criticisms that CalPERS dropped the ball after admitting it didn’t know how much carry it pays its managers.
But here’s the thing: it’s not CalPERS that is paying the carry. Carried interest is a profit allocation made after fund divestments, collected by the GP after hitting a pre-negotiated performance benchmark. Is the expectation that CalPERS knows how many dollars it sacrificed for agreeing a 20 percent profit share with the general partner based on their ownership percentage of the fund? Or how much carry in total the GP receives? Or something else? In the end, what does knowing that number provide CalPERS after the partnership agreement is signed?
This is insult to any reader’s intelligence. PEM is trying to say, with a straight face, that a fee deducted from profits is not a fee.
A profit share by design is contingent compensation. The absurd PEM statement that “…it’s not CalPERS that is paying the carry,” is logically equivalent to, “It isn’t Oracle that is paying a commission to its salesmen,” or “It isn’t the plaintiffs in a class action suit that are paying contingency fees to the attorneys that represent them.” PEM is trying to persuade its audience that because private equity investors have signed agreements that allow general partners to “collect” a profit share, that the investors have not paid it.
Private equity investors are acutely aware of the fact that “carry fees” are taken out of the profits (to the extent there are profits) earned on monies they provide. It’s their money and their risk. Private equity funds typically have only a 3% equity interest in the funds they manage, and much of that is not even a hard dollar investment. Part often comes about via a tax gimmick that the IRS has finally decided to stamp out, that of the management fee waiver. So some of what little investment the general partners make was not to have skin in the game but to lower taxes.
PEM then tries taking the absurd position that a fiduciary like CalPERS can’t possibly have a bona fide reason for knowing what “carry fees” are charged. At a minimum, CalPERS needs the data to make sure it isn’t being ripped off. Given that the SEC has warned investors that pilfering is rampant in private equity, limited partners have good reason to find out the amounts that are being deducted from their distributions. Our understanding is that some funds do disclose this amount when they remit payments, but as CalPERS’ and later CalSTRS’ flat-footedness attests, the practice seems to be far from common.
But at least as important, as Georgetown law professor Adam Levitin pointed out when CalSTRS officials tried claiming that “carry fees” weren’t worth tracking, is that fiduciaries should know what their full investment costs are:
CalSTRS argument is like saying that the only cost of a credit card that matters is the annual fee, not the interest rate or other fees. Smaller management fees could be offset by larger carry costs. It’s total cost that matters.
Recall that Oxford professor Ludovic Phalippou has estimated that the total amount of private equity fees that the general partners extract is 7%. That’s an indefensibly high number, hence the fierce efforts of the industry to avoid and downplay disclosure. As anyone who has read John Bogle knows, even small amount of additional investment costs eat into returns over time, most of all for long-horizon investments like retirement portfolios.
Assuming Phalippou is correct, and there’s no reason to think he isn’t, private equity limited partners should be demanding that overall charges be lowered by at least 2%. And the place to start would be ending clearly abusive portfolio-level charges like monitoring fees (which Phalippou calls “fees for doing nothing”) and transaction fees (which are unjustifiable double charging, since virtually all private equity general partners hire third parties to execute transactions and arrange financings).
But what justification do we get from PEM?
Let’s also remember that carry is not a simple accounting number. It can be accrued, earned, paid or even locked in escrow to secure future clawback obligations. These nuances will need to be considered if we are to speak of carried interest reporting in a meaningful way.
Gee, so general partners make “carry fees” hard to compute and understand? Even better to get more disclosure, particularly since limited partners and their hired guns are asleep at the wheel as far as the impact of many of the finer details is concerned. As we wrote:
As we’ve noted previously, if you look at the reports prepared by industry consultants, they are embarrassingly superficial in how they review fees. Oxford professor Ludovic Phalippou explained in a 2009 paper that this sort of simple-minded comparison is misleading. For instance, supposedly standard terms like a 20% upside fee subject to an 8% hurdle rate, using a representative set of fund cash flows, could lead to success fees being as low as $7.5 million or as high as $19 million depending on the definition of key terms.
The ultimate goal, of course, is more transparency – an objective we here at pfm have thrown our weight behind in the past. But carry is not as significant a number for purposes of discovering industry abuses as is travel expenses, broken deal fees and accelerated monitoring fees, to name a few areas where regulators have unearthed questionable practices.
So in other words, now that the industry has been caught out ripping off limited partners, that is now turned around and treated as the only valid reason for investors wanting more disclosure. The notion that limited partners have a duty to understand total costs is brushed aside. You can’t negotiate effectively when you are in the dark. Private equity is particularly opaque, with unduly complex agreements that contain “squeeze the balloon” features (if you try squeezing on fees in one place, it often has the effect of the general partners getting partial offsets elsewhere). They are quite clearly designed to stymie limited partner efforts to understand total costs and take measures to contain them.
The one bit of good news is that with CalPERS having done the right thing by changing its practices quickly when caught out means that the rest of the industry will follow. The long-standing pattern in private equity is that when CalPERS moves, whether voluntarily or not, to increase disclosures, the general partners have lost the war. It’s thus instructive to see how hard they are fighting a rearguard battle. That shows they know they have a lot to lose.