If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:
• Executive Summary
• Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
• CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity Fees Work
While it was troubling to see CalPERS’ Managing Investment Director responsible for private equity, Réal Desrochers, repeatedly demonstrate that he did not understand basic aspects of private equity economics, its Chief Investment Officer, Ted Eliopoulos, did not fare much better in his star turns in the August Investment Committee meeting of CalPERS’ Board of Directors. Like Desrochers, Eliopoulos made statements to the Investment Committee that are demonstrably false.
Eliopoulos depicted a tax device widely used by general partners as virtuous because it aligns the economic interests of the general partners with those of the limited partners, when it does nothing of the kind. Even worse, he failed to mention that the IRS has recently proposed rules to end this tax abuse.
As Lee Sheppard wrote in Tax Notes, “Private equity often seems like a tax reduction plan with an acquisition attached.” So it is imperative for investors to understand the tax aspects of private equity transactions to assess general partner compensation and risks.
But as a video of the August Investment Committee meeting shows, Eliopoulos apparently does not grasp how a common tax avoidance scheme by general partners is not beneficial to limited partners. Moreover, he compounded the error by putting the most general-partner-friendly spin possible on it.
The truth is that private equity general partners are so determined to get optimal tax results for themselves that interests of their investors, the limited partners, fall by the wayside.
A common tax device in limited partnership agreements is the so-called management fee waiver. It is a provision in the limited partnership agreement that allows the fund manager to forego management fees that it was going to receive for overseeing the fund, substituting a separate profits interest (often mislabeled “carried interest”). So, for instance, if a general partner expects to receive at least $100 million in management fees over the life of a fund, he could use a management fee waiver to recharacterize it as distributable profits, a better tax result when profits take the form of capital gains. The portion of fees waived, say $50 million, is treated as an investment in the fund, meaning it is added to the total capital used to buy companies. In other words, by laundering these “waived” fees through the fund, the general partner will be taxed at much lower capital gains rates when he receives the income.
On paper, this might not seem so bad. After all, isn’t the general partner putting these waived fees at risk? If so, doesn’t that mean he is putting his money where his mouth is?
If you believe that, you have not yet wised up to the fact that the biggest ruses in private equity are buried in the tax language of their agreements.
Why Management Fee Waivers Are Not Good for Limited Partners
From a tax perspective, the management fee waiver is just an exchange of a fixed fee for a priority allocation of the first gains (or profits, depending on the precise mechanics) realized by the fund in the same amount. Fee waivers are designed to all but insure that there will be sufficient gains/profits to be allocated to the general partner to cover the “waived” fee. The end result is that the economics are completely unchanged. As Gregg Polsky, former Professor in Residence in the IRS Office of Chief Counsel and now a professor of law at the University of North Carolina, wrote: “2 and 20 [the prototypical private equity compensation arrangement] without a fee waiver is economically identical to a 2 and 20 with a fee waiver.”
Why would limited partners go along with this scheme? Consider an even more basic question: Why should limited partners allow general partners to have so much in the way of management fees that they can afford to waive them?
The premise of the management fee is that it pays for the overhead that the general partner needs to operate the fund. At least some board members of CalPERS recognize that this is the intent of the management fee. For instance, at one point in this Investment Committee meeting, Priya Mathur asked if management fees were too high given the size of some of funds.
If the general partner has gotten so much money from his management fee that he’s able to use a management fee waiver, he’s clearly being paid too much. As Eric Sloan of Deloitte Tax said at a 2013 American Bar Association conference on partnership taxation:
They [the general partners] were earning more in fees than they needed to cover their basic costs, so they thought about whether there was a more tax-efficient way to handle the receipt of the fee. The general partner wants to defer income.
The influential Institutional Limited Partners Association takes a dim view of fee waivers for the same reason. Its best practices call for management fees to be based on costs. At the same ABA conference, Adele Karig of Debevoise & Plimpton said:
There is a view that if they can be waiving these management fees, then they’re overpaid, and they don’t need these fees.
So the very existence of the management fee waiver makes a mockery of the claim of CalPERS’ Desrochers, that CalPERS was vigilant about making sure that the private equity fund managers weren’t getting rich based on management fees alone, an issue we discussed at length in a post earlier this week.
Why the IRS is Cracking Down on Management Fee Waivers
There are two conflicts with management fee waivers that investors need to heed.
First, a management fee waiver doesn’t really make management fees contingent on the performance of the private equity funds. General partners retain considerable power to define profits for tax purposes so that they magically appear, even if the fund isn’t doing well or hasn’t sold assets recently.
As Lee Sheppard wrote in Tax Notes:
Fund governing documents usually allow the general partner to find profits to cover the waived fee wherever it can. The general partner often has a lot of discretion in accounting for profits. Some fund documents refer to undefined “available profits.” The general partner takes its profits to cover the waived fee out of the first profits in any future accounting period, regardless of losses in other periods.
So a fund could lose money over its lifetime yet have enough isolated successful quarterly or annual periods that the waived fee can be recouped. The point is that there are lots of machinations that the general partner can use to ensure that its waived management fee gets paid.*
As Sheppard concluded in a more recent Tax Notes article (emphasis ours):
There is no real intention to subject the management fee to the risks associated with the general partner’s profits interest.
That means that the argument that investor interests are aligned with the general partner’s interests on a fee waiver is false because managers have not put their fees at risk. The IRS recently proposed rules to require that waivers be made before long fees are earned and tied to future profits that are not readily ascertainable.
Second, and more importantly for this post, general partners frequently use a management fee waiver to fund a required cash contribution of capital to the fund. This is the famed “skin in the game” that CalPERS staff, following industry conventional wisdom, touts as an important due diligence consideration.
The reality is that as the average size of funds grew in the early 2000s, it became more and more difficult for many general partners to pony up even the 1% of the total fund commitment that limited partners deemed to be desirable.** The management fee waiver has increasingly served to solve this problem by appearing to provide the level of capital contribution that trustees and boards of directors prefer to see. In other words, limited partners are actively enabling the fiction of general partners having their money at risk, when in reality, they are allowing general partners to charge excessive management fees and the treat that as if it was the same as a hard dollar capital investment, when it isn’t.
The IRS’ proposed rules for management fee waivers would require income inclusion of the value of the newly created profits interest. Analysts believe that the proposed rules will effectively kill fee waivers.
CalPERS staff and board show some confusion about the general partner’s use of a fee waiver for a cash capital contribution:
Board Member Priya Mathur: And just last question. To what extent is the management fee used to seed that GP contribution?
Managing Director Réal Desrochers: This is what we call the management fee offset to the IRS. Don’t know, Christine, do we have the number? We track that. But I — do you have the number?
Investment Director Christine Gogan: Forty one percent.
Chief Investment Officer Ted Eliopoulos: I think the question, if I could — I think you’re thinking it’s a different question. I think Ms. Mathur was asking about whether or not the — in this example, the $20 million of management fees is effectively being used as the one to three percent…
Mathur: The capital commitment.
Eliopoulos: …the capital contributed by the…
Eliopoulos: …by the general partner. So it’s a — I want to give Réal definitely a chance to answer it. I think there isn’t a legal linkage within the agreement. And some agreements in the past, there actually have been provisions that allow the general partner to use the capital collected, you know, for their asset management fees and apply it to their capital contributions. So that’s happened in the past. I think now, and going forward, those that type of direct legal link between the two is more a disfavored term rather than favored, but it also belies the economic reality that it’s a fairly close connection between the amount of capital committed by the general partner and the fees that they take back. So it all goes to this question of alignment of interests that Réal was emphasizing, which is we’d always like to see more capital by the general partner invested in the commingled fund, because it better secures the type of alignment with the limited partners for risk of loss, risk of their capital at loss, just to the same that we have capital at loss.
If you try parsing what Eliopoulos said, it’s difficult to reach firm conclusions as to what he meant to say about management fee waivers, which is no doubt the point. However, the troubling and perverse part of Eliopoulos’ patter is that he says, in effect, that management fee waivers are beneficial because they align the economic interests of the general partners with that of the other investors. That’s clearly not the case. The investors have to pay the management fee either way. When the general partner substitutes a fee waiver for a capital contribution, he hasn’t put his own cash at risk.
Gregg Polsky had a similar reaction to Eliopoulos’ remarks:
It’s pretty indecipherable. But he seems to be making the case that fee waivers somehow help align the interests of GPs with LPs. But fee waivers don’t affect the economics at all — their whole point is to not change the real economics. And, in fact, as you suggest, the mere presence of fee waivers suggests that the management fees are more of a profit source than they ought to be. Eliopoulos might be getting at the notion that, because fee waivers were thought to be tax-advantaged, there was more money for the GPs to invest (because some is coming from the IRS) and therefore that the GP capital commitment was larger than it otherwise would be. I guess he’s arguing that “It’s OK to pay management fees that are too high so long as some of the excess is invested in the fund.”
A small ray of light comes as Eliopoulos concludes this discussion by saying:
Eliopoulos: But that’s exactly — those are exactly the types of questions that the due diligence team and the private equity team look at in assessing what is the true alignment. Is it really their capital or not, and how much of it is at risk, and how material is that capital to the firm?
In fact, if the private equity due diligence team were doing the sort of careful work that Eliopoulos asserts they are, they would have cracked down on management fee waivers for required capital contributions long ago.*** As Polsky points out:
The problems from the LP’s perspective are twofold: (1) You have public pension funds facilitating tax abuse for the benefit of GPs. Before the IRS guidance, they comforted themselves presumably by noting that everyone did it, so it must be OK. The recent guidance should take care of that. (2) The fact that GPs could so easily waive fees suggested that the fixed fee portion of their pay was too high (i.e, well higher than to keep the lights on).
Another problem is that apparently the LPs apparently don’t understand at all the mechanics and economics of fee waivers (not to mention their tax-abusiveness), which makes me wonder what else they have no clue about.
As Polsky confirms, Eliopoulos’ tap dancing on this issue reveals, yet again, that CalPERS is vastly less knowledgable and vigilant than it fancies itself to be.
We will continue this series next week.
* And even though a special distribution paid out to a general partner on a management fee waived could be subject to a clawback, Sheppard adds that “there is often no way for the limited partners to actually enforce the clawback.”
** General partners need to have an investment in a fund for them to be able to take a profits share for tax purposes, but the IRS has never set a minimum level. When average fund sizes were smaller, lawyers treated a 1% stake as the minimum they regarded as safe, then relaxed that view as fund sizes continued to grow. However, many limited partners treat a level of general partner investment of below 1% as problematic, unless there are extenuating circumstance, like the fund is a first fund by a promising young team with strong personal track records at established firms.
*** Eliopoulos said that “some agreements in the past” had management fee waivers, and again states that “So that’s happened in the past.” It is conceivable that Eliopoulos is trying to tell the Investment Committee that CalPERS hasn’t been signing up for funds that include management fee waivers of late. If that is what he is trying to insinuate, it appears to be inaccurate. For instance, in a recent New York Times article, I.R.S. Targets Tax Dodge by Private Equity Firms, Gretchen Morgenson points out that:
As the private equity industry became aware of the I.R.S.’s scrutiny of management fee waivers in recent years, some funds moved to reduce their reliance on them, industry experts say.
However, in the next paragraph, Morgenson notes:
Still, a fee waiver provision can be found in a limited partnership agreement for a 2014 fund offered by Apollo Global Management, a private equity giant. The firm can “elect to forgo an amount of the management fee in favor of a profits interest in the partnership,” the agreement says.
Sources tell me that the fund is Apollo Investment Fund VIII, a fund in which CalPERS has invested.
And CalPERS cannot try to reassure itself that its current funds that have management fee waivers might conform with the new IRS guidance. As Gregg Polsky writes:
I’ve seen a number of private equity LPAs [limited partnership agreements] — including the ones on your site — and literally zero percent of the fee waivers I’ve seen would pass muster under the recent guidance. So, assuming these LPAs are representative of the ones that CalPERS invests in, I’d expect zero percent to be compliant. This is not to say that all funds use fee waivers. From what I can tell, roughly half of the large PE firms use them.
That “roughly half” figure is similar to the “forty one percent” that Christine Gogan whispered to Réal Desrochers, assuming that she, as Eliopoulos did, took Priya Mathur to be asking about management fee waivers.