As the letter below shows, eight prominent Senators cleared their throats and asked the SEC why it has yet to produce an investor bulletin on private equity, which they observe is puzzling given that the agency has uncovered plenty of gambling in Casablanca.
It is important to understand that the SEC’s failure to issue any investor bulletins on private equity, which are “focused on topical issues including recent Commission actions,” much the less investor alerts, which are “focused on recent investment frauds and scams,” confirms how half-hearted its enforcement efforts have been. The SEC warned of widespread abuses in private equity in May 2014. That speech by then SEC enforcement chief Andrew Bowden was followed quickly by a series of high profile articles in the New York Times and Wall Street Journal that implicated the biggest names in the industry.
Investor bulletins are a basic tool that the SEC uses to keep investors appraised of abuses and consolidates their work on enforcement actions. As a result, several individuals, such as private equity expert Eileen Appelbaum, have suggested to SEC officials in meetings that they issue an investor alert on private equity. Every time, the staff have made a big show of reacting like they never heard the idea before and that it is certainly worth thinking about. It’s ludicrous for them to have pretended that this was a novel suggestion They can no longer play that game now that these Senators have weighed in.
On the one hand, it’s yet another poor reflection on the SEC that eight Senators have had to team up to get the agency to do its job. As their letter makes clear, in bureaucratese, the SEC has no defense for its inaction. One of the excuses that SEC officials have invoked when pressed for their failure to act has been that investors in private equity are big boys (“accredited investors”) and are therefore sophisticated and don’t need this sort of help from the SEC. But as the Senators point out. the SEC has issued investor bulletins for the hedge fund industry, which like private equity, is newly subject to SEC registration as investment advisers under Dodd Frank. And hedge funds, like private equity, target big, professional investors.
On the other hand, while it may seem like overkill for a group like this to go after the SEC on what seems like a minor matter, it is key to see this as a significant shift in the zeitgeist. Private equity abuses have long rested on two factors. One is the industry’s claim to a privileged status, which it’s managed to wrap in its mantle of “private”: “What we do is private, and therefore any intrusion interferes with the fundamental operation of our business model.” That’s clearly an insane and unjustifiable position, yet when you push through the puffery and jargon, that is the underlying logic of the industry’s defense. And it succeeded for decades because the huge profit potential of working with or for private equity firms meant no one would violate their code of omerta. The private equity industry succeeded in suborning academics (private equity is alone among investment strategies in having the faculty members that specialize it act as cheerleaders or faux-objective apologists rather than skeptics). In addition, the overwhelming majority of press stories are from the trade publications, which by nature are industry friendly. That meant this tidy and self-serving, “We are really really special and deserve to be left to our own devices” narrative has gone unchallenged for a remarkably long period of time.
The second factor is that private equity principals are so wealthy that it seemed inconceivable that any elected official would dare to cross them. But the irony is that unlike members of regulated industries, like banks and real estate, private equity has heretofore not needed to cultivate friends in powerful places. True, there are plenty of political kingpins who are large donors and bundlers, but they are involved in politics most of the time out of an interest in imposing their view of society on the electorate rather than advancing the interests of their industry. The private equity industry has a teeny lobbying group, formerly known as the Private Equity Capital Growth Council. It was recently rebranded as the American Investment Council. So the official lobbying group now has to distance itself from private equity via a name change? That’s another proof that private equity is losing its luster. But as before, the organization has a very small budget, and its talking points are tired and persuasive only to true believers.
In other words, this letter is an indicator that private equity is being deligitimated. And as its returns fall, which top industry players have warned will happen, it will also lose its allure to investors, as has happened dramatically with hedge funds this year.
And a final factor to keep in mind: while it’s more appealing to think of mighty forces rising up to combat a powerful industry like private equity, Gulliver was tied down by Lilliputians. It may not be as gratifying to go slowly and systematically after private equity abuses and misrepresentations, but it is already starting to have an effect.
7 14 16 Signed Letter to SEC Chair White on Private Equity Investor Bulletin
Wow. Really well said. One of your best posts.
I hope you are right.
I like the analogy at the end. Fantastic week of articles on PE abuses this week Yves, keep up the heat!
Yes. The PE industry is probably the object lesson in hogging the spoils of globalization. And oligarchy (hello, Carlyle!). Good to see them beginning to take some heat.
Its an election year. At least some small gesture has to be made, let”s see where it goes.
Quite often over the years proposals like this have simply been a way to increase campaign contributions while appeasing constituents.
I have been listening to the Federalist Papers on my commute to work and I’m struck by the arguments put forth to urge adoption of the constitution. The debate to prevent the usurpation of power seems just as relevant today as it was at our nations founding- if not more so – considering just how successful corporate usurpation of power over the people has truly become in todays world.
Reconnecting with the founding principles of our nation seem to point to a positive direction for action. The notion that the ultimate legitimacy and power of government reside with the people being the most important. The ultimate responsibility for protecting the liberties granted lies in the election of representatives. This is where the citizenry has failed completely in its duty. By continuing to elect, year after year, the same usurpers.
The power of the people is what is at stake in our current struggles. When the voice of the people rises up, the current elite rewrite the laws governing action, confusing and quelling dissent. The past 30 years have been an attempt to cut the corporate giant free and are almost complete.
If we believe in individual liberty as a people, we need to understand that the corporate giant needs to be tied down with strands that are not easily broken. You can’t have corporate giants and a free people, they are contradictory terms.
Very well said!!
“What we do is private, and therefore any intrusion interferes with the fundamental operation of our business model.” LOL!!! Isn’t that the preferred logic of the mob as well. Of course the difference between the mob and private equity is just splitting hairs.
I have known both PE players and pretty powerful figures from the Patriarca mob organization. You’re far better off avoiding both– but if I had to choose which group was more trustworthy the latter would win without question!
To me, the SEC’s unwillingness to issue an investor alert seems pretty obvious. If they issued and alert the SEC would have to detail all the ways in which the PE firms have scammed or are scamming their investors, and that’s a lot of ways. It would also show that nearly every PE firm has scammed their investors in the same way in one way or another. For example, which PE firm is not taking termination of monitoring fees? Which PE firm is not engaging in broker dealer activities without being registered? Which PE firm is not assigning the best co-investment opportunities to their most bestest pals? Which PE firm does not take legal discounts and have their lawyers charge full or above fees to the fund or the portfolio companies? Did anyone say private jets? And many more terrible abuses that Yves has exposed in NC. If an investor alert is issued then the SEC would limit its ability to negotiate what little enforcement actions it will take behind close doors and it would need to go after MANY PE firms. But that’s not what the SEC does, it’s not there to play “cop”, it’s there to “nudge” crooks in the path of righteousness with some slaps in the wrist. If the SEC decided tomorrow that ALL PE firms who have been taking transactions fees but were not broker dealers (or running fees through their BD arm) had to pay up what they took illegally, that’s a simple wining argument that would put the PE firms in the path to righteousness double quick! But MJ White does not have the cojones.
It really is a wonder that the SEC has not yet decided to do this. At first glance the SEC appears to be doing nothing because PE is such a small part of the investment world – of course this is untrue because millions of retirees are invested in PE via their retirement accounts. This is a national concern and the SEC needs to step up their game. Of course the revolving doors and cozy relationship do not help.
A fine PE whine: The Carried Interest Loophole? What Loophole? [NYT]
Steven B. Klinsky is the founder and chief executive officer of New Mountain Capital, a private equity firm.
He is actually correct. We are using the wrong term. Loophole indicates an inadvertent inadequacy in the law that allows for people to circumvent or avoid complying with the law legally. This is not a loophole but a flat carve out of the law fully meant to exclude this type of income from being taxed as earned income.
Now we could also have the argument that there is nothing ‘earned’ about most private equity management income, that in many cases it is practically theft. So perhaps we should just call the carried interest clause what it is an unconscionable give away as in ‘the carried interest extortion of tax code and insult to productive Americans’. Probably too long, but far more accurate.
*Sigh*. No, and please don’t promote industry propaganda. I have a friend who is a top international tax expert who was the first, literally, to complain about this 30 some years ago. This is a loophole. I can get further details but partnerships and the tax treatment surrounding them were never intended to be used for large-scale ventures with lots of investors. They were envisaged for stuff like the local two-doctor office that might have a passive money partner because the two doctors were young and needed a backer to get equipment for the practice and put down a big rent deposit. Stuff like that.
The abuse here, and it is an abuse, is that they are getting capital gains treatment for something that is not a capital gain, as in they do not have capital at risk. They have profits share, or what the IRS calls a “profits interest”. They could achieve a similar tax result if they had a true carried interest, as in they borrowed money to invest so that their capital contribution would be 20%, as opposed to the 1-3% it is now (note the real economic investment is closer to 1%, since for many big funds, even the “capital contribution” is via management fee waivers, a practice the IRS has clarified to be a tax abuse). But if they borrowed that money, they’d be at risk of loss, while all they have now is upside.
This is a loophole because very clever structuring has pushed the uses way beyond the original intent. This is in fact the very definition of a loophole, contorting behavior so as to get effects never intended.
My apologies but considering we live in a time where the people who write the healthcare bill are insurance lobbyists, the people who regulate the banks were given big bonuses by the banks to go do that, and the only people consulted about various laws are the corporate ownership class there comes a point where the only logical position to take until proven otherwise is that the incredibly lucrative ‘mistake’ is not a mistake at all on the part of those who wrote and sponsored the legislation or designed the program or… even if for many involved it might be inadvertent. (I’m sure there were some Congresspersons and people in Treasury who honestly believed that HAMP was there to help homeowners.) And frankly tax law is the area where that influence could be seen first. If it predated our current system of deferral to industry lobbyists in practically all things, my mistake.
But one thing I do not apologize for is something you are wrong about. My saying the reason for the existence of an intentional carried interest rule regarding fund managers is the clear result of political corruption to create and advance laws for the wealthy to avoid paying taxes you should owe ‘legally’ is NOT promoting industry propaganda regarding it. In fact it paints it as what was a crime up until the last Supreme Court session, something even worse than just taking advantage of a badly written clause done with good intentions (and then blocking any attempt to correct it).
I don’t mean to seem to be coming down on you, since you’ve provided a lot of very helpful comments, particularly on PE, but you are still incorrect here. This particular loophole has been exploited for over 30 years. It existed BEFORE the 1986 Tax Reform Act, which was Reagan’s big gimmie to the rich. Preferential treatment of capital gains goes back to 1921, and was repeatedly reaffirmed, including in the hardly wealthy favoring Roosevelt administration. I will check with my tax expert who has been on this issue forevah and get you more details.
Having said that, what gave private equity a huge boost was actually the change in the Department of Labor’s 1978 change in the interpretation of ERISA. They were lobbied heavily by the fledgling venture capital industry.
US tax law is ridiculously complicated by world standards not so much because the complexity not so much because it benefits the rich but…drumroll..it benefits H&R Bloc! They are the most aggressive lobbyist against tax simplification. Accountants are too.
Making overwrought charges about corruption plays right into the hands of the powerful who benefit from the status quo. They can take erroneous charges and depict critics as cranks who are jealous and hate the rich.
Yves, What 1978 U. S. Dept of Labor interpretation of the Employee Retirement Income Act (ERISA) do you refer to? Might you mean the misnamed Pension Reform Act of 2006? That law, among other things, increased the percentage of ERISA assets invested in Private Equity/Hedge Funds before ERISA’s protective fiduciary duties applied. I understand from a knowledgeable lobbyist that Senator Schumer was instrumental to its passage. But I cannot find any confirmation of Schumer’s role. In my view this is the best financial blog. Keep it up.
There was a DoL rule reinterpretation in 1978 (no rule change) that mean the prudent man standard could be met by using modern portfolio theory concepts. Risk no longer needed to be assessed on the level of an individual investment (which also BTW worked against investing in stocks; when I was in Wall Street in the early 1980s they were regarded as speculative) but on a portfolio basis. And studies even then had found that the more asset classes you were invested in, the better you did. You did not increase return but you did lower risk, so you were net better off.
I wonder why it was Reed and not Sheldon Whitehouse who represented Rhode Island in this worthy exhortation? I join all others in commending you for your consistently excellent work on the PE scams!
I enjoyed the Casablanca reference. Cultural references such as this help to clarify just how corrupt our financial system is. Most adults in the U.S. know exactly what is going on in the movie, and connecting that corrupt imaginary world to the real world helps to solidify your points.
This letter is better than nothing, but carries no legal weight. What’s needed is arrests, subpoenas, indictments, convictions, and real jail time—-stuff like that—–not just for private equity but for all Wall Street people who break the law. In short, what was needed was President Bernie Sanders, and a real attorney general.
I counted nine, not eight, prominent Senators that signed the letter to the SEC