Historically, private equity funds have had minimal regulatory oversight because their investors were mostly high-net-worth individuals who were better able to sustain losses in adverse situations and thus required less protection. Recently, however, private equity funds have seen more of their investment capital coming from pension funds and endowments. In the aftermath of the financial crisis of 2008, the multi-trillion dollar industry has come under increased government scrutiny.
What Is Private Equity?
Private equity is capital – specifically, shares representing ownership of or an interest in an entity – that is not publicly listed or traded. It is composed of funds and investors that directly invest in private companies, or that engage in buyouts of public companies with the intention to take them private.
Private Equity Fees
Private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee. Private equity firms normally charge annual management fees of around two percent of the committed capital of the fund.
When considering the management fee in relation to the size of some funds, the lucrative nature of the private equity industry is obvious. A $2-billion fund charging a two percent management fee results in the firm earning $40 million every year, regardless of whether it is successful in generating a profit for investors. Particularly among larger funds, situations can arise where the management fee earnings exceed the performance-based earnings, raising concerns that managers are overly rewarded, despite mediocre investing results.
The method by which capital is allocated between investors and the general partner in a private equity fund is described in the distribution waterfall. The waterfall specifies the carried interest percentage that the general partner will earn and also a minimum percentage rate of return, called the “preferred return,” which must be realized before the general partner in the fund can receive any carried interest profits.
Carried Interest Tax Rate
An area of particular controversy relating to fees is the carried interest tax rate. The fund managers’ management fee income is taxed at income tax rates, the highest of which is 37%. But earnings from carried interest are taxed at the much lower 20% rate of long-term capital gains.
The provision in the tax code that makes the tax rate of long-term capital gains relatively low was intended to spur investment. Critics argue that it is a loophole that allows fund managers to pay an unfairly small tax rate on much of their earnings.
In May 2017, US Democrats introduced a bill to end the carried interest tax advantage. The bill, called the “Carried Interest Fairness Act of 2017” was introduced by Senator Tammy Baldwin and House Ways and Means Committee ranking member Sander Levin. Sens. Baldwin and Levin had pushed for the passage of the same bill back in 2015, but the measure has yet to be approved. When first introducing the bill, Senator Baldwin said, “Instead of simply rewarding the wealthy with tax preferences, Washington needs to do more to respect hard work, invest in economic growth, and give the middle class a fair shot at getting ahead.”
The numbers involved are not trivial. In an op-ed piece published in the New York Times, law professor Victor Fleischer estimated that taxing carried interest at ordinary rates would generate about $180 billion.
Private Equity Regulation
Since the modern private equity industry emerged in the 1940s, it has operated largely unregulated. However, the landscape changed in 2010 when the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into federal law. While the Investment Advisers Act of 1940 was a response to the 1929 market crash, Dodd-Frank was drafted to address the problems that contributed to the financial crisis of 2008.
Prior to Dodd-Frank, general partners in private equity funds had exempted themselves from the Investment Advisers Act of 1940, which sought to protect investors by monitoring the professionals who offer advice on investment matters. Private equity funds were able be excluded from the legislation by restricting their number of investors and meeting other requirements. However, Title IV of Dodd-Frank erased the “private adviser exemption” that had allowed any investment advisor with less than 15 clients to avoid registration with the Securities And Exchange Commission (SEC).
Dodd-Frank requires all private equity firms with more than $150 million in assets to register with the SEC in the category of “Investment Advisers.” The registration process began in 2012, the same year the SEC created a special unit to oversee the industry. Under the new legislation, private equity funds are also required to report information covering their size, services offered, investors, and employees, as well as potential conflicts of interest.
Widespread Compliance Violations
Since the SEC started its review, it has found that many private equity firms pass on fees to clients without their knowledge, and the SEC has highlighted the need for the industry to improve disclosure. At a private equity industry conference in 2014, Andrew Bowden, the former director of the SEC’s Office of Compliance Inspections and Examinations, said, "By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time."
As a result, compliance staffs at both small and large private equity firms have grown to adapt to the post-Dodd-Frank regulatory environment.
The Bottom Line
Despite the widespread compliance shortfalls revealed by the SEC, investors’ appetite for investing in private equity funds has so far remained strong. According to industry data from Preqin, global private equity funds raised a record $453 billion in 2017. However, the Federal Reserve has signaled its intent to continue raising interest rates, which could diminish the appeal of alternative investments such as private equity funds. The industry may face challenges in the form of a tougher fundraising environment, as well as from increased oversight from the SEC.