Picking at Nits: SEC Examining Private Equity Fee Calculations
According to Reuters, the SEC is investigating how private equity firms calculate fees. At issue is the fact that some managers report net returns that include capital contributed by investors who received discounted fees as well as the commitments of the managers themselves, which do not incur fees or carry. As a result, the performance presented in marketing materials may overstate the performance that the average investor would have received. Therefore the SEC is likely to insist that these presentations include both net and gross performance figures.
I hope the SEC’s examination is considerably broader than the issue of displaying performance net and gross fees. Typically managers represent a small percentage of the capital contributed to a fund, and the fee discounts to select clients are usually 0.25% to 0.50%. Thus, the distortion is likely to be very small and measured in the tenths of a percentage point.
However, there’s a much larger issue when it comes to the accuracy of private equity performance. Unless a fund is eight or more years old, a great deal of its performance is based on estimates for the unrealized investments in the portfolio. Estimates are, of course, an inevitable part of valuing illiquid, non-public companies. The various techniques for coming up with those values can lead to widely different results. The uncertainty surrounding these estimates is far greater than the difference created by different investors paying different levels of fees.
As a PE firm prepares to market a new fund, there’s a temptation to boost valuations in order to create a more compelling marketing pitch. Thus the challenge for investors and the SEC is to uncover biases in the valuation estimates, and that isn’t an easy undertaking. Tweaking a discount rate, adjusting an earnings model, and/or switching valuation methods can dramatically raise or lower the reported value of a portfolio company.
It will be another good day for the private equity industry if all they have to do to make the SEC happy is to add a couple of exhibits and footnotes to their pitch books.