Monday, December 29, 2014

A Battle Won in a Losing War: Private Equity

A Battle Won in a Losing War: Private Equity

Many of the big private equity firms are succumbing to investor pressure by crediting 100% of those pesky monitoring, consulting, and directors fees charged to portfolio companies against the management fee charged to investors.  For example, when some private equity firm receives $5 million per year from a portfolio company for consulting services, they will now turn around and reduce the management fee to their investors by the same amount.  As The Wall Street Journal reports, the large firms will forego millions of dollars in revenues as a result of this concession.[1] 



Although investors and the SEC can take some comfort from this emerging trend, you and I should remain vigilant.  Professor Greg Polsky at the University of North Carolina continues to remind us that private equity firms are taking every opportunity to convert ordinary income into capital gains and maximize every possible deduction.  As Mr. Polsky points out, some of these practices are legal but should be stopped by Congressional action, and some of these practices are probably illegal.  The wholesale deduction of monitoring fees is just one of PE’s practices that doesn’t stand up to scrutiny. Most of the fees are simply an arbitrary number that don’t compensate the PE firm for any measurable services provided to the portfolio company.   They shouldn’t be deductible.  In my view, they shouldn’t be charged in the first place.

At long last, large investors are starting to exert a bit more influence as a result of the public pressure exerted by private equity critics and the SEC’s Office of Compliance Inspections and Examinations.   The developments reported by the Journal are a tiny step in reigning in the influence of private equity firms.  However, the big firms have already taken major actions that more than offset the fee offsets granted to investors.  They’ve expanded into hedge funds and other asset classes, they’ve raised new sources of investment capital, and they are figuring out how to get into the retail business on a mass scale.  They have become lightly regulated banks.

The members and staff and the Senate Finance and House Ways and Means Committee ought to spend the holidays reading Professor Polsky’s latest paper.  It’s available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2524593.
The paper is a roadmap for needed reforms (e.g., ending the capital gains preference for carried interest) and understanding what’s improper about certain other strategies to convert ordinary income into capital gains and/or claim illegal deductions.  In reality the folks in Congress will be too busy organizing fundraisers where private equity executives can make huge contributions to the committee members under the recently enacted campaign laws.

Investors may have won a battle with private equity, but we are losing the war.





[1] http://www.wsj.com/articles/fees-get-leaner-on-private-equity-1419809350

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