Friday Letter Relentless pressure on fees

GPs must accept and manage around a new era of diminished fee income.  

Among the first news stories about the Obama administration to include the phrase “private equity” was one that GPs weren’t pleased to read. The president’s upcoming budget proposal will include a plan to raise tax on hedge fund and private equity fund managers to a 35 percent rate from the current 15 percent capital-gains rate, the Wall Street Journal reported.

The inclusion of the higher carry tax in Obama’s proposed budget is yet another signal that the private equity industry faces intense pressure on all kinds of fees – and not just from governments. Limited partners, now finding themselves in the most powerful bargaining position in the short history of this industry, are increasingly taking a merciless view on fees that appear to reward the mere management of a fund, as opposed to fees based on the profits produced from said fund.

At the very least, limited partners embrace the proposition the enormous dangling carrot of carried interest is a good thing – it motivates talented investors to create maximum wealth in lock step with external partners, and if successful, everybody benefits (with GPs enjoying the disproportionate share).

Alas – the zeal for the magic of carried interest does not exist in Washington at present. Among the last things on the to-do list of White House staff is entertaining a long-winded explanation as to why carried interest is not ordinary income. An administration elected on a promise to rein in Wall Street greed will zealously seek to strike down low-tax wealth creation strategies for fund managers.

The increased bargaining power of LPs is already being seen in a raft of uniquely structured follow-on funds, annex funds and please-don’t-downsize-your-commitment arrangements. The economic terms of these vehicles all but fulfil the dreams of those who have long said private equity GPs should eat peanut butter sandwiches on the management fees and caviar on the carried interest.

On top of this, a new infrastructure fund from Kohlberg Kravis Roberts raises the possibility that even the untouchable 20 percent carried interest will come under pressure. That fund will charge a 10 percent carry, not to mention a 1 percent management fee. While some may see this merely as evidence that infrastructure assets are different, it should be stressed that KKR in selling this fund is carving out important deals from its private equity track record and calling them “infrastructure” businesses. If KKR is prepared to take 10 percent carry for successful deals like PanAmSat, it means GPs need to ponder a future that still includes caviar, but perhaps the caviar is served with a smaller spoon.