The discussion about private equity fees and tax rates ratcheted up another notch this week. On Monday, four US Democratic senators wrote a letter to US Treasury secretary Jack Lew and International Revenue Service commissioner John Koskinen backing a proposed crackdown on management fee waivers. The letter urged “swift enforcement” of proposed regulations to limit waivers allowing managers to apply lower capital gains tax rates, rather than ordinary income tax.
Management fee waivers may be the latest talking point, but the issue of how much fund managers earn and at what tax rate is not going to go away; we’ve been covering Congress’s and other governments’ various inquests into carried interest tax designation for nearly a decade now.
Another, related, topic that isn’t new or disappearing anytime soon is how much it costs pension funds to invest in private equity, and how relevant fees are reported.
Kentucky’s underfunded state pension has been the latest LP in the hot seat over fee-related issues, having reported a large increase in private equity fees this year because of a change in its accounting methods.
“It’s not that we’re doing anything wrong,” chief investment officer David Peden told PEI this week. “A lot of the numbers in [our consultant’s recent report] are fees, sure, but in some cases opportunity costs are included, and many are adjusted in order to capture an apples-to-apples comparison to our peer group.”
The differences in how LPs track fees were touched on this week by sister publication pfm, which noted that some investors record management fees as an internal expense, while others include them in their cost basis when calculating returns. This leads to a discrepancy in how investors calculate their percentage gain or loss, and thus how they communicate and evaluate manager performance.
“There’s a huge disagreement among our peer group [on whether to include certain fees],” agreed Peden. “When comparing peers, they’re going to get very different numbers.”
Standardising the way fees are reported, which ILPA and others are pushing for, won’t necessarily reflect a jump in costs per se, but the exposure of previously unrecognised fees may increase public scrutiny on US public pensions, says Mike Heale of CEM Benchmarking, the consultancy that authored KRS’s report.
Heale advocates a standardised reporting approach, but cautions it will have knock-on effects.
The perception of rising investment costs may add fuel to the fire for those already wary of the asset class. While that isn’t expected to threaten overall allocations to private equity, the way in which increasingly fee-conscious and under pressure pensions choose to invest could change.
Peden, for example, has said the Kentucky system plans to reduce its reliance on fund of funds – fees for which are typically higher than investing directly with primary GPs. Heale expects other pensions will make the same move.
Meanwhile, other investors are exploring options including separate accounts and investing directly themselves, should they have the ability to do so – all of which suggests the LP-GP dynamic will continue to evolve based on the needs of investors. Standardising fee reporting may accelerate some of that evolution.
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