Lest the buyout industry feel left out of the regulatory crackdown that has recently been visited upon hedge funds and major banks, the Securities and Exchange Commission indicated it’s taking a close look at the fees and compliance structures at private equity funds. The SEC found “illegal fees or severe compliance shortfalls in more than half of the firms it examined since starting a review of the $3.5 trillion industry two years ago,” Drew Bowden, the head of the SEC’s exam program, said in a speech on Tuesday. More scrutiny is sure to come.
Like hedge funds, private equity funds have historically been lightly regulated because their investors were ostensibly rich folk who, by virtue of the sophistication wealth naturally confers, require less protection and could better sustain losses. PE funds, also like hedge funds, typically charge 1.5 percent to 2 percent of assets as a management fee and keep 15 percent to 20 percent of the profits they generate. And, like hedge funds, private equity funds have seen an increasing proportion of their investment capital coming from investors who aren’t sophisticated at all, in the form of pension funds and endowments that manage money for ordinary people.
The 2010 Dodd-Frank legislation gave the SEC greater leeway to regulate private equity firms, and in 2012 the agency created a special unit to look into the industry. The bits of information that have trickled out about the SEC’s findings so far haven’t reflected well on private equity: Most funds were inflating the fees they were charging the companies they’d invested in, Bloomberg News reported on April 7. They’ve also been applying fees to investors that the firms themselves should have been paying.
Tighter regulation and scrutiny of the enormous fees they charge isn’t the biggest threat facing private equity barons. That would come in the form of the looming and inevitable battle over the carried interest tax rate, a provision in the tax code that was meant to encourage investment but in practice allows many hedge fund and private equity fund managers to pay an arguably too-low tax rate on much of their earnings. Specifically, those who invest in companies or even stocks can in some cases treat income from those investments as a long-term capital gain, which is taxed at 20 percent—considerably lower than the rates for income (the highest of which is 39.6 percent). Fund managers’ fee income is typically taxed at income tax rates, but the 20 percent cut of the annual profits is often taxed at the much lower rate.
Private equity fund managers have made clear that they won’t give this up without a fight: In 2010, Blackstone Group (BX) Chairman Stephen Schwarzman described attempts to increase taxes on fund managers such as himself as “a war,” according to Newsweek. He added: “It’s like when Hitler invaded Poland in 1939.” Tom Perkins would approve.