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Government agencies turning up the heat on fees

SEC arguing for more transparency, while IRS looks at waivers

Jason E. Brown
Jason E. Brown said for private equity, fee transparency has moved to the limelight.

The pressure on private equity and hedge fund firms to disclose more about what investors pay them continues to build from Washington regulators questioning long-held traditions.

While officials at the SEC are looking hard at fees and expenses charged to investors, the IRS is looking more at possible abuses by private equity general partners shifting income to more favorable tax treatment.

Securities and Exchange Commission officials are telling private equity and hedge fund managers to prepare for more enforcement cases involving undisclosed fees and misallocated expenses.

But a coalition of public pension fund trustees — not content to wait for a case-by-case approach — is pressing the SEC to require more fee disclosure.

In a July 22 letter to SEC Chairwoman Mary Jo White, 13 state and municipal treasurers and comptrollers representing $1 trillion in public pension fund assets called for an industry standard to give private equity limited partners more transparent and frequent information on fees and expenses.

The only fees investors see regularly, they said, are directly billed management fees, while three other charges — fund expenses, allocated incentive fees and portfolio-company charges — “are often reported deep in annual financial statements,” said the letter, signed by officials from the District of Columbia, New York City, California, New York, Virginia, Wyoming, North Carolina, South Carolina, Rhode Island, Vermont, Nebraska, Oregon and Missouri. Coalition members want more consistent and comparable fee disclosures and believe the SEC is in the best position to require those changes.

SEC officials declined to comment on the letter.

In May, Marc Wyatt, the current acting director of the Office of Compliance Inspections and Examinations who helped create its private funds unit, told a private equity gathering that investors — many of whom were surprised by some of the practices SEC examiners uncovered — are now more focused on fees and expenses, and general partner disclosure practices are changing.

“However, there is still room for improvement,” said Mr. Wyatt. “Many managers still seem to take the position that if investors have not yet discovered and objected to the expense allocation methodology, then it must be legitimate and consistent with their fiduciary duty.

“It is reasonable to assume that the next year may bring additional private equity actions” by the SEC enforcement division, said Mr. Wyatt.

Began in 2012

The scrutiny of private equity and other private fund fees began as part of a focused, risk-based presence exam initiative launched in 2012 to take a look at 150 then-newly registered private fund managers. By 2014, a top concern became the expenses charged to portfolio companies and investors, rather than managers, because of what Drew Bowden, former director of the OCIE, called “an enormous gray area” — how fees and expenses are characterized in agreements with investors.

In addition to what he said were hidden and often bogus fees such as accelerated monitoring, transaction or additional administrative fees, Mr. Bowden raised a flag about managers of zombie funds — old vintage funds kept alive primarily to keep a fee revenue stream open — tempted to increase monitoring fees, shift more expenses to those funds, or unilaterally increase valuations.

With the number of zombie funds in 2015 up 12.5% from July 2014, reaching 1,180 funds with unrealized assets of $126.6 billion, “managers can come under increased pressure from investors to liquidate the fund” if they continue to take management fees, said Christopher Elvin, head of private equity products in London for alternative investment research firm Preqin.

Rhode Island Treasurer Seth Magaziner launched a transparency initiative in May requiring money managers doing business with the state — including the $7.9 billion Rhode Island Employees' Retirement System, Providence — to publicly disclose information about performance, fees, liquidity and investment-related accounting and legal expenses. Mr. Magaziner “is hopeful that most, if not all, existing managers will agree” to the new standards, said spokeswoman Shana Autiello. And while several other treasurers, including Oregon's Ted Wheeler and North Carolina's Janet Cowell, now negotiate for more disclosure with pension fund managers, there should be one standard for all investors, coalition members said in their letter to the SEC.

Taking it seriously

Jason E. Brown, a partner with the private investment funds group at law firm Ropes & Gray in Boston, said: “Private equity firms are taking these matters seriously. The SEC and now investors are interested in the fees and expenses in their agreements. While the historic industry practice was to provide more general information about fees and expenses, the trend (now) in private equity is toward greater transparency about fees and expenses in the fund documents.”

The IRS also is jumping into the fee debate, questioning fee waiver arrangements in which the private equity manager gives up all or part of a management fee in exchange for a larger share of net profits or future distributions. That income is taxed at the capital gains rate, which can be half the tax rate of ordinary income.

After years of speculation over how IRS officials viewed the practice, the agency in late July proposed a rule disallowing such arrangements — which IRS executives said could simply be “disguised payment for services” — unless the money manager can show significant entrepreneurial risk involved on its part, among other tests. While the examples given in the IRS proposal feature private equity funds, they could potentially apply to hedge funds as well, tax experts say. IRS officials are accepting public comment until October, but could enforce the new position now during firm reviews. The new rule most likely will affect only new or modified arrangements, tax experts say.

Not ignored

“These regulations are not going to be ignored,” said Jonathan Brose, a tax attorney with Seward & Kissel LLP in New York. “There is emerging consensus that fee waivers are still going to be permitted, but they (GPs) are going to have to restructure them.” Changes could include making the waiver a prominent and permanent feature of new agreements, building in lengthier times for holding an investment, not allowing managers to take fees quarterly, and the addition of investor clawback provisions, he said.

The key factor for the IRS is whether a firm has taken significant entrepreneurial risk.

“The consequence going forward for general partners is that they will need to invest cash to make their general partner commitment,” said David Fann, president and CEO of the private equity consulting firm TorreyCove Capital Partners LLC, La Jolla, Calif. “I would suspect that some firms may have to lower their percentage of investment in their funds as a result.”

Then there are the investors themselves. “Limited partners, especially those operating under public scrutiny ... are requesting greater disclosure around the issues of fees and expenses paid by portfolio companies, the ongoing accrual of carried interest amounts and the allocation of broken-deal expenses,” said Mr. Fann. “It will take time, but we seem to make more progress every day. ... We expect most firms to willfully change.”

“We are definitely in the age of transparency,” said Mr. Fann. “SEC audits of registered PE firms accelerated the institutionalization of the industry. No firm wants to be found deficient or to be problematic by any regulator.”

This article originally appeared in the August 10, 2015 print issue as, "Government agencies turning up the heat on fees".