Private Equity Management Fees and Regulations

Historically, private equity funds have had minimal regulatory oversight because their investors were mostly high-net-worth individuals (HNWI) who were better able to sustain losses in adverse situations and thus required less protection. However, private equity funds also have investment capital coming from pension funds and endowments, which involves the finances of investors with lower net worths.

In the aftermath of the financial crisis of 2008, the multi-trillion dollar industry came under increased government scrutiny. But that hasn’t stopped private equity from remaining a financial powerhouse.

Key Takeaways

• Private equity regulations have become stricter since the 2008 financial crisis.
• Private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee (generally 2%) and a performance fee (usually 20%).
• The performance fee, also known as carried interest, is taxed at the long-term capital gains rate if the assets have been held for more than three years.
• All private equity firms with more than $150 million in assets must register with the SEC as an investment adviser.

What Is Private Equity?

Private equity is an investment class that acquires ownership of or an interest in an entity that is not publicly listed or traded. It is composed of funds and investors that directly invest in private companies. Private equity firms may also engage in buyouts of public companies with the intention of taking them private.

Private equity firms work to increase the value of the companies in which they are investing by providing capital, operation guidance, or other expertise. Eventually, the firm sells its ownership or interest in the company at a profit.

Investors in private equity are required to commit significant amounts of capital over a long time frame. Because of this, investors in this type of asset are either institutions or accredited with a high net worth.

Private Equity Fees

Private equity funds have a similar fee structure to that of hedge funds, typically consisting of a management fee and a performance fee. Private equity firms normally charge annual management fees of around 2% of the committed capital of the fund.

These fees are a large part of why working in the private equity industry is so lucrative. A $2-billion fund charging a 2% management fee results in the firm earning $40 million every year, regardless of whether it is successful in generating a profit for investors. Particularly among larger funds, situations can arise where the management fee earnings exceed the performance-based earnings, raising concerns that managers are overly rewarded, despite mediocre investing results.

The performance fee is usually in the region of 20% of profits from investments, and this fee is referred to as carried interest in the world of private investment funds.

The method by which capital is allocated between investors and the general partner in a private equity fund is described in the distribution waterfall. The waterfall specifies the carried interest percentage that the general partner will earn and also a minimum percentage rate of return, called the “preferred return,” which must be realized before the general partner in the fund can receive any carried interest profits.

Carried Interest Tax Rate

An area of particular controversy relating to fees is the carried interest tax rate. The fund managers’ management fee income is taxed at income tax rates, the highest of which is 37%. But earnings from carried interest are taxed at the much lower long-term capital gains rate.

The provision in the tax code that makes the tax rate of long-term capital gains relatively low was intended to spur investment. However, critics have argued that it is a loophole that allows fund managers to pay an unfairly small tax rate on much of their earnings.

This loophole was slightly addressed by the Tax Cuts and Jobs Act of 2017, which curtailed some of the tax advantages enjoyed by carried interest. Investment funds must hold assets for more than three years for carried interest to be taxed at the lower long-term capital gains rate.

If the assets have been held for three years or less, then any gains that are allocated to its investment managers are treated as short-term gains. They are taxed at the short-term capital gains rate, which can be up to 40.8% including, potentially, the tax on net investment income.

The numbers involved are not trivial. In an op-ed piece published in the New York Times, law professor Victor Fleischer estimated that taxing carried interest at ordinary rates would generate about $180 billion.

Private Equity Regulation

Since the modern private equity industry emerged in the 1940s, it has operated largely unregulated. However, the landscape changed in 2010 when the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into federal law. While the Investment Advisers Act of 1940 was a response to the 1929 market crash, Dodd-Frank was drafted to address the problems that contributed to the financial crisis of 2008.

Prior to Dodd-Frank, general partners in private equity funds had exempted themselves from the Investment Advisers Act of 1940, which sought to protect investors by monitoring the professionals who offer advice on investment matters. Private equity funds were allowed to be excluded from the legislation by restricting their number of investors and meeting other requirements. However, Title IV of Dodd-Frank erased the “private adviser exemption” that had allowed any investment advisor with less than 15 clients to avoid registration with the Securities and Exchange Commission (SEC).

Dodd-Frank requires all private equity firms with more than $150 million in assets to register with the SEC in the category of “Investment Advisers.” The registration process began in 2012, the same year the SEC created a special unit to oversee the industry. Under the new legislation, private equity funds are also required to report information covering their size, services offered, investors, and employees, as well as potential conflicts of interest.

Note

Venture capital (VC) funds are a subset of private equity that invest primarily in high-growth startups.

Widespread Compliance Violations

Since the SEC started its review, it has found that many private equity firms pass on fees to clients without their knowledge. The SEC has highlighted the need for the industry to improve disclosure.

At a private equity industry conference in 2014, Andrew Bowden, the former director of the SEC’s Office of Compliance Inspections and Examinations, said, “By far, the most common observation our examiners have made when examining private equity firms has to do with the adviser’s collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.”

As a result, compliance staffing at both small and large private equity firms has grown to adapt to the post-Dodd-Frank regulatory environment.

What Is Two-and-Twenty?

Many private equity firms charge a two-and-twenty fee structure. Fund investors must therefore pay 2% per year of assets under management (AUM) plus 20% of returns generated above a certain threshold known as the hurdle rate.

What Is a Typical Hurdle Rate for Private Equity?

The typical hurdle rate for a private equity firm is usually 7%-10%. This can vary depending on the size and age of the firm, its track record and reputation, and the strategy it employs. That means if a private equity fund only generates 6% in a given year, it will not charge investors for any portion of its profits.

Who Can Invest in Private Equity Funds?

Generally, private equity funds are only open to accredited investors. These include wealthy individuals and financial professionals.

The Bottom Line

Despite the widespread compliance shortfalls revealed by the SEC, investors’ appetite for investing in private equity funds has so far remained strong. However, if the Federal Reserve signals its intent to raise interest rates, the appeal of alternative investments such as private equity funds could diminish. The industry may face challenges in the form of a tougher fundraising environment, as well as increased oversight from the SEC.