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 At issue is what's known as a management fee waiver, in which
private equity firms can waive the right to collect a management fee
from an investor and instead accept the same amount of money as a
capital contribution. The device allows the firms to decide
themselves whether to treat their fees as ordinary income or as
capital gains, which are taxed at lower rates.
Almost 60 percent of the $30.5 billion in private equity investments
held by Calpers, the nation's largest public pension fund, contain
the waivers. In September, a group of Senators, including
Massachusetts Democrat Elizabeth Warren, told the Treasury
Department that management fee waivers had resulted in "billions of
dollars" of lost tax revenue, and they expect "swift enforcement of
these long-awaited proposed regulations." In July, the IRS and
Treasury suggested that some waivers may be a "disguised payment for
services."
At the heart of the matter is how private equity firms make money
and what tax rate they pay. When putting money under management at a
private equity firm, an investor such as Calpers pays an annual fee
that's often 1 percent to 2 percent of the assets they're investing.
That management fee is normally taxed as ordinary income. On top of
that, private equity firms also typically collect about 20 percent
of whatever profits are generated by the investment. That money,
also known as carried interest, is taxed as capital gains.
The management fee waiver comes in when a private equity firm's
general partners, ask investors, also known as limited partners, to
agree to pay the general partners' capital contribution in lieu of
the management fee. If the investors do, the general partners can
choose to treat the income as capital gains, which are taxed at 20
percent, a little more than half as much as the top 39.6 percent
rate applied to ordinary income.
Management fee waivers are allowed under the tax code. The waivers
only affect the taxes of the private equity companies that use them,
not Calpers' performance nor the amounts it pays its retirees.
About $17.9 billion of Calpers' $30.5 billion in private equity
assets are affected by fee waiver language, the pension fund told
Reuters. Among those deals – totaling 59 percent of private equity
investments - Calpers would not disclose how much money has been
waived. As a result, the total tax savings is unknown.
"This is basically a tax-avoidance strategy from the GPs," Marte
Castanos, Calpers' senior staff counsel said this week during a
Calpers workshop about private equity. "Calpers still pays the
money, but it doesn't go to management fees. It goes to the GP's
profit interest. It is a controversial practice, but one that does
persist in the industry."
The disclosure by Calpers, a pension fund with approximately $300
billion in total assets, is a rare insight into the prevalence of
fee waivers.
Public pension funds are among the largest investors in private
equity funds, which typically don't disclose profits or how much
they pay in taxes.
Calpers, which started investing in private equity some 25 years
ago, plans this month to publish how much it pays in carried
interest, another unusual disclosure among pension funds and a move
certain to be noticed by others across the country.
Calpers' sister fund, the California State Teachers' Retirement
System (Calstrs), and the rest of the nation's 10 largest public
pension funds either do not track fee waivers or would not disclose
how common they were in their investments.
Calpers, like other pension funds, is barred from disclosing which
investment deals contain fee waivers, because the agreements are
considered confidential trade secrets.
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Private equity firms rarely disclose whether they use fee waivers,
although there are some exceptions. Apollo Global Management, one of
the largest private equity firms, disclosed in public filings that
it had waived $156.5 million between 2005 and 2012. KKR, another of
the nation's 10 largest firms, reported it had waived $69.5 million
in 2008 and 2009.
Apollo says it stopped including fee waivers in funds in 2012. Eight
of Calpers' nine investments in Apollo funds were begun before 2012,
totaling $3.6 billion. Calpers committed $1.9 billion to seven KKR
funds. KKR said it discontinued the practice several years ago.
In another example, the Welsh, Carson, Anderson & Stowe's XI fund's
limited partnership agreement, reviewed by Reuters and not required
to be disclosed to the public, allows the management company to
waive all or a portion of any management fee. Calstrs committed $250
million to that fund in 2008. Calpers committed $125 million a year
later, but the size of the fee waiver is unclear.
Riverstone Holdings and Providence Equity Partners, in whose funds
Calpers has also invested, mentioned the use of fee waivers in SEC
filings but did not offer specifics.
Fee waiver language became "a standard term in LPAs" by 2012, said
Todd Fogarty, a spokesperson for Palladium Equity Partners, which
included fee waiver language in its Fund IV that year but says it
never activated it. Calstrs invested $90 million in the fund in
2012.
The same year, documents from Bain Capital, the private equity firm
founded by then-Republican 2012 presidential candidate Mitt Romney,
showed the firm saved over $200 million in taxes through the
practice.
One of the reasons Calpers does not like fee waivers is that the
fees are intended to cover expenses, said Scott Jacobsen, an
investment director on Calpers' private equity team. If private
equity firms can "waive these fees in lieu of GP contribution, it
implies that the fees are too rich."
The practice may soon be phased out. Since the IRS's and Treasury's
proposed ruling, a number of law firms have posted advisories.
Simpson Thacher & Bartlett LLP published in a memo that some "common
private equity management fee waiver arrangements," could be
considered "a disguised payment for services taxable as compensation
income." The firm warned that although the proposed regulations are
not yet final, "private equity fund sponsors should proceed
cautiously."
(Reporting by Robin Respaut. Editing by John Pickering)
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