It may not surprise anyone that private equity firms are good at making money. That’s what they do, the reason they exist. It’s also why investors, including public pension funds, have rushed to invest.
It seems, however, they’ve gotten a little too good at the endeavor, in part by manipulation of loopholes that allow them to unfairly avoid paying taxes and to nickel-and-dime their investors.
The scheme that allows managers of private equity firms to treat much of their revenue as capital gains rather than income is particularly sketchy. The 20 percent difference means a significant loss of revenue for public coffers from the $3.5 trillion industry. Many will recall that this arrangement allowed former presidential candidate Mitt Romney to pay relatively low taxes for his considerably high income.
But private equity managers have figured out other ways to boost their own profitability though the liberal use of fees, and that also may be coming at the expense of the public.
Some of the schemes have come to the attention of the Securities and Exchange Commission and will likely involve some sort of regulatory crackdown.
In a speech to private equity industry members in May, Andrew J. Bowden, director of the SEC’s Office of Compliance Inspections and Examinations, said that he’s been seeing troubling trends in the public equity industry. One is vague language in contracts. “This has created an enormous gray area, allowing advisers to charge fees and pass along expenses that are not reasonably contemplated by investors.” Furthermore, he said agreements don’t give investors “sufficient information rights to adequately monitor their investments.”
We wouldn’t necessarily care about private well-heeled investors getting fleeced by financial firms. It’s their money to lose. But investors include public endowments and pension funds such as CalPERS. And if CalPERS is getting soaked, so is the public.
It’s virtually impossible to tell if that’s the case, however, since the agreements that public pension funds have with private equity firms are exempt from California’s Public Records Act. CalPERS does disclose the assets it has in private equity, their value and the rate of return, but not the fees paid, which could be in the millions. If these documents were public, then analysts and financial watchdogs would be able to keep track of schemes that cost the funds and their beneficiaries.
The reasoning behind the disclosure waiver was to protect investment strategies. But they seem to have done a better job of protecting the ability of public equity firms to line their pockets with the public’s money. This is an issue ripe for legislation.