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Investment industry welcomes SEC efforts to reform private equity fees

Consultants and investor groups have welcomed plans by US regulators to force greater fee transparency on private equity managers, saying they will help pensions and other fund managers to track performance and to demand fair treatment on costs.

The Securities and Exchange Commission last week proposed that private equity funds should provide standardised quarterly data on fees, expenses and performance, in a move that would transform disclosure standards and curtail managers’ ability to present potentially misleading information to investors.

The shift would bring private equity in to line with public markets as mainstream funds turn to private equity to pad out returns when public stock markets are volatile and bond yields are still close to historic lows.

“The SEC is trying to play catch-up. They want more information as private equity gets more pervasive as an investment option,” said David Larsen, an expert in private fund accounting at Kroll, the business intelligence provider.

In a highly critical report published in late January, the SEC pointed to numerous instances of private equity companies providing inaccurate or misleading information about their performance and overcharging fees to investors when, for example, a portfolio company had been sold.

Private equity managers generally charge “two and 20” — a two per cent annual management fee and a 20 per cent performance fee if a return hurdle is met. This can add up to about 6 per cent a year over the life of a fund. Some tracker funds that have offered similar returns charge just 0.06 per cent. Investors additionally pay a wide range of fees and expenses for services charged to companies owned by private equity companies, eating in to final returns.

The SEC wants details of all the fees and expenses paid by investors to private equity managers to be disclosed, including hidden expenses such as consulting, legal and monitoring charged to portfolio companies and ultimately funded by investors.

“These are a very investor friendly set of proposals. They will provide more leverage to investors,” said Igor Rozenblit, founder of the Iron Road Partners consultancy and a former senior SEC regulator.

US private equity managers controlled assets of $4.7tn spread across 15,584 funds at the end of 2020, a sector that has doubled in size in less than five years as more investors have been drawn to the potential for high returns.

The Institutional Limited Partners Association, a trade body representing large investors in private equity funds said the SEC’s proposals would help to address the conflicts of interest that were becoming increasingly prevalent across the private equity industry, such as offering preferential terms to favoured clients.

“These proposed rules will ensure that investors can validate that the fees and expenses that they are charged match what was contractually agreed and deter practices that feed any misalignment of interests,” said Chris Hayes, ILPA’s senior policy counsel.

The regulator wants all private equity managers to use common performance measures, including gross and net internal rates of return and net multiples of invested capital, to make it easier for funds to compare them.

Both of these metrics have drawbacks and they are not directly comparable to performance data reported by conventional mutual funds. To address that, the SEC also wants private equity managers to reflect cash inflows and withdrawals from their funds, which would allow investors to calculate other helpful performance metrics.

The SEC wants to stop private equity managers from presenting returns that have been artificially boosted by a technique known as subscription-line financing.

Other proposals include rules aimed at standardising some of the industry’s more complex transactions, such as co-investments made by large institutions. It also intends to ask for a “fairness” opinion when senior partners arrange the sale of companies from one fund to another.

Jeffrey Hooke, a finance lecturer at Johns Hopkins Carey Business School, said: “There will be a lot of surprise among institutional investors when they are provided with honest returns data which are unaffected by manipulation and exaggeration.”

The timing of when any new rules will be introduced is unclear as the proposals will now undergo a consultation period. Some observers believe that Gary Gensler, head of the SEC, will push for completion before US midterm elections in November. Stiff resistance to any changes is anticipated from the private equity industry’s powerful lobby in Washington.

The American Investment Council, the lobbying body that represents the private equity industry, said its members were already “working closely” with investors.

“We are concerned that these new regulations are unnecessary and will not strengthen returns for pension investors or help [PE owned] companies innovate and compete,” said Drew Maloney, the AIC’s chief executive.


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