It shouldn’t surprise anyone that private equity firms are good at making money. That’s the reason they exist. It’s also why wealthy investors, including public pension funds, have rushed to invest with those who manage them.
It seems, however, they’ve gotten a little too good at finding money that perhaps they’re not entitled to. Some of these funds literally make billions in profits; you’d think that would be enough. They do this, in part, by manipulating loopholes that allow them to unfairly avoid paying taxes. Now, they’re also nickel-and-diming 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. By setting aside 80 percent of their profits for one year, they are allowed to treat the money as capital gains instead of regular income. Instead of being taxed at 39 percent as income, it is taxed at 15 percent as a capital gain. That means our federal and state governments fails to get a big portion of what it should have gotten from an industry whose income is estimated to be $3.5 trillion.
Many will recall that this arrangement allowed former presidential candidate Mitt Romney to pay relatively low taxes for his considerably high income. But it should be noted that many Democrats, including former President Bill Clinton and Senate Majority Leader Harry Reid, have been among the most ardent defenders of this tax dodge.
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Now, private equity managers are boosting their profitability by charging fees to clients, and that also might be coming at public expense.
Some of the schemes have come to the attention of the Securities and Exchange Commission and will likely result in a regulatory crackdown. At least we hope so.
Andrew J. Bowden, director of the SEC’s Office of Compliance Inspections and Examinations, spoke to private equity industry members in May, saying he’s been seeing troubling trends in the 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.” He said such 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. They were smart enough to make all that money; they should be smart enough to keep it. 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, since the agreements between public pension funds and private equity firms are exempt from California’s Public Records Act. CalPERS discloses the assets it has in private equity, their value and rate of return, but not the fees – which could be in the millions. If these documents were public, then analysts and financial watchdogs could track the fees and schemes that cost the funds and their beneficiaries.
The disclosure waiver was an effort to protect investment strategies. But they have done a better job protecting the ability of public equity firms to line their pockets with the public’s money. This is an issue ripe for regulation or legislation.