Five predictions for 2014

1. GPs will come under more pressure on deal fees…

Already there are more fund managers moving towards a model where they return all deal fees to investors. But some GPs, especially in the US, still reserve a portion of transaction and monitoring fees charged to portfolio companies for the firm. Expect these GPs to reconsider their approach, especially in light of Sun Capital's legal dispute over its responsibility for a bankrupt portfolio company’s unfunded pension liabilities. A court specifically cited deal fees charged to the business as proof that Sun Capital was more than just “a passive investor” – and as such had an obligation to that company’s retirees under the Employee Retirement Income Security Act (ERISA). It’s still not entirely clear whether Sun Capital offset its deal fees 100 percent against management fees, but a GP that does so may be able to convince a judge to disregard this particular factor when determining ERISA liability.

2. …but some will refuse to change their approach

That said, it will be difficult for some firms to concede 100 percent of deal fees to their investors. Under increasing pressure from LPs to reduce management fees, sources say some GPs are more reliant on deal fees to pay for overhead costs and other related expenses that the management fee used to cover.

3. Inspectors will cavil at valuation estimates

The Securities and Exchange Commission (SEC) has already made valuations a priority in its supervision of private equity funds. But so far, it has largely focused on ensuring private equity firms follow their own valuation policies and procedures, rather than on scrutinizing the actual valuation estimates. It’s reasonable to believe that will change. As SEC inspectors achieve a greater understanding of the industry (after all, private equity only first fell under the agency’s purview in March 2012), they will begin to question with greater confidence why one firm it inspects values club deals in a particular way, while another takes a materially different approach.

4. Pay rules will prove less burdensome than expected

In many ways, the Alternative Investment Fund Managers Directive (AIFMD) will drastically reshape Europe’s private equity industry. But don’t expect fund managers’ pay packets to change substantially as a result. In early 2013, EU regulators published final remuneration guidelines that caused some GPs to worry about how carried interest will be treated under the directive. It seems, however, that the carry model is already in line with what the guidelines are trying to achieve – i.e. controlling risk-taking, ensuring investor alignment and limiting rewards from successful investments. That’s largely because carry is a performance bonus, paid only after investors get their preferred return. And of course, the clawback mechanism should ensure GPs never end up with too much should a buyout fund later turn sour.

5. GPs’ wallets remain safe:

For years now, Democrats in the US have tried – and failed – to pass legislation redefining carried interest as ordinary income. Opponents of carry hoped that might change when Mitt Romney’s run for president in 2012 brought the issue to the entire nation’s attention – and although didn’t happen, carry continued to be a debating point during Congressional budget battles. In 2013, some key Republicans responsible for hammering out a fresh budget deal said higher taxes on carry could be used as a negotiating chip. But with Congress expected to pass a two-year federal budget this week that won’t alter carry’s capital gain tax status, it looks like private fund managers are in the clear – at least for the time being.

Got your own predictions for 2014? We’d love to hear them. Email PE Manager editor nicholas.d@peimedia with your crystal ball thinking.