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Paying the piper

Among the certainties in private equity are taxes and paying your placement agent. But structuring your agent's compensation in a tax-efficient manner won't please every LP.

At a recent industry conference, a lawyer addressed the general partners in attendance, saying: ?You all know to pay your placement agent through the partnership, right?? From his tone, it was evident he advised his clients of the practice frequently enough that he felt it should be considered common knowledge by now.

However, most general partners expect to pay the placement agent through the management fee. This is half right, though there's a more sophisticated structure involved. The partnership, not the GP, should write the check to the agent, with the management fee reduced to offset the cost of doing so. This improves the tax situation for the general partners, though GPs should be aware it may complicate the liability for a small number of LPs.

Placement fees are treated as a syndication expense and therefore are not tax deductible when paid from the management fee. But paid through the partnership, the percentage of the fee devoted to an agent is no longer treated as income for the general partners, reducing the total taxable income substantially for GPs. The basic economics are the same, as the management fee is reduced to address the payments made to the agent.

For example, suppose the management fee amounts to $1,000 and the placement agent's fee totals $250. The partnership would only pay $750 in management fees in return for writing the $250 check to the agent.

It should be noted that this shifting of the expense to the partnership can raise a tax issue for certain limited partners. Jay Milkes, a New York-based attorney at Ropes & Gray, warns, ?There is a marginally unfavorable situation for taxable, corporate LPs or individuals in certain cases.?

Individual LPs generally are subject to limits on their ability to deduct fund expenses like the management fee, including a limit on certain deductions that include these types of expenses. For these LPs, the management fee can be deducted only to the extent it, when tallied with other related expenses, exceeds 2 percent of an individual LP's adjusted gross income. Therefore, in many cases an individual would not have received a deduction for his or her share of the management fee anyway.

Milkes explains, ?I say ?marginally? unfavorable to individual LPs as a class because there may be a few cases where an individual could have deducted some or the entire management fee, but one would not expect that to be true of the bulk of these LPs.? Tax exempt and foreign investors aren't affected by the structure, and given the diverse mix of many firms' limited partners, there's rarely a sufficient majority willing or able to veto the partnership-pays structure in the PPM.

While a case can be made for the more tax-efficient, partnership-pays model, selling this model on a meeting-by-meeting basis can prove difficult. One placement agent explains that none of his client GPs had yet used this model. Instead, the management fee is used to pay the placement agent. Given the fact that most partnership agreements address fund formation costs, which frequently fall under the million dollar mark, the addition of a multi-million-dollar placement fee to this category would hardly fly below the radar of the LP audience. The agent says that the break with tradition would require an explanation, and despite the reduced management fee, the resulting shifting of tax liability away from the GP won't sit well with the affected LPs.

The agent adds that alienating just a few LPs can in fact bring a fundraising to a halt.

While some industry participants may swear by the partnership-pays placement fee structure, the agent has little incentive to draft a structure this way. His principal concern is that the fund is raised, ensuring a fee is paid at all.