There’s something about carry

Ever since the US Securities and Exchange Commission (SEC) came down hard on private equity fees and expenses last year, certain costs associated with the asset class have been receiving more heat than others. Management fees have been questioned by LPs, and travel expenses, broken deal fees and accelerated monitoring fees have been slammed by regulators.
Carried interest has not been in the spotlight as much, mainly because it is seen as an example of alignment of interest. Managers have more incentive to hit their preferred return when carry is waiting on the other side: good for LPs, good for GPs.
But last month, carry became the main target of the fee and expense debate when it was revealed that the largest institutional investor in the US, the California Public Employees Retirement System (CalPERS), admitted it could not determine exactly how much money it had paid out to private equity managers in carried interest.
“Profit sharing in the private equity market, in fact the whole private equity industry, it’s embedded in the return. It’s not explicitly disclosed or accounted for. We can’t track it today,” said CalPERS chief operating investment officer Wylie Tollette in an April 13 investment committee meeting.
Coming from an active proponent of disclosure and sophisticated reporting, CalPERS’ statement raised eyebrows throughout the industry, leaving many to ask, why couldn’t the carry be tracked?
Some responded cynically to the claim, wondering if perhaps CalPERS did not want to report the figures because it did not want to publicly reveal the high price it pays for its $30 billion private equity portfolio – a portfolio that has been underperforming its benchmarks, no less. Couldn’t CalPERS reverse engineer information embedded in annual audited financial statements to reveal what it had paid?
“Of course CalPERS can’t calculate it,” said one placement agent in a call with pfm. “They may be thinking ‘Even if we calculated this the number would be huge so it’s better not to know.’ But not being able to know is a big part of not wanting to know.”
Meaningful or not
In all the hubbub over CalPERS’ admission, another leading US LP, the California State Teachers Retirement System (CalSTRS), revealed that it had not been recording and disclosing carry payments made to fund managers since 1988. The reason, CalSTRS stated, was because carried interest was “not a very meaningful number” to them.
Some industry professionals agree, saying that even asking what LPs have paid in total carry is a “nonsensical” question. The premise that LPs are paying massive amounts in money that should have been theirs is flawed, notes one consultant. In reality, they are just following a profit sharing model. Even if LPs had aggregate carry numbers to report, they would not be significant.
Meanwhile, CalPERS responded to the blowout by saying its portfolio was far from alone in experiencing this confusion. While the pension knows the terms they agreed to at inception, carried interest is not consistently reported by its GPs during the life of the fund.
“Industry practice does not currently include uniform disclosure of a detailed ‘gross investment to net capital’ reconciliation. Such a reconciliation would include carried interest, both accrued and paid as well as underlying fees charged to portfolio companies or the funds by the managers,” a pension spokesperson said in an emailed statement to pfm. “In our opinion it’s also a private equity industry issue. LPs need consistent and detailed disclosure of carried interest and fees in order to fully report on these.”
Most in the industry agree with CalPERS – the lack of transparency is an industry-wide issue, not an individual one. And it will take time, along with participation from every corner of the industry, to build a standard carry reporting template and develop the kind of adoption that will finally reveal just how much each LP has been paying out in carry.
Confusion in customization
While a straight 20 percent carry over a standard 8 percent hurdle is simple math, the issue with calculating aggregate carry for a portfolio like CalPERS lies in customization – both of the fee model itself and the way it is reported.
GPs frequently give out fee rebates, which make the calculations more complicated to reverse engineer from financial statements. Moreover, the language describing the carry distribution waterfall in a limited partnership agreement (LPA) or a side letter is often so complex that the way it is interpreted by different parties is likely to vary.
Recently, secondaries advisory firm Cebile Capital was dealing with a top global private equity manager and asked a question related to its carry calculation. The GP responded saying that even their own team was not sure how exactly to calculate it. What is meant, what is written and what is interpreted in an LPA can be three separate things, warns managing partner Sunaina Sinha.
“Sometimes it’s not a question of a GP being resistant to reporting these numbers, sometimes the GPs themselves don’t know,” she says. “The lawyers are as much at fault as anyone else in this whole issue that’s being raised. Sometimes the drafting is so complicated that GPs need help to figure out how it all works.”
CEM Benchmarking published a study earlier this year on the issue, noting that until cost disclosure is standardized in private equity, LPs will never know just how much the asset class is costing them.
“Carry is reported in different ways, and there are no standards in how it’s calculated. Waterfalls in contracts vary and there’s many nuances in the terms,” says CEM principal Mike Heale.
And language is just half of the issue. When it comes to the way carry is reported to LPs, the complications proliferate.
“Historically no consistency in disclosure of transaction info from GP to LP,” says one consultant who works with some of the largest private equity investors in the US. “But the ‘private’ in ‘private equity’ doesn’t mean secret, it means not publicly traded. As an investor you have a right to the information.”
Individualized solutions
Some LPs have been getting that information, receiving detailed fee reports from their GPs via customized templates. The South Carolina Retirement System Investment Commission (SCRSIC), which was the main subject of CEM’s study, for example, has its own “extensive and rigorous process for identifying and reporting private equity costs.”
SCRSIC provides an individualized capital account statement template for their private GPs to fill out each quarter. The expenses portion of the template includes accrued carry/performance fees that are deducted from NAV for the period.
Similarly, one state endowment that invests in some of the largest private equity funds requests carry information each quarter through a personal template. When the private equity director at that endowment heard CalPERS was having difficulty reporting its carry figures, he said he was “quite incredulous.”
“I don’t have any particular problem with figuring out how much I’m paying in carry. There are quite a few sources to find it,” he says.
The endowment’s fee and expense template includes carry paid and carry accrued, so that the LP can see what is being deferred or rebated. It would be time consuming to put all of that information together to report for the entire portfolio, he admits, but the figure could be deduced.
In July, CalPERS revealed it would begin publishing carried interest data through its newly developed Private Equity Accounting & Reporting Solution (PEARS). The LP has been asking all of its current GPs to provide it with information on partner-level carried interest deducted from gross returns since inception since the beginning of 2015.
CalPERS created PEARS to resolve the shortcomings of its legacy private equity accounting system, which it described as unable to “accurately and comprehensively capture, calculate and aggregate” carried interest. Since 2012, CalPERS has collected data on capital calls and distributions using reporting templates formulated by the International Limited Partners Association (ILPA).
CalPERS had yet to receive carry information from 6 percent of its managers as of July, a press release noted, which calls into question the clout of one of the biggest private equity LPs worldwide.
The consultant has worked on a similar project (asking every GP in a private equity portfolio for detailed carried interest data), and notes that some managers are more resistant than others to give out such information in writing.
“A lot of GPs would be more comfortable with providing drilled-down numbers if everyone was doing the same thing,” he says.
Setting a standard
Standardization is proving to be a difficult task, however. The 2012 ILPA reporting template asks for information on carried interest, but LPs are still using their own individual versions, or find that GPs are not fully filling out those sections.
In an effort to get more exact numbers, ILPA has brought together a working group of LPs, fund administrators and consultants to formulate a new template dedicated to fees and expenses, according to ILPA managing director of industry affairs Jennifer Choi.
“We’re trying to understand – where do these communication gaps exist and why?” she tells pfm.
Thus far, the working group has noted that the proliferation of formats in which fee information is provided has been the biggest issue. But those individualized templates are also assisting their efforts. While the group is using ILPA’s own forms as a starting point, they are looking at others to determine what is most user-friendly and effective. A draft is expected to be published next fall for industry feedback.
“As a starting point we need to agree: what do LPs need? Do they get it? And if not, why not?” says Choi.
ILPA is working along with other organizations such as the European Private Equity and Venture Capital Association and Pension Real Estate Association, who are similarly developing fee reporting initiatives and sharing the templates as they evolve.
“ILPA’s push will be good. If they come out specifically with more information for the capital call and distribution template, you’ll find a lot of people adopting it so they can say, ‘We’re ILPA compliant.’” comments the state endowment manager. “Right now, we’re all asking for the same information shown in different ways.”
CEM, too, is working on its own report about fees that it hopes will move the needle. A group of 30 clients across 11 countries (including some of the world’s largest pensions) is pooling together information to compare what level of disclosure they receive from GPs.
“We hope to get a snapshot of the state of reporting as it stands today,” says Heale. The report is set to be published before the end of the year.
A delicate issue
With all of these projects currently underway, standardization in carry language and reporting may seem imminent. Unfortunately, sources say, the motivations for the players involved make the issue more complicated.
The biggest push for standardization and transparency has to come from the LPs themselves, not from industry trade bodies or outside consultants, the consultant notes. Investors need to deny GPs commitments if they do not follow certain disclosure standards. But while many LPs are questioning fees, many (like the state endowment) are happy with their current level of disclosure, and would not sacrifice spots in popular funds.
“The only way it will get better is if the largest LPs band together, but that will not negate the issue completely because there are a lot levers that GPs can play to get an LP on board,” says Sinha. “The LP may say ‘Standardization is great, but why should I pay the full 20 percent in carry if this GP is giving me 15 percent without a catchup? I have to do the best thing for my pension plan.’”
Moreover, the consultant adds that while larger LPs can use big tickets as leverage for greater standardization, those big LPs are also doing more direct deals and co-investments rather than funds.
“As the big guys leave the room to do separate accounts, it removes voices that could push for a certain level of transparency,” he notes. “When smaller tickets are fighting for their allocations, the impetus for improved disclosure falls lower on the list.”
ILPA may be well positioned to improve cost reporting standards, says Heale, but while developing standards is one thing, adoption is another. And that may take up valuable time for LPs.
CalPERS kicking off the debate by admitting what they don’t know about their own portfolio was likely a help to other LPs, since if GPs already had to consolidate and streamline that information in order to give it to CalPERS, they may be more likely to hand over the same information to another LP who asks, Sinha says.
But she stresses that the biggest way to ensure transparency is during the fundraising process, when LPs have bargaining power. LPs should ask GPs to walk through an example of how the carry would work and store that file, so that when a fund is in carry mode they will know how the calculation works.
Until best practices are set in stone, LPs will only have this information if they ask up front, she warns. “The GP is absolutely not incentivized to provide it at any other time.”