Split the fee debate in half

Earlier this year, when we revealed that the ILPA and EVCA were reviewing their reporting templates and guidance in light of regulatory and investor concerns over fees and carried interest we predicted the issue would snowball.

Soon after that letter, a coalition of state officials sent a letter to SEC chair Mary Jo White urging the SEC to mandate standardized fee disclosures by force. In response, our sister title, Private Equity International, wrote that no matter what the SEC does this debate isn’t going away anytime soon. So better to have your affairs in order now, before it means losing LP commitments or, worse yet, regulatory action.

We wholeheartedly agree. But allow us to unpack what’s happening here from a more technical standpoint with respect to reporting (which is of higher interest to the finance and administrative team).

To begin, consider this: what does it mean exactly to report carried interest? It’s a question few are asking, despite most agreeing with criticisms that CalPERS dropped the ball after admitting it didn’t know how much carry it pays its managers.

But here’s the thing: it’s not CalPERS that is paying the carry. Carried interest is a profit allocation made after fund divestments, collected by the GP after hitting a pre-negotiated performance benchmark. Is the expectation that CalPERS knows how many dollars it sacrificed for agreeing a 20 percent profit share with the general partner based on their ownership percentage of the fund? Or how much carry in total the GP receives? Or something else? In the end, what does knowing that number provide CalPERS after the partnership agreement is signed?

Let’s also remember that carry is not a simple accounting number. It can be accrued, earned, paid or even locked in escrow to secure future clawback obligations. These nuances will need to be considered if we are to speak of carried interest reporting in a meaningful way.

The ultimate goal, of course, is more transparency – an objective we here at pfm have thrown our weight behind in the past. But carry is not as significant a number for purposes of discovering industry abuses as is travel expenses, broken deal fees and accelerated monitoring fees, to name a few areas where regulators have unearthed questionable practices. It’s possible a GP (alongside their accountants and lawyers) took a favorable interpretation of gray areas in the partnership agreement when running the distribution waterfall, but auditors are trusted to detect such abuses during the year-end review.

Accordingly, we weren’t much surprised that a CalSTRS spokesman said that carry is “not a very meaningful number” when asked about the building fee transparency debate.

To be clear: it makes complete sense that ILPA and others are working on a template to facilitate more carried interest and expense reporting. Knowing how much performance bonus a GP receives can be useful from a due diligence standpoint. But let’s keep the recent scrutiny on carried interest reporting separate from the more interesting debate on controversial fees and expenses.