The majority of deals signed by the California Public Employees' Retirement System with private equity firms allow the firms to reduce their tax bills by treating ordinary management fees as capital gains, an issue that is drawing increasing regulatory scrutiny.
At issue is what's known as a management fee waiver, in which private equity firms can waive the right to collect a management fee from an investor and instead accept the same amount of money as a capital contribution. The device allows the firms to decide themselves whether to treat their fees as ordinary income or as capital gains, which are taxed at lower rates.
Almost 60 percent of the $30.5 billion in private equity investments held by Calpers, the nation's largest public pension fund, contain the waivers. In September, a group of Senators, including Massachusetts Democrat Elizabeth Warren, told the Treasury Department that management fee waivers had resulted in "billions of dollars" of lost tax revenue, and they expect "swift enforcement of these long-awaited proposed regulations." In July, the IRS and Treasury suggested that some waivers may be a "disguised payment for services."
At the heart of the matter is how private equity firms make money and what tax rate they pay. When putting money under management at a private equity firm, an investor such as Calpers pays an annual fee that's often 1 percent to 2 percent of the assets they're investing. That management fee is normally taxed as ordinary income. On top of that, private equity firms also typically collect about 20 percent of whatever profits are generated by the investment. That money, also known as carried interest, is taxed as capital gains.
The management fee waiver comes in when a private equity firm's general partners, ask investors, also known as limited partners, to agree to pay the general partners' capital contribution in lieu of the management fee. If the investors do, the general partners can choose to treat the income as capital gains, which are taxed at 20 percent, a little more than half as much as the top 39.6 percent rate applied to ordinary income.
Management fee waivers are allowed under the tax code. The waivers only affect the taxes of the private equity companies that use them, not Calpers' performance nor the amounts it pays its retirees.
About $17.9 billion of Calpers' $30.5 billion in private equity assets are affected by fee waiver language, the pension fund told Reuters. Among those deals - totaling 59 percent of private equity investments - Calpers would not disclose how much money has been waived. As a result, the total tax savings is unknown.
"This is basically a tax-avoidance strategy from the GPs," Marte Castanos, Calpers' senior staff counsel said this week during a Calpers workshop about private equity. "Calpers still pays the money, but it doesn't go to management fees. It goes to the GP's profit interest. It is a controversial practice, but one that does persist in the industry."
The disclosure by Calpers, a pension fund with approximately $300 billion in total assets, is a rare insight into the prevalence of fee waivers.
Public pension funds are among the largest investors in private equity funds, which typically don't disclose profits or how much they pay in taxes.
Calpers, which started investing in private equity some 25 years ago, plans this month to publish how much it pays in carried interest, another unusual disclosure among pension funds and a move certain to be noticed by others across the country.
Calpers' sister fund, the California State Teachers' Retirement System (Calstrs), and the rest of the nation's 10 largest public pension funds either do not track fee waivers or would not disclose how common they were in their investments.
Calpers, like other pension funds, is barred from disclosing which investment deals contain fee waivers, because the agreements are considered confidential trade secrets.
Private equity firms rarely disclose whether they use fee waivers, although there are some exceptions. Apollo Global Management, one of the largest private equity firms, disclosed in public filings that it had waived $156.5 million between 2005 and 2012. KKR, another of the nation's 10 largest firms, reported it had waived $69.5 million in 2008 and 2009.
Apollo says it stopped including fee waivers in funds in 2012. Eight of Calpers' nine investments in Apollo funds were begun before 2012, totaling $3.6 billion. Calpers committed $1.9 billion to seven KKR funds. KKR said it discontinued the practice several years ago.
In another example, the Welsh, Carson, Anderson & Stowe's XI fund's limited partnership agreement, reviewed by Reuters and not required to be disclosed to the public, allows the management company to waive all or a portion of any management fee. Calstrs committed $250 million to that fund in 2008. Calpers committed $125 million a year later, but the size of the fee waiver is unclear.
Riverstone Holdings and Providence Equity Partners, in whose funds Calpers has also invested, mentioned the use of fee waivers in SEC filings but did not offer specifics.
Fee waiver language became "a standard term in LPAs" by 2012, said Todd Fogarty, a spokesperson for Palladium Equity Partners, which included fee waiver language in its Fund IV that year but says it never activated it. Calstrs invested $90 million in the fund in 2012.
The same year, documents from Bain Capital, the private equity firm founded by then-Republican 2012 presidential candidate Mitt Romney, showed the firm saved over $200 million in taxes through the practice.
One of the reasons Calpers does not like fee waivers is that the fees are intended to cover expenses, said Scott Jacobsen, an investment director on Calpers' private equity team. If private equity firms can "waive these fees in lieu of GP contribution, it implies that the fees are too rich."
The practice may soon be phased out. Since the IRS's and Treasury's proposed ruling, a number of law firms have posted advisories. Simpson Thacher & Bartlett LLP published in a memo that some "common private equity management fee waiver arrangements," could be considered "a disguised payment for services taxable as compensation income." The firm warned that although the proposed regulations are not yet final, "private equity fund sponsors should proceed cautiously."
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