Private Equity and Private Equity Real Estate have been under attack in the press and recently drew the ire of pop musician Taylor Swift as company destroyers, sneaky asset stealers, enjoyers of tax loop holes and sky high, risk-free management fee collectors.
The Beginning: How Private Equity Started and Operates
1,679 PE investment vehicles with a North American focus raised over $460 billion in 2019. Private Equity began as an alternative asset class back in the 70’s. Investment mangers create an investment thesis and set up a new Limited Partnership in which investors can buy units in.
The investors in this alternative asset space are everyone from the person next door, wealthy individuals, endowments and institutional investors that look after money collected in a pension fund. When investors invest in the partnership, they are called Limited Partners (LPs) because they are limited in their liability within the entity. The LPs do not deal with the day to day operations of the fund but can still oversee a funds operations (Investment Committee). The investment manager, usually the same team as the General Partner (GP) run the fund, collecting a management fee and part of the profit for doing so.
After a portion of the money is raised, the GP looks for assets to purchase on behalf of the fund based on the investment thesis. After they invest all the capital they raised into assets or companies, they hold and operate the asset for several years, either selling it or selling it just before the stated fund life, generally 5–10 years.
The best investments are ones in a raising market sector, hot geographic area, are a unique product/new disruptive product or have some kind of revenue stream. Sometimes the GP buys other companies or competitors to strengthen and consolidate the initial company they bought (Bolt on Acquisition).
Myth #1: Private Equity Makes Outrageous Fees
Let’s attack the myths of high management fees in a different way. Imagine going to an interview, and the employer starts talking about compensation. They say it is a great company to work for and you get a wage and a profit share. The employer tells you there is a lot of competition for this job and they are going to pick the best candidate and that candidate may even have to work for a discount to his normal wage for 5 to 10 years if you are somewhat new to the industry. The normal management fee is 2% yearly on the Equity (money) under management (EUM). Payable every 3 months (on average).
But, warns the employer, if you quit before the fund winds up, consider yourself out of the business, because no one will invest in you again if you left the fund and the investors holding the bag.
The second part of the compensation is a profit share. That share comes when you sell a company or asset within the fund for a profit. The profit share is calculated like a waterfall, at the top is the investors money (LPs), plus whatever they were promised as a preferred return or hurdle, 8%
(IRR or percentage) is average. Then LPs get all of the start-up expenses and overhead costs returned to them over the fund life at the fund windup. In some cases, the management fees earned (2%) go back to the investors as well (larger funds). Then the you (the employee) get to have a share of the profit if there is any money left (GP catchup) you get 20% of the 8%, then the investor gets 80% of the rest of the profit and the GP gets the remaining 20% (carried interest).
But you don’t get all of that profit share, you only get 35% of it. The remainder of 65% (GP Clawback) is held in escrow and doesn’t accumulate any distributions or major interest and can be payable to you when the fund winds up, in 5 to 10 years.
If the fund doesn’t make money, you don’t get that 65% escrowed profit share that you earned and you have to pay back the other 35% of the profit share at the end if the investors don’t make back their investment plus plus their preferred return. Oh, and I forgot to mention says the employer, “I need a check for one to 5 percent of the total size of the fund, you won’t get any preferred return on that money or profit sharing but it lets investors know you are serious.”
Imagine how many employees would work for a wage and bonus structure like this?
Imagine starting out and going years without being paid, but having to actually pay to go to work? (what new investment managers do)
Imagine how many employees would work pay to work?
Also all the debt incurred by the fund, the structure states that the GP/investment manager has unlimited liability, so the creditors can come after all your personal and family assets.
Still interested in the job? Think that this is a lot of personal risk? Still think private equity is easy, low risk structure for GPs where investors are being taken advantage of? If this wasn’t at will employment you could argue that investors are taking advantage of GPs….
Compare this to hedge funds where they get a 20% profit share yearly, no clawback and a 2% management fee paid quarterly. Or, what if you bought a stock, held it for years, then when you sold the stock, the company gave you a pro-rata share back of all the money they spent on overhead and salaries and stock options while you owned the stock? Unimaginable. Or if the stock underperformed, the CEO of the public company would take money out of their salary and bonus to make you whole?
Yet the myth prevails that Private Equity managers are scamming LPs, charging them high rates, cheating, downsizing, crushing companies and taking advantage of poor pop artists every chance they get.
The investor protection and legitimate benefit that private equity and private equity real estate funds provide is unapparelled in the investment world.
Myth #2: Private Equity enjoys a favorable tax advantage
Do they really have more tax advantages than very large public companies or pension funds or corporations? Short answer, No. In fact, private equity exposes itself to at least two sets of tax, one at the portfolio company/asset level (the companies/assets they bought in the LP) and the second at the LP level which passes through taxes. Elizabeth Warren, has called upon private equity to be more heavily regulated and drawn up bills. But her bill is impossible to regulate in a free market- because privately owned companies can and do operate the same way as a PE fund. The very pension funds she thinks she is trying to “save” are the biggest investors in private equity and some even have internal private equity teams.
All can run up debt, hire, fire, sell assets or close the business they own. The tax benefits, if there is a profit left over for the GP, is that carried interest taxed like capital gains (currently 23.8%) rather than income (which could be 37%) if Biden has his way. Potentially Biden would want to tax these profit shares at 40%. And raise corporate tax in general, which would prompt even more firms to move to low corporate tax states like Florida. This higher tax would put downward pressure on the stock market, reducing pension fund earnings, depressing the economy further. Add to this Biden’s plan to tax all dividends to 40% and this places increased pressure on the elderly and retired that depend on dividends to supplement their fixed income.
Real estate partnerships would be affected greatly as they are almost 50% of the 3.7 million partnerships in the US, according to IRS data. In the majority of large private equity funds, the LPs pay the GP a “tax grossup” which pays for the GPs tax obligation. In the case of pension fund investors, any regulation to raise tax only lowers pensioners returns because the pension fund LPs are paying the bill.
In terms of assets being purchased and sold in a legal and mutually agreed manor, Taylor can choose according to her contract to work or not work for corporations that now own her old songs, but she is wrong to call out an industry because of a personal grudge (looking at you Scooter).
Carried further, it’s like a manufacturer being upset that someone bought their product and sold the product later for a profit, because the product still has continued intrinsic & revenue generating abilities. Her music having intrinsic value can be debatable, but an artist signing a contract is not.