Consultants and investor groups have welcomed U.S. regulators’ plans to impose greater fee transparency on private equity managers, saying they would help pension plans and other fund managers track performance and to demand fair treatment of costs.
The Securities and Exchange Commission last week propose that private equity funds should provide standardized quarterly data on fees, expenses and performance, which would transform disclosure standards and reduce the ability of managers to present potentially misleading information to investors.
The shift would align private equity with public markets as traditional funds turn to private equity to inflate returns when public equity markets are volatile and bond yields are still near all-time lows.
“The SEC is trying to catch up. They want more information as private equity becomes more prevalent as an investment option,” said David Larsen, private fund accounting expert at Kroll, the market intelligence provider.
In a very critical situation report published in late January, the SEC reported numerous cases of private equity firms providing inaccurate or misleading information about their performance and overcharging investors for fees when, for example, a holding company had been sold.
Private equity managers typically charge “two and 20” – a 2% annual management fee and a 20% performance fee if a performance hurdle is hit. This can be up to around 6% per year over the lifetime of a fund. Some tracking funds that have offered similar returns only charge 0.06%. Investors additionally pay a wide range of fees and expenses for services charged to companies owned by private equity firms, which reduce final returns.
The SEC wants details of all fees and expenses paid by investors to private equity managers to be disclosed, including hidden expenses such as advisory, legal and monitoring services charged to portfolio companies and ultimately funded by Investors.
“This is a very investor-friendly package of proposals. They will provide more leverage to investors,” said Igor Rozenblit, founder of consulting firm Iron Road Partners and former chief regulator at the SEC.
U.S. private equity managers controlled $4.7 billion in assets across 15,584 funds at the end of 2020, an industry that has doubled in size in less than five years as more investors have attracted by the potential for high returns.
The Institutional Limited Partners Association, a trade body representing large investors in private equity funds, said the SEC’s proposals would help resolve conflicts of interest that were becoming increasingly prevalent in the private equity industry. -investment, such as the offer of preferential conditions to privileged customers.
“These proposed rules will ensure that investors can validate that the fees and expenses charged to them are what has been contractually agreed upon and will deter practices that fuel any misalignment of interests,” said Chris Hayes, senior policy adviser at the ILPA.
The regulator wants all private equity managers to use common performance measures, including gross and net internal rates of return and net multiples of invested capital, to make it easier to compare funds.
Both of these measures have drawbacks and are not directly comparable to performance data reported by conventional mutual funds. To address this issue, the SEC also wants private equity managers to reflect cash inflows and outflows from their funds, which would allow investors to calculate other useful performance measures.
The SEC wants to prevent private equity managers from presenting artificially inflated returns through a technique known as subscription financing.
Other proposals include rules to standardize some of the more complex transactions in the industry, such as co-investments made by large institutions. It also intends to ask for “equity” when senior partners organize the sale of companies from one fund to another.
Jeffrey Hooke, senior lecturer in finance at Johns Hopkins Carey Business School, said, “Institutional investors will be very surprised when they receive honest performance data that is unaffected by manipulation and exaggeration.”
When new rules will be introduced is unclear as the proposals will now be subject to a consultation period. Some observers believe SEC chief Gary Gensler will push for completion before the U.S. midterm elections in November. Strong resistance to any change is expected from the powerful private equity industry lobby in Washington.
The American Investment Council, the lobbying body that represents the private equity industry, said its members “already work closely” with investors.
“We are concerned that these new regulations are unnecessary and will not strengthen returns for retirement investors or help [PE owned] companies innovate and compete,” said AIC CEO Drew Maloney.