It's surprising what even a little sunshine can do.
Private equity (PE) funds operated for decades without regulatory oversight. That changed in 2010 with the passage of the Dodd-Frank financial reform bill. Now most PE funds have to register with the Securities and Exchange Commission (SEC), and what the SEC found when it looked at those funds rattled the private equity industry and opened the eyes of pension funds and other investors in PE funds. Last May, in what has come to be known as the "sunshine" speech, the SEC's Andrew Bowden, director of the Office of Compliance Inspections and Examinations, described a troubling situation in which more than half of the PE funds examined had serious legal or compliance violations and were not sharing fee income that rightfully belonged to PE fund investors. While no major enforcement action has occurred to date, many PE funds — under pressure from the SEC and demands from investors — have begun paying investors the fee income owed them instead of pocketing it for themselves.
Federal securities laws require all investment management fees to be disclosed to investors. In the case of private equity, this includes not just the annual management fees that investors pay to the PE firm, but the performance fees — known in the PE industry as carried interest — as well. Clearly some private equity funds (as well as hedge funds and other alternative investment funds) share this information with public pension funds and other investors. In its 2014 Annual Report, the New Jersey State Investment Council reported paying $281 million in management fees and expenses to fund managers for managing private equity and other alternative investments. In addition, New Jersey reported that in "fiscal year 2014, the alternative investment fund managers received $334.8 million of performance allocations." Including carried interest paid to fund managers, the New Jersey state pension fund paid nearly $616 million in fees for managing the pension fund's alternative investments.
Not all public pension funds are this forthcoming and report to taxpayers and beneficiaries the performance fees as well as the management fees paid to private equity firms. It is not uncommon for pension funds to report only management fees and to report pension fund returns from alternative investments "net" of carried interest without specifying how much carried interest has been paid. Moreover, there is currently no way to accurately measure the aggregate amount of carried interest PE and other alternative investment firms receive in carried interest. Transparency on this issue would seem to be in the best interest of the public and of investors in funds sponsored by these firms.
There is a straightforward way to address this. College professors who report income on Schedule C of their federal income tax returns are required to break out royalties on books they have published from consulting income from services they provide to clients. Why not require private equity funds to report carried interest separately from other capital gains on the Schedule K-1 distributed to each partner?
Such a reporting requirement would have two important effects. As with the distinction between royalties and consulting income, this breakdown of long-term capital gains income would provide more detailed information on Americans' sources of earnings. Such information can play an important role in research on income inequality. It would enable researchers to distinguish performance fees earned by alternative investment fund managers for their active engagement in managing their funds from other long-term capital gains. In addition, once fund managers are required to report carried interest on their tax forms, it will be a routine matter for them to share this information in a standard format with investors in these funds.
As the New Jersey State Investment Council concluded in its 2014 Annual Report, "While there is no standard for reporting performance allocations among public [pension] funds, the Council strives to be an industry leader as it relates to transparency." This is a goal that all pension funds should strive to achieve. Requiring private equity and other alternative investment funds to routinely provide this information to investors would greatly improve transparency and the ability of investors to make informed investment decisions.
Appelbaum is senior economist at the Center for Economic and Policy Research and co-author of Private Equity at Work: When Wall Street Manages Main Street.