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Tax News
Revived focus on monitoring fees
May 13, 2016
Miscellaneous
This issue had died out for a while since the 2014 articles by Gregg Polsky and the NYT but is now back in full force. The Center for Economic and Policy Research (for short CEPR) just released a populist paper titled “Fees, Fees and More Fees: How Private Equity Abuses Its Limited Partners and U.S. Taxpayers.” In addition, Americans for Financial Reform addressed a similar letter to Jack Lew and John Koskinen. The spirit of these reports is basically a rehash of Mr. Polsky’s 2014 arguments. The gist of it is, bad private equity is abusing the law and hurting hard working families. In the particular instance of monitoring fees, the alleged abuse is unauthorized fee deduction instead of a nondeductible dividend. 

A few years ago when this argument first surfaced the industry came out and tried to explain that actually treating the monitoring fees as a dividend could lead to less revenue to Treasury. Then Mr. Polsky came out with a follow up article arguing that this would not be the case based on the assumption that the fees ought to be treated as dividends to fund investors and then a payment to the fund managers.  These arguments could become pretty technical quickly and the ultimate result to Treasury may be hard to estimate one way or another.

What may seem peculiar to people in the industry, however, is the heightened focus on this issue and the proposed “dividend” solution. For one, the magnitude of these fees for the typical PE fund is not that great.  More importantly, the predominant form of PE portfolio company investment these days is a LLC or partnership. In fact, when a PE fund wants to acquire an S-corporation, the third most popular private form of business in the U.S. along with sole proprietorship and LLCs, it typically asks for a LLC dropdown. The reports are alleging that, you see, PE funds are conspiring and disguising dividends as fees.  This is a bit perplexing considering that in the most common PE scenario there are no dividends because the investment is in a flow-through entity. If the fee were to be recharacterized as a partnership distribution it would in all likelihood be a nondeductible return of capital (Sec 707 notwithstanding due to various applicable exceptions), possibly, an even better result for the fund depending on how the underlying flow-through income is allocated.   Perhaps this “dividend” theory could be explained based on the fact that the data points for the monitoring fee studies, such as the Phalippou study, are SEC filings for public-to-private LBOs (not the greatest reference point for a typical PE deal).

In any event, it seems that the industry can’t win no matter what in the eye of the public. Structure something as an allocation and distribution (the waiver situation), it gets recharacterized into a fee. Structure something as a fee (the monitoring case), it gets recharacterized as a distribution. When you throw in the carried interest Democles sword and it sort of starts looking like a tax Armageddon for PE.

The two reports can be found here and here
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Tags: fee waiver, monitoring fees