How Private Equity Makes Its Fortune at the Expense of Its Limited Partners and U.S. Taxpayers

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How Private Equity Makes Its Fortune at the Expense of Its Limited Partners and U.S. Taxpayers

WASHINGTON - In recent years, the private equity industry has been subject to increased scrutiny from investigative journalists, institutional investors, the Securities and Exchange Commission (SEC), the Internal Revenue Service (IRS), and the tax-paying public. In a new CEPR report, Senior Economist Eileen Appelbaum and Cornell University’s Rosemary Batt provide an overview of the practices and abuses, some bordering on fraud, that have come to light since the SEC began auditing private equity firms in 2012. The report documents the many ways in which private equity (PE) firms and their general partners gain at the expense of their investors and tax-payersIt shows that if the IRS enforced the tax code, it would, in essence, shut down a billion-dollar-a-year tax cheat.

In “Fees, Fees, and More Fees: How Private Equity Abuses Its Limited Partners and U.S. Taxpayers,” the authors show that private equity general partners (GPs) have misallocated PE firm expenses and inappropriately charged them to limited partner (LPs) investorshave failed to share income from portfolio company monitoring fees with their investors, as stipulated; have waived their fiduciary responsibility to pension funds and other LPs; and have collected transaction fees from portfolio companies without registering as broker-dealers as required by law. In many instances, their practices violate the U.S. tax code, violations which often go unenforced by the IRS.

Private equity firms charge their portfolio companies monitoring fees that can cost the company millions of dollars each year. The practice itself is fraught with conflicts of interest. The monitoring fee is stipulated in the Management Services Agreement (MSA) between the private equity firm and a portfolio company that it controls. The PE firm has representation on the portfolio company’s Board of Directors that approves the agreement, and fees are paid directly to the PE firm.

“The monitoring fees that Main Street companies pay to PE firms that own them are of special concern. Portfolio companies deduct these fees as an expense on their income taxes, thus reducing the amount of taxes they pay. It is often unclear, however, what services they are paying for, or even if any services have been provided. Taking a tax deduction in cases where the services provided by the PE firm are not commensurate with the monitoring fee paid by the portfolio company is a violation of the tax code. Taxpayers are disadvantaged when PE-owned companies avoid paying their fair share of taxes,” said Eileen Appelbaum, co-author of the report.

Despite the mounting evidence of private equity abuses and potentially illegal behavior, SEC enforcement actions to date have been minimal, with only six actions against PE general partners between 2014 and 2016. In a welcome development, there is evidence that the IRS has recently begun auditing management fee waivers. However, even with the growing evidence of fee manipulation by private equity GPs and major media exposés in recent years, pension funds and other limited partners have been unable or unwilling to challenge the improper or illegal behavior of PE firms.

In order to combat these practices, greater transparency is the most pressing requirement to bring private equity out from the shadows. Important steps to make private equity more transparent include reforming the regulations that govern pension plans, the IRS actually enforcing the tax code, and the SEC taking a more aggressive approach to ending fraudulent practices.

The full report can be found here.

This report coincides with a letter from eight organizations to top officials at the Treasury Department and the IRS urging them to enforce regulations to stop private equity firms from evading taxes. You can read the letter here.

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The Center for Economic and Policy Research (CEPR) was established in 1999 to promote democratic debate on the most important economic and social issues that affect people's lives. In order for citizens to effectively exercise their voices in a democracy, they should be informed about the problems and choices that they face. CEPR is committed to presenting issues in an accurate and understandable manner, so that the public is better prepared to choose among the various policy options.

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