The scandal over CalPERS’ and CalSTRS’ failure to track private equity “carry fees” has the industry worried enough that it is offering up ludicrous rationalizations.
Perversely, the fact that private equity mouthpieces have escalated so quickly to strained arguments, particularly over a new, nothingburger threat, is a good sign. It shows both how threatened private equity firms are by the prospect of having their economics exposed, and how utterly incapable they are of making any sort of credible case for their long-standing secrecy practices.
By way of background, we broke the story on CalPERS’ failure to monitor its “carry fees” in early June. A mere month later, CalPERS was in full retreat. It was contacting all of its private equity managers to have them give the giant pension fund all the historical data on the “carry fees” CalPERS had paid on funds the general partners managed.
As an aside, “carry fees” are the largest fees that private equity limited partners like CalPERS pay across their private equity programs, unless they have the misfortune to invest only in really dodgy funds. In the prototypical fee schedule of “2 and 20,” 2% is the annual management fee (which typically scales down later in a fund’s life) and 20% is the participation in profits, usually after beating an 8% hurdle rate.
We’re also starting to put “carry fees” in quotes, since the term is a misnomer. It implies, incorrectly, that private equity firms have a “carried interest”. This term is also widely misdefined in layperson investor guides, a sign of the effectiveness of private equity propaganda efforts.
A true “carried interest” occurs when an investor allows another party to borrow from them in order to acquire a stake in the venture. Borrowing to obtain your participation means that the party with a true “carried interest” is at risk of loss. They eventually have to repay the lender the full amount borrowed, irrespective of whether the investment works out. If the borrower is the promoter, as the private equity funds are, a true “carried interest” exposes him to loss and thus aligns his incentives with those of his funders.
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