CAPITULO II: EL PROBLEMA, OBJETIVOS, HIPÓTESIS, Y VARIABLES
2.2 FINALIDAD Y OBJETIVOS DE LA INVESTIGACIÓN
In addition to the management fee received by the private equity firm, the private equity firm also receives a share of the profits generated by the private equity fund. This is generally known as ‘carried interest’ as mentioned earlier.577 According to Kocis et al, the origin of carried interest can be traced back to the 16th century, when European ships were crossing to Asia and the Americas. The captain of the ship would take a 20 percent share of the profit from the carried goods, to pay for the transport and the risk of sailing over oceans.578 According to Lemke et al, carried interest is:
‘… a form of performance fee that rewards the manager for enhancing performance.’579
The Private Equity Group Capital Council (‘PEGCC’) defines carried interest as:
‘the share of profits that a general partner of an investment fund receives from his or her ownership interest in the fund’s assets.’580
According to the PEGCC, carried interest plays a crucial role in private equity growth capital investing and is provided to the private equity firm in recognition of the substantial and material work required to restructure and direct the underlying portfolio investments of the private equity fund.581 In addition, it also serves to align the interest of the private equity firm with those of the investors.582 Carried interest is based on the principle that if the private equity fund does well, the private equity firm
575Frase, D., Helm, R., and Day, M. (2012), ‘Practitioner's Guide to Conflicts of Interest in the Financial Services Industry’, Sweet and Maxwell Publishers, 1st edition, at pages 138-170.
576Frase, D., Helm, R., and Day, M. (2012), ‘Practitioner's Guide to Conflicts of Interest in the Financial Services Industry’, Sweet and Maxwell Publishers, 1st edition, at pages 138-170.
577Kumpf, S. (2013), ‘Listed Private Equity: Investment Strategies and Returns’, Volume 6 of Alternative Investments, Diplomica Verlag Publishers, at pages 17-20.
578Kocis, J.M., Bachman, J.C., Long, A.M. and Nichols, C.J. (2009), ‘Inside Private Equity’, John Wiley Publishers, 1st Edition, at page 22.
579Lemke, T.P., Lins, G.T., Hoenig, K.L. & Rube, P.S. (2014), ‘Hedge Funds and Other Private Funds: Regulation and Compliance’, 2014 Edition, Securities Law Handbook Series, Thomson West Publishers, at 13:20.
580Available at www.pegcc.org/about/the-pegcc-and-public-policy/carried-interest/, accessed in April 2015. 581Available at www.pegcc.org/about/the-pegcc-and-public-policy/carried-interest/, accessed in April 2015. 582Available at www.pegcc.org/about/the-pegcc-and-public-policy/carried-interest/, accessed in April 2015.
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shares in the gains; however if the private equity fund does not do well, the private equity firm receives nothing.583 Investopedia defines carried interest as:
‘A share of any profits that the general partners … receive as compensation, despite not contributing any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund's performance … While all funds tend to have a small management fee, the management fee is meant to only cover the costs of managing the fund, with the exception of compensating the fund manager. Carried interest is meant to serve as the primary source of income for the general partner. However, the general partner must ensure that all the initial capital that the limited partners contribute is returned along with some previously agreed upon rate of return.’584
In order to receive carried interest, the private equity firm must first return all capital contributed by the investors, plus the pre-agreed rate of return referred to as the ‘hurdle rate’ to investors. The hurdle rate is calculated on the amounts actually invested.585 According to Gilligan and Wright, the customary hurdle rate in the US is seven to eight percent per annum586 and in South Africa it is eight to 10 percent per annum.587 Therefore a hurdle rate of 10 percent means that the private equity fund needs to achieve a return of at least 10 percent before the profits are shared according to the carried interest arrangement.588 Once this is achieved, then only will the private equity firm share in the excess, usually to the extent of 20 percent of any excess.589 Typically in practice, the private equity firm will only receive its carried interest after the successful exiting of an underlying portfolio investment, which may take several years taking into account the long term nature of private equity investing. This sharing of the profits of the private equity fund is also referred to as the 80/20 rule because the profits are shared on an 80/20 basis with 80 percent going to the investors and 20 percent to the private equity firm.590
583Available at www.pegcc.org/about/the-pegcc-and-public-policy/carried-interest/, accessed in April 2015. 584Available at www.investopedia.com/terms/c/carriedinterest.asp#ixzz3a08qjHLY, accessed in April 2015. 585Fang, L., Ivashina, V. and Lerner, J. (2014), ‘The disintermediation of financial markets: Direct investing in private equity’, Journal of Financial Economics, August 2013, at pages 1-31.
586Gilligan, J. and Wright, M. (2010), ‘Private Equity Demystified: An Explanatory Guide’, ICAEW Corporate Finance Faculty, 2nd Edition, March 2010, at page 5.
587Sourced and available at www.ethos.co.za/communications/archived-news/private-equitys-retail-tilt/, accessed in April 2015.
588Fang, L., Ivashina, V. and Lerner, J. (2014), ‘The disintermediation of financial markets: Direct investing in private equity’, Journal of Financial Economics, August 2013, at pages 1-31.
589Kumpf, S. (2013), ‘Listed Private Equity: Investment Strategies and Returns’, Volume 6 of Alternative Investments, Diplomica Verlag Publishers, at pages 17-20.
590Lerner, J. (1999), ‘Venture Capital and Private Equity: A Casebook’, John Wiley and Sons, at pages 11-144. It must be noted at this point, that it is not the intention of this discussion to discuss the various accounting methodologies and investment formulas used in calculating carried interest as it is beyond the scope of this discussion.
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The most vociferous criticisms of the remuneration of private equity firms relate to the taxation of carried interest.591 Carried interest is typically taxed as a capital gain and the management fee income is usually taxed as income.592 The reason why carried interest is taxed as capital gains is that a private equity firm hold its investments for several years and as such, the capital gains from private equity funds typically qualify as long term capital gains, which receive favourable tax treatment. The taxation of carried interest has been subject to much criticism since the mid-2000s.593 Chapter four will examine these criticisms as part of the discussion of the taxation of carried interest in the US, Canada, Australia, UK and South Africa. For example, in paragraph 2.3 of chapter four it will be noted that there is a continuous debate in the US over the taxation of carried interest. This debate pertains to the treatment of carried interest as capital gain for the managers of private equity funds. Under current US tax law,594 income resulting from carried interests is often taxed at capital gains rates. However, in terms of legislative proposals in the US carried interest income would be taxed at the higher ordinary income tax rates.595 Nevertheless, in concluding this paragraph, it is submitted that carried interest serves as the primary source of income for the private equity firm for (a) successfully raising a private equity fund; (b) sourcing investment opportunities and structuring investment transactions on behalf of the private equity fund; (c) managing the underlying portfolio investments on behalf of the private equity fund; and (d) exiting the underlying portfolio investments on behalf of the private equity fund at a profit. In addition thereto, the private equity firm receives an annual management fee which is determined as a percentage of the capital it has raised from investors. This management fee is meant primarily to cover the operating costs of the private equity firm rather than for meaningful wealth creation for the private equity firm.
Despite the criticism of the remuneration model of private equity firms, it is also evident (particularly when considering the discussion in paragraph 3 of this chapter) that a significant amount of effort and resources are required on the part of private equity firms in sourcing, executing and managing private equity investments in underlying portfolio companies, including relationship management with individuals who may give access to such transactions.