June 6, 2011
Dear Ms. Murphy,
This note is in reference to the proposed rules on incentive-based compensation. Specifically, it is a response to the Private Equity Growth Capital Council's (PEGCC) May 31, 2011 letter to you on the topic that was later linked to an article on the NYTimes.com. My comments may simply reflect my own ignorance on the topic but, nevertheless that letter raised the following questions/issues in my mind:
(1) Carried interest seems to be dependent/calculated based on the internal rate of return (IRR) of the fund's investments. IRR is time sensitive though. Thus one way to maximize IRR (and thereby carried interest) is to decrease the length of investment. Thus even if the value to the portfolio company would increase from a longer stay, the private equity (PE) firm may nevertheless have the incentive to get out earlier and extract that added value for itself in the form of IRR rather than to stay in the firm (even if the dollar per dollar gain on investment is the same in both scenarios).
(2) Which leads me to my second point of concern. When the rules speak of "interconnectedness" related risks, does that not include the risks that arise simply from players interacting with each other in the market? Meaning, that if a PE fund invests in a portfolio company and then decides to exit its investment at a time that while good for the PE, leaves the portfolio company in a precarious position, and that portfolio company then fails--wouldn't that be a risk "interconnected" with the PE fund's/firm's actions? Do interconnected risks really only include risks to that firm's other funds/assets or to that fund's other portfolio companies? If so, it seems like an overly narrow definition that runs contrary to the notion that we are protecting the financial system from systemic risks.
(3) Likewise, throughout its letter the PEGCC repeatedly mentioned that PE firms and funds are not interconnected with other financial system participants. But can't PE funds acquire financial institutions? Including unlisted firms that deal/trade in financial derivatives and exotic securities? And can't PE firms be themselves publicly listed?
(4) If a PE firm is publicly listed, doesn't the argument about the compensation being negotiated between equals and overtly assented to fail to hold true with regards to the firm's public shareholders? Why would it make sense to treat the shareholders of a PE firm differently than those of an investment banking firm?
(5) Lastly, if systemic risk really is a problem/concern, why wouldn't it make sense to look at the assets under management when determining whether the firm is a covered financial institution (CFI)? Wouldn't the magnitude of the firm's management assets be indicative of its reach/interconnectedness/impact/sway on the financial system? That is, if a PE firm/fund manages several billions worth of investments and those investments go bad, wouldn't that be bad for the financial system/economy as a whole? (Even if the firm's/fund's other funds/investments are not directly impacted?)
Thanks for taking the time to consider my comments, thoughts and queries. Best of luck in your endeavors