Suddenly, Hedge Fund Fees Seem High

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Private equity funds face pressure, too. "We believe there is a real need for the industry to reassess the fee and carry structure—and that the first firms to do so will reap some major rewards," says Mark O'Hare, managing director of Private Equity Intelligence, a research firm based in London.

Some Shops Trimming Fees

But private equity managers feel that top-performing funds can justify their fees. "There's still more demand for top-performing funds than there is supply," says Steve Persky, co-founder of Dalton Investments, a $1.1 billion fund focused on Japan. "Investors are looking for returns. That's what drives things, not fees."

In some cases, private equity shops are trimming fees as a response to the sheer size of many new funds. The Blackstone Group, which is in the process of issuing about $4 billion worth of stock in its management company to the public, charges a management fee closer to 1%, industry experts say. Blackstone's latest fund is so big, at $20 billion, that the typical 2% management fee can't be sustained. But as management fees come down, private equity firms may take a larger slice of profits on their investments. Private equity giant Bain Capital Partners is exploring the idea of taking 25% of its profits on future funds and splitting the remaining 75% among its investors, according to an industry executive familiar with the matter. A Bain spokeswoman declined to discuss fees, but said the Boston company is not currently raising any investment funds. Bain completed a $10 billion fund last year.

Adding to the pressures on the industry, there's now talk in Congress of raising the tax rate for private equity profits, which have soared (see BusinessWeek.com, 10/8/06, "Private Equity Keeps Booming"). They currently are taxed at the capital gains rate of 15%, but Senator Chuck Grassley (R-Iowa) has raised the idea of taxing such gains as regular income, a move that could boost the rate to about 40%. "He's exploring the idea," says spokeswoman Jill Kozeny.

Could Raise Billions

Grassley is the ranking member of the Senate Finance Committee, which is hunting for ways to boost tax revenue without raising marginal tax rates, industry insiders say. A reclassification of private equity profits could bring in billions of additional dollars without tripping public alarms of a widespread tax increase. Grassley wasn't immediately available for comment.

Private equity firms are alarmed, to say the least. "We're taking the idea very seriously," says Doug Lowenstein, head of the Private Equity Council, an industry trade group. Attorneys say, however, that such a change would be difficult to implement, and tough to justify. "It would be difficult to tax private equity partnerships as regular income without changing the tax classification of other kinds of partnerships, from real estate ventures to dental and accounting groups," says Robert Kennedy, a partner with law firm Jones Day in New York.

Once regarded as useful supplements to mainstream investments, private equity firms and hedge funds now sit in the mainstream of institutional investing. But success always comes with a price.

Rosenbush is a senior writer for BusinessWeek.com in New York.