Markets

Nir Kaissar is a Bloomberg Gadfly columnist covering the markets. He is the founder of Unison Advisors, an asset management firm. He has worked as a lawyer at Sullivan & Cromwell and a consultant at Ernst & Young.

The fiduciary rule is coming!

The Department of Labor announced on Monday that its much-anticipated fiduciary rule -- or at least the lion’s share of its provisions -- would go into effect on June 9. In a nutshell, the rule prohibits brokers from taking money from mutual funds they recommend to clients unless they disclose those payments to their clients.

Brokerage firms have been arguing that the rule is pointless and potentially harmful to investors. But on the same day that the department made its announcement, the California Public Employees’ Retirement System, or Calpers, reminded everyone why the fiduciary rule was necessary -- if not inevitable -- albeit in a different context.  

Calpers is the nation’s largest pension plan. It has 380 people overseeing its $320 billion in assets. And yet despite its size and resources, Calpers didn’t know until recently how much it paid its private equity managers in performance fees.

No Chump Change
Calpers had $26.4 billion invested in private equity a year ago
Source: Calpers

The Wall Street Journal reported on Monday that Wylie Tollette, Calpers’s chief operating investment officer, was asked about those fees at the April 13, 2015, board meeting. His response: “We can’t track it.”

Obviously, that’s not good. Performance fees can dwarf management fees in a private equity fund. Investors must therefore consider those performance fees when deciding whether to invest or remain invested in a fund.

That’s more important now than ever. There’s a growing awareness that high fees devastate returns over time, and fees charged by private equity funds are notoriously high. There’s also widespread concern that the $2.5 trillion invested in those funds has stretched private equity valuations and thereby compromised future returns. If there was ever a time to blindly throw money at private equity, now isn’t it.

Private equity managers would no doubt point out that investors pay a performance fee only if they make money. In many cases, managers don’t receive a performance fee unless they beat a hurdle rate -- 8 percent is common. And if the fund manages to beat the agreed-on hurdle, it shouldn’t matter how much the manager collects in performance fees. 

Even Better
Listed private equity firms have beaten the S&P 500 since March 2009
Source: Bloomberg
Note: Indexed to 100.

It’s not that simple, however. Performance fees come in many varieties. There are various combinations of hurdles and catch-ups and other terms. Without seeing the actual dollars, it’s not entirely clear how much investors are paying. And if investors saw those dollars, they might think more critically about whether there are better ways to spend them. Just ask Calpers, which says that getting smarter on fees motivates it “to explore alternative ways of investing in private equity that might have less of a fee burden.”

Slimmer Pickings
If the fruits of private equity continue to dry up, fees will become more important
Source: Preqin

Surely Calpers isn’t alone, which is presumably why many private equity firms won’t disclose their performance fees. But they can’t keep investors in the dark forever. Pensions and other private equity investors are turning to new software to calculate what they pay in performance fees. All that aggravation could be avoided, however, if private equity firms would simply disclose them.

Which brings us back to the fiduciary rule. There’s a long-standing debate about whether financial-related disclosures should be mandated by law or left to the market to sort out. For 150 years, the U.S. largely deferred to the market. But the Wall Street crash of 1929 shook investors’ faith in the market’s invisible hand, and an avalanche of disclosure rules followed.

There were new rules for publicly traded companies in the Securities Act of 1933 and the Securities Exchange Act of 1934; for mutual funds in the Investment Company Act of 1940; and for money managers in the Investment Advisers Act of 1940. Subsequent market crashes brought additional disclosure rules. Most recently, Sarbanes-Oxley followed the dot-com crash and Dodd-Frank followed the 2008 financial crisis.

At its core, the fiduciary rule is another disclosure rule. Like private equity firms, brokerage firms won’t give investors the information they need to make fully informed choices because -- let’s be honest -- they profit from keeping their clients in the dark.

Financial firms love to complain about regulations. But many of those regulations would be unnecessary if they put their clients’ interests ahead of their own.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Nir Kaissar in Washington at nkaissar1@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net