How to Make Private Equity Honest
The people who manage some of the country's largest public pension funds -- money that ensures the retirements of teachers, police officers, firefighters and other state employees -- say they want government regulators to help them avoid getting ripped off when they invest in private equity firms.
Instead, regulators should push them to do a better job of monitoring the investments on their own.
In a letter last month to Securities and Exchange Commission Chair Mary Jo White, 11 state treasurers, plus the New York state and New York City comptrollers, asked for "better disclosure" of expenses at private equity firms, which typically generate returns by buying companies, restructuring them and selling them at higher prices. The officials' complaint: The firms have been levying all sorts of suspicious fees without their knowledge, effectively siphoning money away from future retirees.
The accusations are well-founded. In May 2014, the SEC warned that more than half of the private equity firms it had examined were stealing from investors or engaging in other serious compliance violations. The commission attributed the mischief in part to the unique "temptations and conflicts" of private equity executives, who have a lot of power over the portfolio companies they purchase and face "lax" oversight from investors.
Examples abound. So-called monitoring fees, derided by Oxford finance professor Ludovic Phalippou as "money for nothing," typically obligate the portfolio company to pay a certain amount without requiring the private equity firm to provide any services whatsoever. Firms have presented individuals as members of "the team," meaning part of the overhead that investors must pay, when they were in fact billed as consultants to portfolio companies. For its part, the supposedly savvy CalPERS, the largest public pension fund, has failed to keep tabs on the largest fee it pays, the profits interest widely called a "carry fee."
Mind you, this sort of thing has been going on for decades, raising the question: Why didn't the pension funds do something about it long ago? One possible explanation is that private equity firms agreed to share with investors some of the excessive fees they were extracting from their portfolio companies. But the sharing was limited to specific fees named in partnership agreements. Investors were bizarrely willing to trust the firms, failing to demand either access to portfolio company financial statements or disclosure of related-party transactions. As the SEC put it, they regularly signed contracts that did not provide "sufficient information rights to be able to adequately monitor" their investments.
The state and local trustees who wrote to the SEC are perfectly capable of addressing the problem if they want to. Together, California Treasurer John Chiang, Oregon Treasurer Ted Wheeler and New York State Comptroller Thomas DiNapoli represent five of the six largest public pension fund investors in private equity, giving them extraordinary negotiating clout. Chiang sits on the board of CalPERS, which has repeatedly set new standards for the investment management industry. Elsewhere, officials have been more active: The $200 billion Dutch pension fund PGGM recently announced that it will not invest in private equity funds that refuse to disclose all fees and costs.
One can only conclude that the state and local officials are trying to shift responsibility to the SEC for their own failure to perform their fiduciary duties. This is clearly cynical, because there's not much the SEC can do. The agency is already struggling to get private equity managers to improve the very general annual disclosures that regulations currently require. Often masterpieces of obfuscation, the documents describe the types of fees received, but not the amount. More detailed disclosure would require a radical rewrite of existing rules.
Private equity executives would argue that they give investors plenty of opportunity to do due diligence and that the investors all have their own lawyers who signed off on these deals. What is seldom acknowledged is the public funds' outside counsel often invest in private equity funds, sometimes on a preferred basis relative to their clients, and typically earn far more working for private equity portfolio companies than advising public funds. Moreover, private equity firms are big political contributors: They have been barred from contributing to state treasurer elections, but they still spread vast sums around state legislatures.
The most realistic solution lies with the SEC -- but it won't be what the state officials have in mind. If public pension funds persist in feigning helplessness, the agency should consider rescinding their accredited status. This designation allows large and sophisticated investors to operate with minimal oversight. It requires that they be competent to review legal agreements and negotiate terms, including disclosure and audit rights, when the SEC has not reviewed the offering documents for accuracy and completeness. Without it, the pension funds would not be able to invest in private equity unless the latter submitted to the higher cost and disclosure of registering their offerings with the SEC.
Losing accredited status would be a huge embarrassment. As such, it could serve as a wake-up call, forcing complacent and captured public pension fund trustees and staff to just say no to private equity shenanigans.
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