How to make pri­vate eq­uity hon­est

The Pak Banker - - OPINION - Yves Smith

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 re­lat­ed­party 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 stan- dards 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.

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