Pension funds fuel private equity’s bad behaviour
• Change the accounting standards of public retirement funds to cut off the turbocharged search for returns
Private equity is the latest economic bogeyman. And there are good reasons for that. Assets in the private market have grown exponentially in the past 20 years, especially in North America, and now amount to nearly $12-trillion.
The number of companies backed by private equity more than doubled from 2006 to 2020, while the number of public companies shrank. Private equity firms are buying up companies that provide services we use and depend on: hospitals, nursing homes, property, chain restaurants and even prisons.
That has caused alarm because private equity firms have a reputation for focusing ruthlessly on the bottom line to the detriment of those depending on the company’s services. One study even found private equity control can kill you. Two new books argue the private equity industry is not only killing you, it is ruining your local businesses by loading them with debt, harvesting their assets and pushing them to bankruptcy.
There are some terrible abuses that private equity firms should be held accountable for, and the market does need to change. But mitigating the damage does not require a bunch of new rules on private equity itself. A better and less obvious solution would be fixing a distortion in the market that has provided private equity funds with so much money in the first place. It starts with looking at the investors in these funds, and in particular public sector pensions that have provided some of the bags of cash that have empowered the reckless behaviour.
Some of the criticisms of private equity are unfair. There is nothing wrong with running a company for profit.
Private equity can serve an important function in the economy by making unproductive companies better. When it comes to making companies more profitable and productive, private equity firms have had a successful track record. And while private equity takeovers tend to lead to job cuts in the short term, over the long run more jobs are created.
But not all companies are a good fit for private equity and in the past decade private equity buyouts have become associated with more job losses and less productivity.
The change began when private equity funds started getting more money from public pension funds, Columbia Business School PhD candidate Vrinda Mittal argued in a recent paper.
Public pensions make up 31.3% of all investors to private equity funds and contribute 67% of their capital. Many of these pensions do not have enough assets to pay out all their promised benefits.
Mittal estimates that from 2006 to 2018, the capital invested in private equity funds from the most underfunded public pensions tripled to 15.6% of all committed capital.
These underfunded pensions had a good reason to invest in private equity. Ultra-low interest rates in the past 15 years added urgency to pensions’ need to boost returns.
Public pension accounting standards suggest the pension funds measure their liabilities based on the expected rate of return on their investments.
The way it works is that pension funds project future benefits and discount them to today ’ s dollars using this return estimate. The higher the return, the lower their liabilities appear. It is an accounting convention that, to put it mildly, enrages financial economists because it does not account for how risky the pension’s investments are.
Public pension funds should account for risk because their benefits must be paid no matter what happens to financial markets. If the pension cannot pay benefits, taxpayers are on the hook.
The accounting standards not only ignore risk, they create an incentive to invest in riskier assets that claim higher returns with little transparency.
Private equity is perfect for this because it locks up pension fund money for years. In the meantime, they can claim a high and stable return because the private equity investments do not have an objective market value. If you are an underfunded public pension, it is the ideal solution because the higher (on paper, at least) private equity return will increase your overall expected return and, like magic, your pension looks much better funded.
This is a problem not only because the pension fund will eventually realise its losses and may run out of money. It also created a big market distortion that resulted in a lot of money flooding into subpar private equity funds.
Mittal’s argument seems right to me: flush with what he calls “desperate capital”, these private equity funds made many poor investments that resulted in worse outcomes for the companies they targeted.
In the public imagination, the concept of private equity will always be unpopular because it means rich outsiders come in and shake up local businesses and services. But the industry has undeniably fallen short in recent years and resulted in higher job losses, companies failing and less productivity.
The good news is that there is a simple solution: revise the public pension accounting standards. Private sector pension plans must determine their liabilities using the interest rates of bonds traded in the market. Public sector pensions should do the same. Ideally, the bonds used to measure liabilities should have the same default risk as the pension benefits. Since public pensions cannot default on their benefits (it is written into their state constitutions), the appropriate rate should be treasuries, or maybe municipal bonds.
This would have been a heavy lift a few years ago because if you discounted future benefits with near-zero interest rates, the underfunded plans’ situation would look dire. Today, the boost from higher rates offers an opportunity to switch to a better standard.
The new pension standards would not only result in better and more transparent retirement fund management, they would also eliminate the market distortion that has been turbocharging the private equity market. Maybe it would even save lives.
THE ACCOUNTING STANDARDS NOT ONLY IGNORE RISK, THEY CREATE AN INCENTIVE TO INVEST IN RISKIER ASSETS