In our “all Orwell, all the time” world of brazen misrepresentation by public officials, the Treasurer of North Carolina has reacted to pending legislation designed to shed more light on the murky world of private equity investments by having allies sponsor their own “transparency” bill that represents a big step backwards.
David Sirota of Pando has done some excellent sleuthing on this evolving story, but his account is undercut by failure to understand the current private equity secrecy regime. As a result, he misses the implications of the legislation and well as the barminess of some of the Treasurer’s arguments.
Let’s first recap Sirota’s informative account of the broad outlines of this battle. Private equity has become a political football in North Carolina due to the release of a report commissioned by the State Employees Association of North Carolina and prepared by former SEC investigator Ted Siedle that slams the current Treasurer, Janet Cowell, in her role as sole trustee for the state pension. He accuses her of supporting a “pay to play” system as well as failing to curb abuses and promoting a secrecy system essential to hiding them. He also estimates that her oversight failures have cost North Carolina $6.8 billion during her term in office. The union has also filed an SEC complaint against Cowell over her pension fund investments and misleading reporting.
The profound lack of transparency related to these risky so-called “alternative” investments provides investment managers ample opportunities to charge excessive fees, carry out transactions on behalf of the pension on unfavorable terms, misuse assets, or even steal them outright…..Cowell’s efforts to thwart disclosure have helped mask potential violations including, but not limited to the following: fraudulent representations related to the performance of alternative investments; concealment and intentional understatement of $400 million in annual alternative investment fees and expenses to date;concealment of approximately $180 million in placement agent compensation; the charging of bogus private equity fees; violations of securities broker-dealer registration requirements related to private equity transaction fees; securities and tax law violations regarding investment management fee waivers and monitoring fees; self-dealing involving alternative investment managers; mystery investor liquidity and information preferences, amounting to licenses to steal from TSERS; pension investment consultant conflicts of interest; predatory lending and life settlement related fraud.
Further, the Treasurer has invested billions of dollars of pension assets in North Carolina
private equity funds and companies via an initiative with dubious economic prospects and which has the markings of political influence-peddling.
In our opinion, billions in TSERS investments can only be explained by the improper collateral benefits they provide to the Treasurer — as opposed to any supposed investment merit.
To be clear, there are two sets of issues conflated in this scorching overview. North Carolina’s investment performance in alternative investments is terrible. Of 23 reporting public pension funds, it ranked 21 in real estate and 23 in private equity. Whether due to corruption or incompetence, it is clear the state would have done better and at lower cost buying a mix of index funds. So the notion that these persistent bad results are due to payola is worth taking seriously.
However, the overwhelming majority of abuses Siedle cites, such as charging of dubious fees, pervasive broker-dealer violations, pension fund consultant conflicts of interest, various securities and tax law violations, also take place with investors who have no potential for pay to play to be operating, such as private pension funds, life insurers, and endowments like Harvard that also invest in private equity. We’ve written about many of these bad practices in earlier posts, and have had to stress the degree to which limited partners have deeply internalized the idea that they can get better returns from private equity than from other investment strategies, and therefore they can’t cavil about the terms, since otherwise they won’t be allowed into this club. In keeping, the SEC has said, with uncharacteristic bluntness, that supposedly sophisticated limited partners have entered into agreements which are vague on far too many key terms and weak on investor protections.
Here is how the fight has moved into the legislative arena. From Sirota:
Following the report, (SEANC) is now pushing the legislature to adopt a simple two-page bill that would force the Treasurer to open up the state’s books so that taxpayers and public employees can at least see how their money is being invested. In response, Cowell sprung into action against the transparency initiative and on behalf of the financial and securities industries that have given her election campaign committee more than $250,000 since 2008.
This is the critical part of the bill:
(6) Shall collect and maintain as public records the amounts in fees paid to each investment manager, the performance of each investment manager, and all other documents related to these investments. The fee information that shall be collected and maintained as public records pursuant to this subdivision H1237 [Edition 1] includes investment management fees, asset-based fees, performance fees, incentive fees, fund of fund fees, operating fees, transaction fees, property management fees, payments to placement agents, and any other expenses, regardless of whether those fees are paid directly by the State or the Retirement Systems or by other parties for a purpose that is in any way related to an investment of Retirement System assets. The information collected and maintained by the Treasurer pursuant to this subdivision is a public record as defined in G.S.132 and not confidential or a trade secret under G.S. 132 1.2(1).
The requirement to publish performance “of each investment manager” isn’t well conceptualized; for instance, Blackstone manages all sorts of funds, and throwing its results from real estate, distressed debt, and private equity funds all together and coming up with one number is not meaningful. Fund-level disclosure is what is germane, and this general “performance” language would probably permit the annual dubious IRR calculations that private equity funds permit to be released to be satisfactory.
While the detailed information on actual fees paid (as opposed to the general structure of permitted fees) would be novel and extremely helpful, the language covers only fees charged at the level of the fund. As we’ve discussed, some fees are charged to the portfolio companies and thus would not be covered.
But the part that the industry will find far and away the most threatening is the catchall language: “all other documents related to these investments.” That would include records that the industry has insisted must be kept in strict secrecy, including the super-secret limited partnership agreements and any information related to portfolio companies, including even their names (note that this provision is hard to take seriously, since large funds like Bain, Blackstone, and KKR often borrow against portfolio companies using public bonds, which leads not only to the name of the company becoming public, but its full financial statements. If this information is made public for some portfolio companies, it’s hard to swallow the claim that the companies will be harmed if it were routinely made public).
Sirota gets exercised about the fact that these contracts require secrecy as if this were an unknown outrage. In fact, the industry insistence on extreme secrecy is well known, if he’d bothered to investigate. A protracted Public Records Act battle between the Sacremento Bee and CalPERS finally led CalPERS to agree to publish certain investment information on a quarterly basis. The private equity general partners were so alarmed at this opening of the information door that in every state, they got legislation passed or obtained state attorney general opinions that provided that limited partnership agreements be deemed trade secrets in their entirety and thus exempt from state Freedom of Information Act laws.
For instance, here are the sorts of public records related to private equity that are exempt from disclosure in California:
6254.26. (a) Notwithstanding any provision of this chapter or other law, the following records regarding alternative investments in which public investment funds invest shall not be subject to disclosure pursuant to this chapter, unless the information has already been publicly released by the keeper of the information:
(1) Due diligence materials that are proprietary to the public investment fund or the alternative investment vehicle.
(2) Quarterly and annual financial statements of alternative investment vehicles.
(3) Meeting materials of alternative investment vehicles.
(4) Records containing information regarding the portfolio positions in which alternative investment funds invest.
(5) Capital call and distribution notices.
(6) Alternative investment agreements and all related documents.
Sirota is also unhappy that he can’t verify whether the confidentiality sections of the limited partnership agreements are as sweeping as Cowell says they are. He might have bothered taking a gander through the limited partnership agreements we’ve published before asserting that no information was available.
Cowell claims that passing this bill, which would have an effective date of July 1, 2014, would lead to litigation and estimates it would cost the state $1.8 billion. Oh, but that estimate comes from “our investment professionals,” meaning her staff, so that’s obviously worthless.
In fact, based on the limited partnership agreements we have seen, no specific damages are provided for if the confidentiality provisions are violated. Let’s look at the language from KKR’s 2006 fund. KKR has the most sweeping language among the fund documents we’ve read as far as the privileges of the general partner are concerned:
Each Partner agrees that the provisions of this Agreement, all understandings, agreements and other arrangements between and among the parties hereto and all other nonpublic information received from, or otherwise relating to, the Partnership, any Partner, any Portfolio Company, the Management Company or any of its Affiliates shall be confidential, and will use its best efforts not to disclose or otherwise release to any other Person such confidential matters without the written consent of the General Partner, except that:…
(ii) a Partner may provide such confidential matters if required by law….but only that portion of such confidential matters which, in the written opinion of counsel for such Partner, is required or would be required to be furnished to avoid liability for contempt or the suffering of other material judicial or governmental penalty or censure, provided that such Partner (other than the General Partner) notifies the Partnership of its obligation to provide such confidential matters prior to disclosure (unless notification is prohibited by applicable law, regulation or court order) and such Partner fully cooperates to protect the confidentiality of such confidential matters..;
In fact, it’s a standard provision of non-disclosure agreements that a party who is compelled legally to disclose information can reveal it with no adverse consequences. Usually there is a notification requirement (which we see here); we also find requirements to have a legal opinion to say the disclosure is necessary and to “cooperate to protect the confidentiality” which likely includes supporting general partner in fighting the requirement to disclose.
Based on this language, Cowell’s claim of possible huge losses is simply laughable. Moreover, we’ve seen that the accidental (and hence not covered by this clause) release by Pennsylvania of the dozen limited partnership agreements that we published did not lead the sky to fall on them.
However, it’s certain that the industry will regard these provisions as tantamount to a declaration of war and will not allow any public entity in North Carolina to invest in future funds. They might even try to find ways to buy out North Carolina at a modest premium to prevent disclosure. Given North Carolina’s dreadful investment performance, that is an outcome sorely to be desired.
So what is Cowell’s response? To perpetuate the information lockdown but call it transparency. Again from Sirota:
Cowell’s allies in the legislature filed a bill to serve as a replacement for the transparency legislation…Cowell’s legislation claims to be about transparency, but weaves in provisions that seem designed to enshrine the exact opposite.
Specifically, section 3(b) of the proposal says that if Wall Street firms demand secrecy, the law will automatically bar the public from viewing key information about public pension investments for 10 years after the investment is terminated. That includes, according to the bill draft, “information regarding the portfolio positions” of public pension fund investments; “capital call and distribution notices” sent to state pension officials by investment firms; investment firms’ “private placement memorandum and other offering and marketing material”; and, perhaps most important of all, “the investment’s contractual documents.”
Sirota seems to miss how long the blackout period really is. These funds typically have a twelve to fifteen year life. Indeed, there are some funds listed in CalPERS latest quarterly performance report that date from the mid 1990s, and one from 1991, so who knows when they will be wound up. So ten years after termination, at least for a public equity fund, is over 20 years after investors entered into agreements with the funds. The provision that the state auditor and legislators can see this information “at any time” is a sop. One imagines that they will be allowed to read documents but not be allowed to take them or have access to electronic versions, which is what you’d need to do real analysis.
Sirota contends that the motivation is to escape securities law liability by providing information only after the statue of limitations has expired. But the SEC is now investigating these funds now that they are required to register as investment advisers, and the SEC has access to limited partnership agreements and other critical fund information in its role as regulator.* However, disclosure would allow for broad public examination of these records. Given the SEC’s stark warnings about the level of embezzlement and dubious conduct, putting this information in public hands has the potential to produce such a hue and cry once it begins to be analyzed that some public pension funds might find themselves under intense pressure from beneficiaries and legislatures to sue the general partners.
The reality is that while the union’s bill is a bold idea, it’s a certainty that banks, who get huge fees from private equity firms and hedge funds, as well as the investment managers themselves, will pour contributions and lobbying dollars into the state to make sure it does not pass. But the very idea that it is being proposed is raising public awareness of the unjustifiable secrecy private equity incumbents have managed to maintain for so long, and how that has made large-scale abuses possible. The more the public hears about private equity scamming, the more it will become difficult, if not unacceptable, for public pension funds to pour so much money into this strategy, particularly since its performance has been underwhelming.
* Private equity Limited partnerships are technically securities but are exempt from many securities law requirements because they comport themselves so as to fall under Reg D exemptions. Private equity funds typically have to make blue sky filings in some states, but states generally lack the manpower to enforce their securities laws aggressively.