Institutional and well-informed retail investors have for the last several decades recognized the importance of limiting the fees and expenses they incur, since those will eat away at investment returns and potentially at principal. That’s a big reason for the rise in popularity of index investing. In stock and bond investing, where fees and costs are transparent, academic studies have repeatedly confirmed that active investment managers don’t generate enough (if any) outperformance to justify their higher fees and costs.
As we’ve discussed in previous posts, investors in private equity can only see the books and records of the investment fund, that is, the limited partnership entity in which they invest. They have no right to examine the financial records of the companies in which they invest. That has led to tons of mischief, including, as former SEC examination chief Andrew Bowden said in a speech last May, that taking of impermissible charges, which in most circles would be called stealing or embezzlement. (Notice how private equity misconduct is whitewashed through the use of tepid terminology).
A corollary of investors not seeing the monies that private equity firms pilfer, um, route from investee companies directly into the firms’ pockets is that they have no clue as to how much they are paying in total for the privilege of having private equity manage their money. A major standard-setter in the private equity industry, CEM Benchmrking, has thrown down a gauntlet to investors. It said in a recent report that it is impossible for private equity investors to know how much they are paying in private equity fees and costs. Moreover, CEM also points out that most public pension funds are not complying with government accounting standards in how they report private equity fees and costs, and that based on their benchmaring efforts with the South Carolina Retirement System Investment Commission and foreign investors, most public pension funds are missing at least half of the total costs.
This report is particularly significant because CEM is an authoritative voice in the investment industry. It didn’t simply say that public pension funds are out to lunch as far as not understanding what they were investing in. It also pointed out as a result, the public pension funds have been not been reporting fees accurately are out of compliance with government reporting requirements. Mind you, the CEM report does not make a bald statement to that effect, but points to new accounting standards implemented in 2012 regarding “separability” (which one might think of as “identifiability”) of costs and expenses, which CEM contends should have led to more transparency. The fact that the South Carolina Retirement System Investment Commission can isolate these costs means there is no good excuse for the failure of other public pension funds to do the same.
So why have public pension funds (and their private investor cousins) chosen to put their heads in the sand as far as the true costs of investing in private equity are concerned? David Sirota and Matthew Cunnningham-Cook reported on the CEM study shortly after it was released and hint that it may well have to do with the desire of public officials to curry favor with powerful political donors. While this is no doubt true in some cases, the lack of inquisitiveness likely has at least as much to do with bad incentives at the public pension funds themselves.
At most public pension funds, the teams that oversee public pension funds get to travel and go to lavish conferences, and they (bizarrely) regard the PE funds as partners, as opposed to vendors. The staff has no reason to make their life difficult by working harder on issues that would make the dealings with PE funds adversarial and hence more stressful for them. It’s the path of least resistance to go through due diligence and compliance theater rather than the real thing. After all, exposing how hugely costly PE investing really is would make it much more controversial to allocate funds to the strategy. Lower allocations would likely mean lower staffing in those areas, potentially putting their jobs at risk.
Gretchen Morgenson of the New York Times weighed in over the weekend. Morgenson pointed out that Oxford professor Ludovic Phalippou wrote in a 2009 paper that the typical private equity fund charged a whopping 7% in total fees per year. CEM didn’t come up with a hard figure, but the CEM study is generally consistent with Phalippou’s grim reading. As Morgenson wrote:
CEM concluded that the difference between what funds reported as expenses and what they actually charged investors averaged at least two percentage points a year. For a $3 billion private equity portfolio, that would add up to $61 million.
And this estimate, CEM acknowledges, is probably low. It comes from Dutch pension fund data, and Europeans pay far less to private equity firms than pension funds in the United States typically do, investment experts say.
What is particularly disconcerting (and we’ve previously written about this sort of misguided reasoning at CalPERS) is that public pension funds are typically choosing to kid themselves about one of the most basic, visible fees they pay, the annual management fee. That charge is clearly set forth in the investment documentation. But investors in most funds don’t pay that all of that fee in cash. Due to a combination of investor acquiescence and tax issues, when investors have pushed back against other fees, like transaction fees, the mechanism for reducing them has been to rebate (or “offset”) those fees against the management fee. But what do the investors like CalPERS do? Treat the management fee as if it has been reduced since the cash payment are lower. That is simply barmy. The management fee is unchanged, but part of the cash payment now comes directly from the portfolio companies (the effect of the rebates is to shift part of the payment to them) and the balance from the investor.
A source for Morgenson’s story and a figure in past NC posts, CalPERS board member JJ Jelincic, pointed out that this willful blindness about fees and expenses also means that funds like CalPERS aren’t able to do an adequate job of negotiating. And remember, the behemoths like CalPERS do have negotiating leverage.
Mr. Jelincic, who before joining the board was on the Calpers staff for 24 years, said in an interview that being in the dark on fees created problems for the overseers of the $300 billion pension fund.
“You don’t think to negotiate on fees that you’re not aware you’re being charged,” he said. “As a trustee I’m really concerned about not knowing what we’re paying on private equity. We may be getting a really good deal, we may be getting a really bad deal. I just don’t know.”
Warren Buffett explained this issue in colloquial terms in 2006:
To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks…
But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others.
The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new “beat my- brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.
The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants…
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions…
The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.
The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY…
And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.
Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.
Yet here we are, nine years later, and soi-disant fiduciaries have continues to allocate more and more money to alternative investment strategies like private equity, even as returns flounder. But that is because people like Buffett mistakenly believe that these fidiciaries are in the game of delivering the best risk-adjusted returns for their beneficiaries. In reality, the name of the game is blame and liability avoidance, so hiring costly Helpers is a feature, not a bug.