One of the remarkable elements of the private equity industry is the ludicrous things incumbents are willing to say to defend a bad status quo.
The latest example is a memo from a leading pension consulting firm, Pension Consulting Alliance (PCA). It weighs in on the row over the fact that most private equity limited partners, and in particular the giant public pension funds CalPERS and CalSTRS, have no idea what they’ve been paying in the share of profits pervasively mislabeled as “carry fees”.* These fees just happen to be the largest fees investors in private equity incur, unless they have the bad fortune to have invested in really lousy funds.
PCA defends the failure of limited partners to report on “carry fees” while trying to wrap itself in the mantle of being pro-transparency.
In case you are new to this fight, a quick overview from a recent post:
By way of background, we broke the story on CalPERS’ failure to monitor its “carry fees” in early June. A mere month later, CalPERS was in full retreat. It was contacting all of its private equity managers to have them give the giant pension fund all the historical data on the “carry fees” CalPERS had paid on funds the general partners managed.
As an aside, “carry fees” are the largest fees that private equity limited partners like CalPERS pay across their private equity programs, unless they have the misfortune to invest only in really dodgy funds. In the prototypical fee schedule of “2 and 20,” 2% is the annual management fee (which typically scales down later in a fund’s life) and 20% is the participation in profits, usually after beating an 8% hurdle rate.
What is particularly disturbing about the PCA memo (embedded at the end of the post) is that it not only makes multiple misrepresentations, but it also echoes the talking points made by a private equity industry mouthpiece. The reason the latter is troubling is that PCA holds itself forth as being free of conflicts of interest, that it works only for investors and does not market or manage funds.
However, PCA does have some strong reasons to side with the general partners, which is tantamount to siding against the plan beneficiaries to which investors like CalPERS and CalSTRS are responsible.
First, the entire consulting industry has egg on its face by being caught out for being in the business of providing compliance and oversight theater, as opposed to the real thing. As the SEC’s Andrew Bowden pointed out in his May 2014 speech fingering the private equity general partners for widespread grifting and the limited partners for cluelessness and complacency: “…investor oversight is generally much more lax after closing.” And Bowden cited “broadly worded disclosures and poor transparency” as not adequately mitigating the risks of general partner misconduct. And who is to blame for this failure to have adequate checks in place? Firms like PCA bear significant responsibility for blessing thees dubious practices. It’s now doubling down by continuing to stand behind them.
Second, Oxford professor Ludovic Phalippou has warned that there will be a hue and cry when the full fees and costs of investing in private equity are exposed. He estimates the total annual load to average 7%. That’s so ludicrously high as to demand cutting them down by at least a percent or two a year across the industry, particularly since private equity returns are flagging. And the obvious place is the rent extraction that takes place at the not-at-all-properly supervised portfolio company level. The exposure of the magnitude of private equity’s rent extraction has the potential to call the legitimacy of investing in private equity into question, which would lead to lower allocations. That in turn would mean fewer assignments for firms like PCA.
Bear in mind that CalPERS is a PCA client, and the date of the PCA memo is July 22. That’s nine days after the due date CalPERS gave to its private equity general partners to provide CalPERS with the data on all the carry fees that CalPERS had paid over the history of each of the funds those general partners managed. That means that PCA is trying to wage a rearguard action against CalPERS’ pro-transparecny, pro-accountabilty measure. And since historically, when CalPERS has made changes on the transparency front, other public pensions funds have followed. PCA is quite deliberately choosing to be on the wrong side of history.
Now to the particulars of PCA’s memo below. You’ll see it’s short and written at a high level of abstraction, which suggests that the target is board members and trustee of fiduciaries.
The first paragraph is fluff save perhaps the final clause, which seeks to imply that the fact that private equity conventions long-standing means they are sound: “…how private equity disclosures have operated since the industry’s inception.”
In fact, if you look at how private equity has evolved, there’s ample reason to argue that long-standing practices should have changed long ago. Private equity was first “bootstrapping” and later “leveraged buyouts”. The private equity industry founders came out of M&A; you can see old M&A indemnification language, which is not appropriate for long term, passive investors, largely preserved in limited partnership agreements. Similarly, the early private equity investors were wealthy individuals risking their own money, not fiduciaries. Thus the fact that early practices are still largely in place is a mark against the industry.
It’s in the next paragraph that the Mighty Wurlitzer of Obfuscation really cranks up:
Those terms of the partnership agreements dictate the disclosure requirements of fees and expenses and the accounting thereof. The accounting profession and most investors consider carried interest to be an allocation of profits between/among partners in a fund, not as an expense as it has been characterized in recent reports and articles
First, this big of sleight of hand tries to depict an incentive fee, which is what a profit participation is, as not being an expense. Huh? The fact that a fee is computed based on profits and is deducted from profits does not make it any less a fee. PCA’s formulation is tantamount to trying to claim, “The contingency fees you agreed to pay to your class action lawyer isn’t coming out of your hide.” This argument is even less appetizing given that the limited partners provide pretty 97% of the money, and some of that 3% from the general partners often isn’t real cash, but waived management fees, which the general partners threw in the pot only to lower their taxes (as we wrote recently, the IRS has ruled recently that these “management fee waivers” are a no-no).
Second, PCA is trying, misleadingly, to conflate tax treatment and definitions with accounting treatment. As we discussed in an earlier post, the IRS sees the “carry fee” as a type of “profits interest”. But as anyone who has had even a minor brush with tax versus accounting treatments, the two are often different, sometimes wildly so. And world-recognized tax expert Lee Sheppard in Tax Notes also snorted at the private equity industry’s effort to depict the “carry fee” as somehow not really being a cost:
Now, an appropriate response from private equity lobbyists should have been: Well, we provided the pension funds with sufficient information about the hazards of placing money with us that any trustee who had a semester or two of business school should have understood what he was getting into. But no, private equity’s house organ argued in an editorial that investors aren’t really paying over the profits represented by the managers’ typical 20 percent profits interest (Private Equity Manager, July 28, 2015).
Moreover, PCA seems to be behind the eight ball as far as accounting for fees is concerned. Private equity standard-setter CEM Benchmarking in an April report said that most public pension fund investors are not complying with government accounting standards in how they report private equity fees and costs. CEM’s report is titled, “The Time Has Come for Standardized Cost Disclosure in Private Equity”. Here’s our summary of the issue that CEM flagged; you can find the CEM report embedded in the post:
CEM…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.
The report stresses that while the new standard allows funds to determine which costs are “separable,” and therefore “should be reported as investment expense if they are separable from (a) investment income and (b) the administrative expense of the pension plan.” It goes long-form through the expenses that South Carolina is able to identify, as in separate, meaning that CEM believes that South Carolina-level expense capture should be the industry norm (it also points out that some foreign countries, such as the Netherlands, Denmark, and Switzerland, also require extensive cost reporting):
SCRSIC has found that they cannot collect total investment costs using only manager statements due to timing and a lack of consistency…And, the unaudited quarterly PE statements are not consistent across managers in their detail and/or depth of fee disclosure.
To correct the timing issue, the validation process is performed on a quarterly basis. SCRSIC provides a detailed capital account statement template for their PE managers to fill‐out each quarter. The expenses portion of the template includes lines on which to report full management fees, the LP share of portfolio company fees which issused towards payment of the management fees, other fund‐level fees and accrued carry/performance fees that are deducted from NAV for the period. The capital account statement format ensures that the manager reconciles the costs associated with the change in NAV for the period. This provides SCRSIC with a first level of quality control for reported fee data. Based on other provided data such as contributions, invested value and distributions, the expected full management fee and performance fee are compared to the partnership contract terms. SCRSIC reconciles their manual calculations from the contract terms to the fee amounts provided by the managers. If there are material discrepancies, SCRSIC asks for explanations and documents the changes for future validations.
While the vast majority of managers comply with the SCRSIC process, a few managers do not complete the
template. For those accounts, SCRSIC manually collects data from statements that are provided and asks for any missing figures. Since this process is more manual, it is more time‐consuming.
That gives you an idea of how hard it is to do cost verification well. Yet we get this bald-faced misrepresentation from PCA:
Almost all investors verify the profit allocation when distributions from general partners to limited partners occur (after realization of the proceeds from the sale of a portfolio company). This point has been lost in the recent media reports.
Remember, CEM is actually in the business of benchmarking costs, and does so for over 350 funds. This is what CEM has to say:
Many pension funds do not undertake a detailed validation process perhaps because it is very manual and they may not have enough resources.
“Many….do not” is a hell of a lot less than “almost all” do. So the media looks to be a lot better informed than PCA (or alternatively, PCA does know the score but is choosing to misrepresent it).
The second half of that paragraph includes a lot of handwaving about how it’s hard to calculate the “profits interest” on unrealized profits. This isn’t what the contretemps is about. The embarrassing revelation at CalPERS was that it had no idea what it had paid in “carry fees” on companies that had been sold, and that CalSTRS has given equivocal responses on the same matter. This muddying of the waters looks like bad faith argumentation.
The PCA again tries using hoary old tradition as an excuse:
Most investors have historically concluded that the aggregation and reporting of a manager’s share of profits was unnecessary for those with plan sponsor fiduciary responsibility.
The SEC has clearly said that investors haven’t done a good job of protecting their interest, which means these fiduciaries are failing to do their job. The PCA’s position is thus equivalent to arguing for “historical” building methods after houses have started falling down due to shoddy construction.
And even after Dan Primack of Fortune pointed out that investors were gobsmacked at CalPERS’ claim that it was not possible to get “carry fee” data, and CalPERS has disproven that with its volte face of demanding that its general partners provide the information (which the Financial Times reported had been supplied in all but a handful of cases), PCA tries running the canard that this information can be obtained only by…hold your breath…negotiating it in future contracts! Remember, this memo is headed “Private Equity and Carried Interest”. It’s not about other transparency issues:
PCA has been a longstanding proponent of increased transparency in private equity. While regulatory scrutiny and media attention can be helpful at the margins, at its core, private equity relationships are governed by contracts. Meaningful changes will only be achieved through an evolution in the parties’ willingness to accept different terms and conditions. We strongly encourage our clients and industry groups to collaborate and apply collective pressure on general partners to achieve greater transparency.
So if you want to know why limited partners like CalPERS are so cognitively captured by private equity, you don’t need to look much further than the complacent consultants they hire to get “objective” advice. It’s hard to find solutions when even supposedly independent professions find it more expedient and/or more profitable to be part of the problem.
* As we wrote in a July 29 post:
We’re also starting to put “carry fees” in quotes, since the term is a misnomer. It implies, incorrectly, that private equity firms have a “carried interest”. This term is also widely misdefined in layperson investor guides, a sign of the effectiveness of private equity propaganda efforts.
A true “carried interest” occurs when an investor allows another party to borrow from them in order to acquire a stake in the venture. Borrowing to obtain your participation means that the party with a true “carried interest” is at risk of loss. They eventually have to repay the lender the full amount borrowed, irrespective of whether the investment works out. If the borrower is the promoter, as the private equity funds are, a true “carried interest” exposes him to loss and thus aligns his incentives with those of his funders.
By contrast, the upside fees that private equity and hedgies extract from investors are a profit participation, or what the IRS calls a “profits interest”. This profits interest is yet another example of how private equity general partners structure their relationship with limited partners to be “heads I win, tails you lose” arrangements.