We wrote last week about how the SEC gave fund management giant Blackstone a wet-noodle lashing in the form of $39 million in fines and disgorgement for private equity abuses. Not only did the SEC’s order reflect poorly on the agency, since it’s increasingly becoming clear that the SEC is dinging private equity firms on only a subset of the bad conduct in which they’ve engaged, and then only fairly easy-to-ferret-out scams.
But just as poor was the conduct of the investors in Blackstone funds. As the order indicated, Blackstone told them of one of its abuses, that it had entered into overall fee agreements with law firms that were doing work for both Blackstone and the funds Blackstone was managing, and those agreements provided that Blackstone got heftier fee discounts, even though the funds’ billings were much larger in total.
North Carolina’ former chief investment officer, Andrew Silton, who had said he had retired from financial blogging, was so disturbed about this revelation that he felt he had to address it. I’m taking the liberty of quoting extensively from his post:
This settlement isn’t a victory for investors. Rather, it points out the failure of sophisticated investors to protect their own interests. The SEC doesn’t have substantive authority over money management firms, so it can’t do much more than pursue PE firms that fail to make proper disclosure or lack adequate policies and procedures. Presumably the SEC will bring similar proceedings against other PE firms, but it won’t change the dynamics or nature of the industry….
The failure of LPs to protect their interests is highlighted in the text of the SEC’s order. The SEC reveals that Blackstone notified all of its LPs about its legal arrangements and the disparate fee structure without receiving any complaints from the investors. CalPERS, CalSTRS, Oregon, and Washington are major investors with Blackstone because they disclose the performance of their PE managers. However, none of them complained about Blackstone’s legal arrangements.
As “sophisticated investors” the public pensions and other LPs ought to have been apoplectic over the legal arrangements and fee discounts. No LP should be comfortable, let alone permit, a General Partner to use the same law firm as the firm representing the fund. And if the legal arrangement didn’t bother the LPs, the discount afforded Blackstone, but not the funds, should have concerned them. Investing with a private equity firm requires a high level of trust. The GP (in this case Blackstone) has all sorts of discretion in buying and selling companies and retaining bankers, accountants, and lawyers. When the GP cuts corners on hiring an attorney to represent the investors, it should raise concerns about the entire relationship with the GP.
As a result of the SEC’s action, Blackstone has curtailed its monitoring fees and ended its practice of charging large termination fees when the monitoring contract is terminated prematurely. I’m left to wonder why large, sophisticated investors tolerated these practices in the first place. Blackstone and other GPs have been charging all sorts of unjustified fees for years. Even if the disclosure was poor and procedures were deficient, major investors like CalPERS, CalSTRS, Oregon, and Washington knew about these practices. Incredibly they’ve tolerated them.
Silton reaches comes to the same conclusion that we did in a Bloomberg op ed earlier this year: that public pension funds like CalPERS and CalSTRS have demonstrated repeatedly that they are not sophisticated enough to invest in private equity. As we wrote:
If public pension funds persist in feigning helplessness, the agency should consider rescinding their accredited status. This designation allows large and sophisticated investors to operate with minimal oversight. It requires that they be competent to review legal agreements and negotiate terms, including disclosure and audit rights, when the SEC has not reviewed the offering documents for accuracy and completeness. Without it, the pension funds would not be able to invest in private equity unless the latter submitted to the higher cost and disclosure of registering their offerings with the SEC.
And as we’ve also stressed, there’s no justification for public pension funds claiming they can’t afford to buck the private equity industry because they can’t get the returns elsewhere. That’s utterly bogus. First, as we’ve explained regularly, the results from CalPERS, CalSTS, and other public pension funds investing in private equity have shown that over the past decade, they’ve consistently underperformed their benchmarks, and by a large margin. That shows that investors are not getting even close to the income they need to justify investing in this risky a strategy. And it’s not as if they can’t get a similar level of absolute returns from other investment styles, as academics have argued. Moreover, since they are more liquid and involve no higher level of leverage, they would likely come out ahead on a risk-return basis.
So as we’ve said, the only justification for this unwarranted fealty to private equity is too many professional, both at the advisors like the pension fund consultants, and the public pension funds themselves, have a personal stake in preserving these investments, and are putting their interests over their professional and fiduciary duties. In some cases, like New Jersey, reporters like David Sirota have unearthed overly-cozy relationships with state officials and Wall Street firms who too often are both campaign donors and manage state monies. But in most cases, the complexity of private equity and other high-fee alternative investment strategies serves to preserve the jobs of the incumbents. The result winds up being economically equivalent to featherbedding, but at a much higher cost to retirees.