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.
16 comments
Comments are closed.
“Sophisticated investors” sounds to me like flattery, designed to make those who are investing in private equity associate the ‘sophisticated’ label and treatment they no doubt get from PE firms, in the form of ‘sophisticated’ perks such as expensive wine and restaurants, and who knows what else, with their own (assumed) position above the swirling mass of lesser humanity below.
This becomes all the more egregious when they are playing with other (hard-working) people’s retirement livelihoods. Kudos for keeping at ’em. From the looks of it you are making good progress standing up to PE’s useful idiots, and protecting the unwilling pawns in their game. That said, I wouldn’t expect anything less from NC.
Just for fun.
Is this a new phenomenon?
This has been a problem with investors vis a vis thier investments. Theoretically, investors have control over their companies but they’re too lazy or stupid to exercise that control.
In the case of hedge (punt) funds they just don’t read the contracts which tell them black on white that they’re going to be taken to the cleaners.
The trouble is that this has been going on since the 1980’s and no-one has worked it out yet
Thanks for this post.
No LP should be comfortable, let alone permit, a General Partner to use the same law firm as the firm representing the fund.
Yes. Thanks for keeping the attention on PE malfeasance and Pension Board capture. If the boards are so intellectually captured that they pass off these violations as no big deal then maybe the suggestion to remove their accredited investor status isn’t out of the question.
I’ve said it before, public pension funds don’t need high returns, they just need somebody who will PROMISE high returns. In that, it’s similar to the RE bubble, which was chock full of multiple levels of “These are the lies I need you to tell me.”
I dedicate half a chapter to Blackstone in my book Kentucky Fried Pensions. I think Citizens United has accelerated these practices as in our current KY governors race 70% of the spending comes from dark money pools, which I believe much comes from Wall Street. Blackstone has 20 registered lobbyists in Kentucky, how many do they have in California?
…and remind me, who actually suffers as a result of the stuff so well documented here, where parasites play appointed, or even elected, useful idiots with inflated egos for fools, or run with them or co-conspirators?
I’m sure all this has been covered by NC over time, but some links for the curious, starting with a primer on carried interest produced for the would-be Vampire Squids: “The Private Equity Professional’s Guide To Carried Interest,” http://www.jobsearchdigest.com/private_equity_jobs/career_advice/carried_interest_guide
Taibbi’s exegesis: “Looting the Pension Funds– All across America, Wall Street is grabbing money meant for public workers,” http://www.rollingstone.com/politics/news/looting-the-pension-funds-20130926
A push piece dated April 13, 2013, provided to the House Ways and Means Committee by the Private Equity Growth Capital Council (note syntax — the compound subject is “private equity growth,” quelle surprise), “LONG-TERM COMMITMENTS: THE INTERDEPENDENCE OF PENSION SECURITY AND PRIVATE EQUITY,” explaining in LobbyistLingo the utility and ineluctable necessity of Private Equity/s, http://waysandmeans.house.gov/UploadedFiles/Private_Equity_Growth_Capital_Council.pdf
A little more jaundiced white paper on the “virtues” of private equity: “A Primer on Private Equity at Work
Management, Employment, and Sustainability,” http://cepr.net/documents/publications/private-equity-2012-02.pdf From the Executive Summary:
Private equity companies are investment firms that recruit private pools of capital from pension funds, endowments, hedge funds, sovereign wealth funds, and wealthy individuals. They use extensive debt financing to take ownership and control of relatively mature businesses in a leveraged buyout. That is, private equity firms buy businesses the way that individuals purchase houses – with a down payment or deposit supported by mortgage finance. A critical difference, however, is that homeowners pay their own mortgages, whereas private equity funds require the firms they buy for their portfolios to take out these loans – thus making them, not the private equity investors, responsible for the loans. The only money that the private equity firm and the investors in its funds have at risk is the initial equity they put up as a down payment.
Private equity is a lightly regulated financial intermediary that provides an alternative investment mechanism to the traditional banking system. Among the financial intermediaries that have emerged as major players, it is the one that most directly affects the management of, and employment relations in, operating companies that employ millions of U.S. workers. This primer provides an introduction to private equity – the institutional environment in which it emerged, its size and scope, its business model, and how it operates in different industries. We are especially interested in private equity’s effects on jobs, management decision-making, and the sustainability of productive enterprises in the U.S.
And in case anyone still has questions about “Who Rules America,” it ain’t ordinary people via representative government: “Pension Fund Capitalism or Wall Street Bonanza? A Critique of the Claim That Pension Funds Can Influence Corporations,” http://www2.ucsc.edu/whorulesamerica/power/pension_fund_capitalism.html
So, the fix is in — but what’s the fix for that? In “our” Ownership Society, that is?
bearing in mind that this is all in the category of “corruption”…
Pension funds aren’t “sophisticated” investors. They are sheep who follow each other to the slaughter. They don’t read the LP agreements; they just sign up for every follow-on fund blindly because of prior good performance. It is never until performance truly suffers that investors finally read the documents and scrutinize the fees, expenses, and other cozy relationships that the GP’s enter into with third party service providers. But then it’s too late. Until then, GP’s buy investors silence with ‘feel good’ advisory board positions that have no teeth and nice meetings in even nicer locations.
I still don’t understand why pension funds need high returns.
If they were properly funded with a long term conservative strategy in mind [like their beneficiaries actually need], why would they take on any risky deals?
Are these guys underfunded?
Don’t know how it’s supposed to work in California for CalPERS, but in my state the employee puts in x% every pay period and the state is also supposed to put in y%. No real surprise that when the stock market was going up in the late 80’s and 90’s the politicians in my state stopped having the state put in the required y%. My state hasn’t put in the required y% for over 20 years. So that has left the state PERS pension fund underfunded. The politicians decided this year to borrow big, as in 3 commas, on the bond market and use the cash to invest in the stock market and PE. Sort of a financial Hail Mary pass. The state legislators think they can invest on margin (more or less) and miraculously bring the pension funding up to soundness, or push out the bad news date until they’re out of office.
Shorter: you’re right. If they were properly funded. They haven’t been properly funded for over 2 decades thanks to legislators.
. . .yes, and also notice how the MSM jubilantly beats up unions (specifically teachers) for their “magnanimous pensions”. When, in fact, most teachers do not control the Pension Board or the state Legislature and the average pension is about $20K.
Yes, bingo! Virtually all pension funds are underfunded thanks to the crisis and then the post crisis policies (ZIRP and QE) making it pretty much impossible to earn enough income to meet overall portfolio return assumptions (for instance, in CalPERS case, 7.5%) without taking a lot of risk.
Here’s a 2015 account of CalPERS and CalSTRS. More recent info won’t differ all that much:
http://calwatchdog.com/2015/01/26/state-pensions-improve-but-members-living-longer/
California’s current problems date to the Tech Bubble/Internet Start-up Ponzi of the late ’90’s. CalPERS was “super funded” due to frothy assets, and public entities were granted a “contribution holiday” for a period of years during which they failed to “smooth” contributions in anticipation of the inevitable crash. They’ve been chasing unrealistic returns ever since. Thus, their willful blindness to PE abuses, abetted by their supposed oversight by elected officials addicted to PE Dark Money.
Kind of what I suspected.
It’s like a bad Western.
The local luminaries screw up the towns funding and future prospects through sheer stupidity and greed. Carpetbaggers roll into town after salting a gold mine and sell them shares – naturally they buy, but the town goes bankrupt anyway and the con-men ride off in a cloud of free-market dust.
But unfortunately this isn’t a movie but real life.
In fairness, an employer contribution holiday wasn’t the sole product of the “new economic paradigm” of Internet Start-up Ponzi froth in the 1997-2001 period. CalPERS and the state legislature also provided benefit enhancements to employees, purportedly in order to bleed-off the plan’s “super-funded” status.
These benefit enhancements are no longer offered to new hires under Gov. Jerry Brown’s “Pension Reform,” but remain vested for employees who worked during 2000-2012.
The Shock Doctrine in action!