Private equity assets under management are higher than they’ve ever been – estimated at $3.5 trillion – but their role in retirement funds is quickly coming into serious question.
These questions center on the funds’ opacity, risk and the often enormous fees guaranteed to fund managers no matter how they perform.
Regulators, politicians, unions, trustees and plaintiffs’ attorneys across the country all seem to have turned their attention to potential shenanigans in private equity.
The Securities and Exchange Commission’s Andrew Bowden sent a shockwave through the industry last week at the Private Equity International Forum in New York. There, he told attendees that the SEC found “violations of law or material weaknesses in controls” in over 50 percent of the private equity funds the agency has inspected.
The SEC, according to various reports, is especially interested in “backdoor” fees that investors are expected to pay for the services of “operating partners,” people with supposed expertise who, in reality, are just employees of the private equity firm and should be paid out of its own income.
The growth in private-equity funds over the past two decades has much less to do with a propagation of high-income individual investors (those worth more than $5 million), than it does with the private equity firms successfully raising cash from public and private pension funds.
The website of the Private Equity Growth Capital Council, the industry’s lobbying arm, says that institutional investments from pension funds, endowments and foundations accounted for 64 percent of all private equity investment in 2012.
“Mom and pop are much more invested in these funds than people realize,” Bowden, the SEC’s director of the Office of Compliance Inspections and Examination, told his audience.
Bowden called the extent of violations a “remarkable statistic.”
His comments left no doubt that the SEC is on the offensive on the issue.
In fact, the agency already has filed a case against a private equity firm, Clean Energy Capital, and its president, Scott Brittenham.
The agency alleges Brittenham and Clean Energy misappropriated more than $3 million from 20 private equity funds by failing to disclose to investors that it had allocated Clean Energy’s expenses for compensation, office space, gifts and business cards to the funds.
Brittenham and his firm deny the SEC's allegations.
Transparency in private equity, advocates will say, is much improved over the past 10 years. Critics, however, argue much more is needed, especially in terms of fees and valuations.
One of the biggest critics is Ted Siedle, who began his career at the SEC 30 years ago, moved to the private sector and ultimately became general council of Putnam Investments. He’s now an independent consultant, and has conducted over 2,000 “forensic investigations” of the money management industry.
“I’m like CSI for Wall Street,” Siedle said. “I go in, look at the body, and try to figure out if there’s been foul play.”
Siedle believes the “blanket secrecy” in private equity funds and their relationship with trustees of public pensions is alarming.
“If you had told me 30 years ago fees would go up and disclosure would become less common I would have told you you’re nuts. The movement then was to lower fees and improve disclosure, which is the exact opposite of what we have now.”
Siedel said that public pension funds are supposed to be the most transparent by law, but that confidential fee arrangements fund managers establish with trustees makes that impossible.
“Transparency has been thwarted by an unholy alliance between public pensions, attorneys general, trustees and the alternative industry, and it’s happening across the country,” Siedle said.
The SEC isn’t the only regulatory body or investor raising questions.
Among others, Siedle’s firm, Benchmark Financial Services, is working with the State Employee Association of North Carolina, a union, to review its investment in alternative funds, including private equity, and the more than $400 million in fees it paid out.
A similar issue has been raised in Rhode Island, while in Kentucky, documents have surfaced suggesting private equity investments are costing more in fees than most believed.
Richard Solomon, chairman of Oregon’s Investment Council, said the state “take(s) seriously the recent reports regarding the SEC’s investigations. Accordingly, we have directed our consultants and treasury staff to continue to verify that the private equity firms with whom we invest have assessed only those fees allowed by the terms and conditions of their contacts.”
In California, pension giant CalPERS – reported to have more than $42 billion of exposure to private equity investments as of mid-2013 – has reduced its allocation of private equity to 12 percent from 14.
Amid these questions, Cambridge Associates, a consultant to private equity funds, notes the industry had a banner year in 2013, returning $120 billion in cash to investors, more than ever before.
At the same time, retirement advisors have greater access to private equity funds than ever, in part because shares of several of the industry’s biggest funds are publicly traded and partly because investment thresholds are dropping.
For example, the Carlyle Group is letting investors enter into a buyout equity fund for as little as $50,000. Previously, the minimum entry was $5 million.
KKR has revealed in filings to the SEC that it is working on a fund that would allow accredited retail investors in for as little as $10,000.
Among the multitude of issues, advisors will have to consider the question of liquidity.
Private equity contracts typically cover a 10-year period. Shares of private illiquid investments will have to be sold on a secondary market.
Advisors wondering how to assess these investments for their clients will no doubt start by looking at what the regulators are saying about them, as well as how they’ve performed for institutional funds.
Check out Andrew Bowden's speech, "Spreading sunshine in private equity."