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Fee secrecy is wrong, period

Public retirement system trustees are breaching their fiduciary responsibility by agreeing to hire private equity, real estate and other alternative managers that demand secrecy on fees. This practice is unacceptable.

This resistance to transparency comes at an especially troubling time for public retirement systems, facing the challenges of severe underfunding and a low-return investment environment.

Seeking to expand the investment opportunity set to boost returns, public plans increasingly embrace more risk and reach out to alternatives in a quest for higher returns, allocating more to asset classes subject to secrecy on fees, conflicts and complexities in portfolio holdings. Public plans had a combined total of 24% in private equity, real estate and other alternatives as of Sept. 30, 2015, up from 22.2% the previous year, according to the Pensions & Investments report on the 1,000 largest retirement funds.

In moving more to alternatives, public plans have taken nearly 25% of their investment assets off the grid, a move that can shortchange participants, the public and sometimes trustees of important information. It is a disturbing development, especially because private equity and other alternatives are the most expensive asset classes of pension funds.

About 10 years ago, some big plan sponsors pushed for state legislation to exempt private equity from the Freedom of Information Act. That lack of transparency makes accountability more challenging for participants and taxpayers to determine if trustees are upholding their fiduciary duty.

Pension funds can point the finger only at themselves. They should have fought harder to demand transparency on fees, using their size and the marketing cachet that a manager gains in working for them to obtain more information.

Some public plans have made moves in the past year to become more transparent in fee disclosure. But for many funds, those moves have not gone far enough, as demonstrated by state legislative efforts to intervene to break down barriers on disclosures.

Eight states have considered fee disclosure for alternative investments. Such bills have failed in Alabama, Kentucky and New Jersey. Legislatures in California and Washington have passed bills, but none requires as much disclosure as the fee-reporting template released in January by the Institutional Limited Partners Association.

In Illinois, the bill was amended in May to resolve concerns expressed by state pension fund executives that they might lose access to alternatives managers.

In California, the $192.9 billion California States Teachers' Retirement System and the $19.5 billion Los Angeles Fire and Police Pension Plan raised concerns about being shut out of alternative investments. The California Legislature passed an amended version of the fee disclosure bill.

Trustees should step up demand for transparency on fees, expenses, incentives and conflicts of interest rather than leave the issue to legislators, who haven't the granular knowledge about the complexities and risks of alternative investments to write comprehensive legislation.

After the financial crisis, the Securities and Exchange Commission strengthened its oversight of alternatives by requiring private equity, hedge funds and other such managers to register as investment advisers.

As SEC Commissioner Michael S. Piwowar said in a speech in March: “The financial crisis revealed that many market participants and regulators were not fully aware of the risks underlying residential mortgage-backed securities. ... This lack of transparency also contributed to the overreliance on credit ratings by market participants and regulators.”

In examinations, the focus of which included fees, allocation of expenses and valuation at more than 150 private equity advisers, the SEC found “expense shifting and hidden fees where disclosure was limited or inadequate,” Marc Wyatt, acting director of the SEC office of compliance inspections and examinations, said in a speech last year.

“One of the most common and often cited practices in this area involves shifting expenses away from parallel funds created for insiders, friends, family, and preferred investors to the main commingled, flagship vehicles.”

“The private equity business is complex with many moving pieces with the adviser frequently controlling operating companies and other entities,” Mr. Wyatt said. “At the same time, private equity operations are not always transparent to investors. This, combined with the fact that many LPs do not have the staff or access to delve as deeply into manager operations as our examiners, may create an environment where bad conduct can occur.”

Andrew J. Bowden, director of the SEC office, in a 2014 speech, said “that most limited partnership agreements do not provide limited partners with sufficient information rights to be able to adequately monitor not only their investments, but also the operations of their manager.” He added that “we find that broad, imprecise language in limited partnership agreements often leads to opaqueness when transparency is most needed.

“While investors typically conduct substantial due diligence before investing in a fund, we have seen that investor oversight is generally much more lax after closing,” Mr. Bowden said. “When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.“

Clearly, fund trustees are not fulfilling their fiduciary duties if they are not seeking enough oversight to discover such violations or potential violations.

David M. Silber, chief investment officer of the $4 billion City of Milwaukee Employes' Retirement System, in a P&I commentary last year called on private equity managers “to stop claiming that fees, expenses, internal controls and subscription documents are confidential information.” As he pointed out, private equity's “competitive advantage is not driven by” confidential terms on fees but by experience, skill, resources and other qualities.

Trustees express anxiety of getting shut out of private equity deals by managers who demand secrecy. But public funds cannot appropriately evaluate performance without including fees and taking into account investment risks that include operations, compliance and transparency. Pension fund executives might fear excluding a growing part of the investment opportunity universe in private equity by demanding disclosure of such information. But they must not compromise their fiduciary duty. In acquiescing to the confidentiality demands of alternative managers they are doing just that.

Trustees who dissent from agreeing to secrecy must raise their voices about the moves against transparency. Participants who are at risk in underfunded pension plans and their union representatives also should speak out.

Are the assets safe? Are the funds earning all of the return that is due to them, or is too much flowing to the managers in fees, expenses and costs transferred to them, hidden from view by lack of transparency?

Lack of transparency presents a challenge even for whistleblowers to come forward because even trustees might not have enough information to recognize problems and bring them to light. n

This article originally appeared in the October 3, 2016 print issue as, "Fee secrecy is wrong, period".