Several large pension funds are asking if private equity returns are all they're cracked up to be.
The funds are questioning if the returns justify the high fees, and why the general partners' returns often are higher than those of the limited partners.
To educate themselves on these and other relevant issues, the Minnesota State Board of Investment, the California Public Employees' Retirement System, 11 other large state pension funds and the $60 billion pension fund of Lucent Technologies Inc., Murray Hill, N.J., have sponsored a highly detailed due-diligence questionnaire they want partnerships to answer.
The questionnaire, which could provide an industry standard, was prepared by Pension Consulting Alliance Inc., Portland, Ore.
CalPERS has put the questionnaire on its Web site, where it has gotten several hits, said Sheryl Pressler, chief investment officer of the $153 billion Sacramento-based fund. She also has been talking it up to pension funds and small private equity publications.
Howard Bicker, executive director of the $40 billion Minnesota system in St. Paul, has been disseminating the questionnaires -- and gauging reaction -- at private equity conferences.
At one conference this month -- the Institute for International Research's Deal Quest -- Mr. Bicker challenged keynote speaker Stephen A. Schwarzman, president and chief executive officer of The Blackstone Group, one of Minnesota's private equity managers.
Good news for whom?
Mr. Schwarzman said the private equity business has been so strong that some of his firm's investments had quadrupled within three months.
"That's wonderful," Mr. Bicker said. "But the bottom line is that, in one instance, the net to a limited partner was 22%, even though the general partner made 39%.
"In fact, Minnesota's net return on private equity investments over the last five to seven years has been a mere 200 basis points over public investments. Is that a good deal? Once a fund is closed, the general partner gets rich or very rich. We (pension funds) take all the risk. They (general partners) take none of the risk. They get the best fee structures."
At the conference, Mr. Bicker explained the new questionnaire is a followup to a 1996 due diligence study developed by William M. Mercer Inc. for several corporate and public pension funds.
Allan Emkin, managing director at Pension Consulting Alliance, said his firm designed the questionnaire at the request of the pension funds, which wanted to find a way to get more information out of their partners.
"What's different about this questionnaire is that it has hard questions plan sponsors weren't asking before," he said.
The questions cover -- deal by deal -- investment approach, performance and how internal rate of return is calculated. The questionnaire also asks for full financial disclosure, requesting general partners to list their net worth; specify what percentage of profits each partner in the firm receives; and details of the firm's operating budget.
"We want to know how much of a contribution the general partner is putting into a deal, how much it costs to run the operation compared with your fee income. There seems to be a nice spread between those two items," Mr. Bicker said.
Origin of profit
He and Ms. Pressler both stressed in interviews that they would prefer a structure where management fees are set to cover costs of running a fund, instead of the current average 2% management fee. "It (the management fee) shouldn't be for a profit. The profit should come out of the carried interest," Mr. Bicker said.
Even though that profit -- or carried interest -- is typically 20% for general partners now, and at some funds, 30%, Mr. Bicker believes the percentage should relate to the size and type of deal.
Most of the funds that sponsored the questionnaire plan to have their staff or consultants use it, Ms. Pressler said.
"We want to be responsive to general partners who say that every pension fund asks the same questions in a different format. I'd rather see them (the partners) spending their time on investments than filling out questionnaires," she said.
The questionnaire is now being circulated, so there hasn't been a lot of feedback yet. But both Ms. Pressler and Mr. Bicker said the early reaction is favorable, although some general partners are reluctant to answer the financial disclosure portion.
Some general partners interviewed doubted most firms would answer the sensitive questions that ask for full financial disclosure.
Douglas Brown, president and chief executive officer at Advent International, Boston, said that while he thought it was great to attempt to standardize the questionnaires, he certainly wouldn't answer the questions about partners' interests, net worth and what percentage they would get of carried interest.
"I wouldn't have a problem saying how we allocate carried interest among the partners at the firm, but I won't say how much they'll get or answer questions about our operating budget. The information that's really of a personal nature, such as net worth, should not be in the public domain," he said.
Some unlikely to respond
Mr. Brown observed that many pension funds can't get into top performing partnerships as it is, and that because there is such a demand to get those slots, the managers of those funds were unlikely to answer sensitive questions.
Brooks Zug, managing director at HarbourVest Partners LLC, Boston, concurred. "It's been more of a sellers' market recently," he said. Investors often find they can't achieve everything on their wish lists. If they have a rigid requirement for a certain set of terms, it could result in their not being included in some of the top funds.
Mr. Zug added he's found more sophisticated institutional investors use a less rigid approach to due diligence, and general partners appreciate that.
Nevertheless, Mr. Bicker warned that when the stock market slides and the initial public offering market collapses, a new fee structure will be proposed.
"There is an arrogance in this business now, because it doesn't remember a bear market," Mr. Emkin said.
"The reality is that with current market conditions the best performing funds don't even have to negotiate. However, when the bear market comes, GPs will have to beg for money. Sponsors will say, 'Why weren't you reasonable? Why didn't you fill out the questionnaire?' "
Ms. Pressler explained it makes sense to ask for full financial disclosure, because as limited partners, the pension funds give up control.
"As fiduciaries, we need to understand who we're giving discretion to for 10 years. Besides, these same firms wouldn't invest in an entity, without asking these same kinds of questions," she said.
It's a sellers' market now and CalPERS might still take a look at a partnership that didn't provide certain financial disclosure, she said. But if the system decided to hire the firm, it would ask for full disclosure and expect to get it. "We're long-term investors, and I don't believe we would want to be partners with people who won't give us full disclosure," Ms. Pressler said.
The other pension funds that sponsored the questionnaire are the California State Teachers' Retirement System; Florida State Board of Administration; Kansas Public Employees' Retirement System; Massachusetts Pension Reserves Investment Management Board; Michigan Department of Treasury; Montana Board of Investments; New Jersey Division of Investment; New York City Retirement Systems; Oregon Public Employes' Retirement Fund; South Dakota Investment Council; and State of Wisconsin Investment Board.