The City of Milwaukee Employes' Retirement System believes it is in the best interest of everyone involved in the private equity industry for private equity managers to stop claiming that fees, expenses, internal controls and subscription documents are confidential information.
It is time to acknowledge and accept that the attributes that make private equity investing attractive to asset owners like CMERS have nothing to do with these “confidential terms.” CMERS leadership would expect that top-tier private equity managers would understand better than anyone that their respective competitive advantage is not driven by a confidential term but rather by qualitative factors that cannot be copied by reading a subscription document.
CMERS invests in privately held companies and startups because of the potential to better diversify its defined benefit plan. This diversification comes from the expansion of the opportunity set of available investments, the longer-term focus of privately held companies (at least compared to the quarter-to-quarter mentality of many companies listed on Wall Street), and the expected excess return that private investments should generate over time compared to public market investments given characteristics such as the illiquidity associated with investing in privately held companies.
Excluding private equity investments from a diversified portfolio removes a significant portion of the U.S. economy from the investment opportunity set. In addition, successful private businesses and startup companies are an essential ingredient for a healthy market economy. In the United States, approximately 99% of the 5.7 million companies with employees are private firms, according to a Forbes May 26, 2013, article.
Private firms also make up the vast majority of companies with 500 employees or more, the Forbes article noted. Specific to young firms, studies have been published in recent years that attribute the majority of net job creation in the United States to new companies (“The Importance of Young Firms for Economic Growth,” Entrepreneurship Policy Digest, Ewing Marion Kauffman Foundation, Sept. 25, 2014, and “Who Creates Jobs? Small vs. Large vs. Young,” August, 2010, ssrn.com). Private equity investment managers, and investors such as CMERS that pool their money and allow private equity managers to invest in privately held companies, play a very important role in fostering a well-functioning market economy.
While CMERS trustees believe that private equity investments are an important part of a diversified portfolio, CMERS is troubled by the lack of transparency that private equity managers offer investors on issues including fees, internal controls and subscription documents. The stated fees on private equity vehicles are lucrative to begin with, but the unstated fees managers earn in the form of transaction, consulting, monitoring and other fees are far more concerning.
Furthermore, fee-disclosure practices and concerns over internal controls at private equity managers have been raised by representatives from the Securities and Exchange Commission's Office of Compliance Inspections and Examinations group, including by Andrew J. Bowden, then-director of the office in a May 6, 2014, speech, “Spreading Sunshine in Private Equity” and recently by Marc Wyatt, acting director of the office, in a May 13 speech, “Private Equity: A Look Back and a Glimpse Ahead.”
CMERS leadership is skeptical of private equity managers' insistence that fee structures, internal controls and subscription documents, particularly limited partnership agreements and side letters, are confidential information that provides a given manager a competitive advantage. Another way of saying this is that CMERS officials have never heard a manager attribute its top-quartile returns to its fee schedule, allocation of expenses, internal controls or obfuscating legal documents. What should differentiate one private equity manager from another are qualities including, but certainly not limited to, experience, relationships, skill, resources and alignment of incentives and interests. These qualities are not easily copied and an average manager cannot obtain these qualities and become a top-tier manager just by reading a competitor's subscription documents.
CMERS challenges the private equity industry to acknowledge that much of what is claimed to be confidential:
- does not provide a competitive advantage and
- should be made public through increased transparency with investors going forward.
CMERS leadership also is appalled to learn that investors in certain private equity vehicles managed by Oak Investment Partners might have money at risk due to the alleged fraudulent actions of a general partner who used to work at the firm as described in the complaint SEC vs. Iftikar Ahmed and Iftikar Ali Ahmed Sole Prop and I-Cubed Domains LLC, filed May 6. These are assets of corporations, public employee pension plans and non-profits that are pledged to fund retirement benefits, grants and charitable activities, according to Bloomberg Finance LP. While CMERS is well aware that investments in venture capital firms have a higher level of investment risk, fraud is not a risk that CMERS, or any other investor, has any tolerance for.
Private equity managers need to understand that their industry is damaged by the lack of transparency and negative headlines. In this environment of poor transparency and negative headlines, it would be natural for investors, including CMERS, to ask questions, such as: Are there other undisclosed fees? How much are private equity managers truly compensated? How serious and prevalent are the lack of internal controls at private equity firms that the SEC observed in its examinations? Are industry incentives aligned with investors' objectives? Do the majority of private equity firms have strong enough internal controls to minimize the risk of a single employee defrauding a firm and its investors?
The failure of private equity managers to adequately address these issues leaves a vacuum that will likely be filled by additional public scrutiny, continued frustration from the investment community, and increased attention from regulators and tax authorities. Ultimately, it may take a more concerted effort by CMERS officials and other investors to work together to demand changes to break down the transparency barriers that currently exist in the industry to create the alignment of interest that is beneficial to all.
David M. Silber is chief investment officer of the City of Milwaukee Employes' Retirement System. His commentary is endorsed by other CMERS leaders: Bernard J. Allen, executive director; John Barmore, board chairman; Michael Murphy, investment committee chairman; Gust Petropoulos, board and investment committee vice chairman.
