Private equity has come under renewed scrutiny over the issue of fees and transparency.
Executives at the California Public Employees' Retirement System, Sacramento, have admitted they don't know what it is paying in total to its private equity managers, and how costly it is to manage its most expensive asset class. While it does report private equity management fees, which amount typically to 1% to 2% of assets, CalPERS hasn't been reporting the carried interest, or performance fee, which typically amounts to 20% above a return hurdle, although it expects to shed light on the profit-sharing fees later this year.
Other asset owners investing in private equity face a similar situation. This must change or trustees of such funds are failing in their fiduciary duty. Fiduciaries must do more to account for and disclose all fees, upending the status quo, while pressuring private equity managers to become more transparent in operations and other matters outside the proprietary investment management intelligence that is the source of their value-adding performance.
Many fiduciaries haven't been doing much of either.
Private equity managers, because they claim to offer unique strategies with limited capacity that are in high demand, have the upper hand in relationships with asset owners, and this sets the stage for ambiguity about fees. In private equity, structured as limited partnerships, the managers write the investment agreements rather than the asset owners writing the agreements with investment management firms.
In fact, private equity managers attribute their success in adding value, in part, to a lack of transparency and confidentiality.
The problem arises in part because asset owners don't write checks for performance fees. Instead, limited partnerships embed profit-sharing fees in the returns.
But asset owners should demand the information, or back out fees based on returns.
“It's not explicitly discussed or accounted for,” Wylie Tollette, CalPERS' chief administrative investment officer, was quoted as saying in a P&I story about performance fees. “We cannot track it today.”
But there is no excuse for not knowing the amount of performance fees paid — these are plan assets.
CalPERS has stepped up to provide more disclosure. Its officials announced on July 2 that, as a result of a new computer system to track the data, it would begin to report the performance fees it pays to private equity firms. They plan to begin the disclosure in fall. Other fiduciaries should do likewise and step up. They have an obligation to know what they are paying in performance fees. Without that knowledge they cannot benchmark and evaluate the performance of private equity funds and their managers, analyze risk and manage it, and balance the resources necessary to commit to the asset class with those needed for other allocations.
The Global Investment Performance Standards, a worldwide set of voluntary standards for reporting investment returns for investment management firms, created and administered by the CFA Institute, extended the application of the standards in 2014 to asset owners, including pension funds. Under GIPS, private equity reporting of net returns excludes both investment management fees and carried interest, profit-sharing or performance fees.
“We are trying to move the industry toward greater transparency,” said Jonathan A. Boersma, executive director, GIPS, CFA Institute.
“This is their money,” Mr. Boersma said of pension funds paying private-equity profit-sharing fees. “They should demand to know what those fees are and how their capital is being spent.”
Fiduciaries have accepted this unlevel playing field arrangement as part of the price of obtaining exposure to the asset class and highly regarded private equity managers, contending they cannot easily walk away from unfavorable terms. With so much money chasing returns, private equity often enjoys a market with more investors lined up ready to make commitments than the available capacity, limiting the ability of asset owners to negotiate terms. But fiduciaries cannot surrender their duty because of the special structure of private equity.
In private equity, the concept of fees is straightforward but the execution is complicated.
Private equity is the most expensive asset class for most asset owners. CalPERS acknowledges it pays $1.6 billion in fees each year, including $441 million in private equity management fees that generally are 1% to 2% of assets. But private equity performance fees could add another $600 million to $900 million a year, making CalPERS' total investment management fees upward of $2.5 billion, according to J.J. Jelincic, a CalPERS trustee.
It's indefensible to neglect the measurement and reporting of performance fees. What gets measured gets managed. But when a fee is out of sight, it tends to be out of mind, and risks becoming out of control.
Some aspects of the confidentiality and lack of transparency in the private equity world have served the asset class well, enabling many managers to add value, but have hampered better oversight of fees or costs. The structure of fees hardly provides any added value for clients, stripping the need for their confidentiality.
When investment returns are in the double digits, asset owners tend to pay less attention to fees compared with when returns are scarce, a time when they try to squeeze more in performance by negotiating lower fees or questioning manager offsets to fees. Now in a low interest-rate environment, each basis point of return is more precious.
But performance shouldn't distract from a fiduciary's duty always to minimize fees. Asset owners need to scrutinize more thoroughly the precision that goes into a fund's measurement of outperformance and netting of costs to arrive at the profit sharing.
What gets expensed to limited partnerships and general partners into netting performance fees is tricky. General partners arrange annual audits. Asset owners don't have the resources to independently audit each of their private equity funds. Even if they did, the limited partnership agreement makes no provision for such audits.
The Securities and Exchange Commission is trying to shed more light on private equity fees. It is looking under the hood of private equity managers to make sure they are playing by the rules, examinations that could contribute generally to easing asset owner concerns about audits, especially in uncovering fraud and overcharging.
Asset owners face many challenges when investing in private equity, from high fees to lack of transparency, from restrictive agreements to a lack of a benchmark similar to those for public equities against which to measure performance and risk. At the minimum, assets owners must begin to measure and disclose performance fees.
General partners would be wise to listen to concerns and embrace more transparency. Otherwise pressure brought to bear on the SEC could lead to more onerous regulation. n
