Asset owner fiduciaries have fallen short in their oversight in identifying, understanding and disclosing investment management fees, especially in alternative investments. They have just not been up to the task.
That practice is unacceptable.
John Chiang, California state treasurer, in an Oct. 12 letter to the investment committee chairs of the California Public Employees' Retirement System and California State Teachers' Retirement System, urged them to work with him to draft a state law to “require private equity firms to disclose all fees charged to California pension funds” and “place fee disclosure requirements” on private equity managers.
Such a law is necessary only because trustees have failed to undertake that fiduciary duty. Any such law should have provisions to hold fiduciaries accountable for such failure. Legislatures across the country should step up their own scrutiny of fees and enact guidelines to establish frameworks for fiduciaries to identify fees. Private equity managers have only themselves to blame for the lack of transparency and potentially more costly legal requirements than would be necessary had they volunteered comprehensive details.
Private equity firms have been seeking out asset owners as investors. Asset owners have the clout to demand more transparency. Pension funds, private and public, as well as foundations and endowments accounted for 57% of all investment in private equity in 2013, according to the Private Equity Growth Capital Council.
In September, the Institutional Limited Partners Association, whose members include representatives of big pension funds, launched a fee transparency initiative to develop a standardized reporting template to bring more uniformity to reporting practices. That initiative should be welcomed and drive new compliance standards.
The catalyst for all these actions — including a resolution adopted by the National Association of State Treasurers at its annual conference calling for public pension fund officials to develop more transparent and consistent methods of reporting fees for private equity managers — might have come from a combination of a need to find sources of more investment return in a low-interest-rate and market-return outlook, as well as from the Securities and Exchange Commission, whose office of compliance inspections and examinations, in prioritizing markets risk for this year, included a focus on private equity fees.
As Ruston Smith, chairman of the U.K. National Association of Pension Funds, said in March, in a low-interest-rate world, “every pound lost in inefficiencies or excessive charges is a pound lost in return.”
Tom Scheibelhut, managing principal at CEM Benchmarking Inc., Toronto, said last month of private equity: ”A big reason why (asset owners) never had (all) these costs is they thought they did. It's really hard to get those costs. Over time (asset owners) have learned they weren't getting them all.”
David M. Silber, chief investment officer, City of Milwaukee Employes' Retirement System, in a July 13 commentary in Pensions & Investments, noted “the lack of transparency that private equity managers offer investors on issues including fees,” as well as “unstated fees managers earn in the form of transaction, consulting, monitoring.”
“CMERS leadership is skeptical of private equity managers' insistence that fee structures, internal controls and subscription documents ... are confidential information that provides a given manager a competitive advantage.” Mr. Silber wrote.
Asset owners have failed in their fiduciary duty by not reaching out to those who could identify the costs. They don't have that excuse anymore. They must ensure disclosure includes all fees.
Asset owners have been sitting ducks. They have let the private equity managers off the hook by not demanding transparency on fees. The lack of disclosure limited the degree to which asset owners could challenge and negotiate fees.
To their credit, a number of pension funds, including CalPERS and the New York City Retirement Systems, have in recent weeks either stepped up to identify fees and disclose what they pay or have promised to do so. The fund executives have been demanding more transparency from investment managers while promising enhanced disclosure to their participants and other constituencies.
But these improvements are not enough. Fiduciaries must be held to account for their lack of oversight and scrutiny of investment management fees, particularly in private equity and other alternative asset allocations. Fiduciary duty calls for maximizing return for the risk taken for the sole benefit of participants or their financing objectives. Without examining fees, including profit sharing, fiduciaries cannot evaluate the full cost of investment management, properly assess performance and risk, or make decisions on the allocation of assets.
Fiduciaries also have failed to seek out adequate assistance, or the guidance they received from investment consultants and pension fund attorneys has been insufficient to uncover all the components of fees so they could derive the full costs.
Fiduciaries need to shed light on their own practices and policies pertaining to identifying and accounting for fees, including profit-sharing arrangements and how they net those costs to determine net performance, which is the bottom line that affects the value of the funds and the pension benefit security.
At many public retirement systems, participants, active and retired, elect some of the trustees to the governance and oversight boards, while elected officials appoint other trustees. These constituencies must demand an examination of the failure to account for fees and replace trustees that failed the due diligence. Private equity and other alternative investments are generally the most expensive asset classes for asset owners, and allocations to them have been steadily increasing — meaning fees, identified or not, have been increasing. Those increases provide even more reason to better account for fees.
State legislatures unfortunately also have fallen short of their oversight in not making fee disclosure a priority. In fact, some years ago, a number of legislatures across the country enacted legislation to exempt public pension funds from disclosing details about private equity investments, shielding from public disclosure information about the investments and the investment management firms that manage them. The legislatures took action after some private equity funds refused, or threatened to refuse, to do business with asset owners that provided disclosure.
But that neglect is changing. In his letter, Mr. Chiang criticized private equity managers over their “lack of transparency and detail in how much it cost our pension systems to invest in their products.” But Mr. Chiang, ex-officio trustee of CalPERS and CalSTRS, should have raised his voice sooner and louder to draw attention to the neglect of fee disclosure. It's better late than never.
It could be that lower fees will result from disclosure, so it will be a double win for the funds. n