Report On The Challenging Relationship Between Public Pension Funds And Private Funds Published By The Lowell Milken Institute At UCLA School Of Law
Guest Post: Joel A. Feuer[1]
On May 18, 2016, the Lowell Milken Institute for Business Law and Policy at UCLA School of Law published its 2016 Private Fund Report entitled, Public Pension Plans and Private Funds – Common Goals, Conflicting Interests. The Report focuses on several aspects of the sometimes challenging relationship between public pension funds and private funds. Public pension funds, as a group, have been the largest or among the largest and most reliable investors in private funds. Nevertheless, the dismal performance of private funds to generate high investment returns has revealed tensions in the relationship between public pension funds and private funds.
The Report consists of seven articles by academics as well as individuals involved with the fund industry. Starting with the concept that public pension funds need private funds to help achieve the returns necessary to fund the retired employee-beneficiaries, the articles consider the specific problem of fees and expenses as well as the broader issue of the fiduciary duty of public pension plans.
Over the past few years, some public pension funds have admitted that they do not know how much they are paying in fees[2]; others have announced paying astonishing sums to private fund managers.[3] The Report explores the several reasons why public pension funds have failed to gain a grip on the fees and expenses charged them by private funds including: (i) the private fund managers’ ability to extract rents from their investors generally; (ii)public pension fund managers’ failures to understand the contractual language in the LP agreements; (iii) deeper structural flaws in some public pension funds that inhibit their abilities to monitor and analyze information provided by the private funds’ general partners and (iv) the dysfunctional political milieu in which some public pension funds exist. As the articles explain, in general, because public pension funds have not been able to capture and analyze fees and expenses for their investments, they are not yet in a position to negotiate meaningful reductions even though they are largest class of investors in certain private funds and should have market power to reduce charges. More importantly, without a timely analysis of the information provided by the private fund’s general partner, the pension fund is often unable to analyze the value of its investment, until it is too late.
The Report also considers the broader issues of fiduciary duty owed by public pension funds to their beneficiaries in the context of investing with private funds. Because public pension funds stand outside the statutory framework governing private pensions under ERISA, the authors identify and develop the long-standing legal concepts of fiduciary duty and equity as tools to hold public pension fund trustees to account. However, as explained in the Report, there are serious questions of legal doctrine and public policy about whether these two legal concepts are sufficiently robust to change behaviors in the management of public pension funds in connection with their search for alpha by investing in private funds.
As the Report makes clear, the stakes are high. To the extent that private funds can generate high returns for public pension funds, retirees, their dependents and the taxpayers will be protected. However, the recent revelations that private funds general partners have received billions in fees without delivering the hoped-for extraordinary returns threaten the well-being of the relationship.
[1] Joel A. Feuer is the executive director of the Lowell Milken Institute for Business Law and Policy at UCLA School of Law. The Lowell Milken Institute supports the Business Law and Policy specialization at UCLA School of Law and also provides a forum for the business law community to explore timely and important issues in business and business law. It publishes an annual report and hosts a conference on Private Funds. [2] “Pensions’ Private-Equity Mystery: The Full Cost,” The Wall Street Journal, Nov. 22, 2015 http://www.wsj.com/articles/pensions-private-equity-mystery-the-full-cost-1448235489 [3] “The Impact of Management Fees on Pension Fund Value,” New York City Comptroller, April 9, 2015, http://comptroller.nyc.gov/wp-content/uploads/documents/BAM_Report_Impact_of_Management_Fees.pdf
The Challenging Relationship Between Public Pension Funds And Private Funds
Many observers inexperienced with private funds are often quite surprised when they first learn that the retirement plans of teachers and police officers and sanitation workers serve as the foundation for these financial high fliers. The difference in remuneration is only one of the many, many ways the world of government differs from the world of private funds. What brings these two very different worlds together is central to understanding the key dynamics in the industry and the growth of these funds in recent years.
With public pension funds being asked to achieve higher and higher investment returns in order to deliver retirement benefits to their beneficiaries, these retirement plans are being forced to allocate more of their money to riskier and riskier funds. Unfortunately, the results are not as clear cut as many would like.
Over 30 years ago, the relationship between US public pension money and private equity investment acumen began. In 1981, KKR used money provided by the Oregon Investment Council to acquire the retailer Fred Meyer. Since then, the relationship has deepened and broadened considerably, driving the alternatives industry forward. Conventional wisdom holds that in the US approximately one-half of the money in private equity and venture capital funds comes from tax-exempt investors such as public pension funds.
The most significant group of investors in private equity and hedge funds remain the large US public pension plans, whether on the west coast (California Public Employees Retirement System (CalPERS), California State Teachers Retirement System (CalSTRS), Los Angeles County Employees Retirement Association (LACERA), Los Angeles Fire and Police Pensions (LAFPP), San Diego County Employees Retirement Association (SDCERA), Sacramento County Employees Retirement System (SCERS)), the east coast (Massachusetts Public Employees, New Jersey Division of Pension and Benefits, New York State and Local Retirement System (Common Fund), New York City Retirement Systems (NYCRS), Virginia Retirement System (VRS), Florida Retirement System) or from points in between (Michigan State Office of Retirement Services (ORS), Missouri Public School and Education Employee Retirement System (PSRS/PEERS), Missouri State Retirement Systems (MOSERS), Ohio School Employees Retirement System (SERS), State Teachers’ Retirement System of Ohio (STRS), Texas Teacher Retirement System, Texas County & District Retirement Systems (TCDRS), Employees Retirement System of Texas (ERS), Illinois Teachers’ Retirement System, State Retirement System of Illinois, Illinois Municipal Retirement Fund.)
Why invest in private funds at all? Perhaps by better understanding what these investors believe they will gain from entrusting their money with these entrepreneurial firms, it will shed light on the underlying drivers that have led to the relentless growth of private equity and hedge funds during our lifetimes. The simplest answer would, of course, be high investment returns. Dressing this obvious conclusion up a little bit more, the benefits of private equity and hedge funds to investors include attractive risk-adjusted returns, downside protection, low correlation to other asset classes, diversification and access to exceptional investment talent.
As participation in private funds has increased over recent years, investors have gained invaluable experience and knowledge about how these funds operate. Although one byproduct of this development could have been a rapid evolution of the structure of these vehicles, this has not occurred. The fundamental structure of private equity and hedge funds has remained largely unchanged, with the principal economic motivation of fund managers continuing to be the opportunity to receive substantial performance-based compensation.
Importantly, since the beginning of the global financial crisis, more and more attention has been spent by investors on understanding how the funds operate and locating areas of particular risk. For many, the fallout from the crisis has provided them with a very expensive education! Investors contemplating allocations to these asset classes today are increasingly allocating more and more time to understanding the risks each fund possess.
It is worth stressing again this fundamental linkage between highly remunerated financial professionals and large numbers of public employees with generous retirement benefits that must eventually be paid out. If the hedge fund managers and private equity professionals are not able to make up the difference between what is in these pension pots today and the contractually-mandated retirement benefits, then all taxpayers, regardless of their own personal pension entitlements, will be expected to make up the difference.
Nowhere are the principles of supply and demand more evidently in operation than in the processes of securing a prospective investor’s participation in a new private equity or hedge fund. During a particular fundraising cycle, it is not uncommon to see a very small number of elite fund managers facing massive over-subscription, while a significant number of others have difficulties obtaining money sufficient to even launch their funds. The practical implications of this tendency for investors to adopt a “herd mentality” around established brand names, influenced in part by subjective factors such as perceived exclusivity, arguably grants too many fund managers the higher ground when it comes to negotiating the commercial terms surrounding the actual investment in the fund, including provisions related to fees and expenses.
See full report below.
