nakedcapitalism.comhttp://www.nakedcapitalism.com/2015/05/private-equity-standard-setter-exposes-investors-no-idea-firms-charge.html

Private Equity Standard-Setter Confirms That Investors HaveNo Idea What Firms Charge Them

Institutional and well-informed retail investors have for the last several decades recognized the importance oflimiting the fees and expenses they incur, since those will eat away at investment returns and potentially atprincipal. That’s a big reason for the rise in popularity of index investing. In stock and bond investing, where feesand costs are transparent, academic studies have repeatedly confirmed that active investment managers don’tgenerate enough (if any) outperformance to justify their higher fees and costs.

As we’ve discussed in previous posts, investors in private equity can only see the books and records of theinvestment fund, that is, the limited partnership entity in which they invest. They have no right to examine thefinancial records of the companies in which they invest. That has led to tons of mischief, including, as former SECexamination chief Andrew Bowden said in a speech last May, that taking of impermissible charges, which in mostcircles would be called stealing or embezzlement. (Notice how private equity misconduct is whitewashed throughthe use of tepid terminology).

A corollary of investors not seeing the monies that private equity firms pilfer, um, route from investee companiesdirectly into the firms’ pockets is that they have no clue as to how much they are paying in total for the privilege ofhaving private equity manage their money. A major standard-setter in the private equity industry, CEMBenchmrking, has thrown down a gauntlet to investors. It said in a recent report that it is impossible for privateequity investors to know how much they are paying in private equity fees and costs. Moreover, CEM also pointsout that most public pension funds are not complying with government accounting standards in how they reportprivate equity fees and costs, and that based on their benchmaring efforts with the South Carolina RetirementSystem Investment Commission and foreign investors, most public pension funds are missing at least half of thetotal costs.

This report is particularly significant because CEM is an authoritative voice in the investment industry. It didn’tsimply say that public pension funds are out to lunch as far as not understanding what they were investing in. Italso pointed out as a result, the public pension funds have been not been reporting fees accurately are out ofcompliance with government reporting requirements. Mind you, the CEM report does not make a bald statementto that effect, but points to new accounting standards implemented in 2012 regarding “separability” (which onemight think of as “identifiability”) of costs and expenses, which CEM contends should have led to moretransparency. The fact that the South Carolina Retirement System Investment Commission can isolate thesecosts means there is no good excuse for the failure of other public pension funds to do the same.

So why have public pension funds (and their private investor cousins) chosen to put their heads in the sand as faras the true costs of investing in private equity are concerned? David Sirota and Matthew Cunnningham-Cookreported on the CEM study shortly after it was released and hint that it may well have to do with the desire ofpublic officials to curry favor with powerful political donors. While this is no doubt true in some cases, the lack ofinquisitiveness likely has at least as much to do with bad incentives at the public pension funds themselves.

At most public pension funds, the teams that oversee public pension funds get to travel and go to lavishconferences, and they (bizarrely) regard the PE funds as partners, as opposed to vendors. The staff has noreason to make their life difficult by working harder on issues that would make the dealings with PE fundsadversarial and hence more stressful for them. It’s the path of least resistance to go through due diligence andcompliance theater rather than the real thing. After all, exposing how hugely costly PE investing really is wouldmake it much more controversial to allocate funds to the strategy. Lower allocations would likely mean lowerstaffing in those areas, potentially putting their jobs at risk.

Gretchen Morgenson of the New York Times weighed in over the weekend. Morgenson pointed out that Oxford

professor Ludovic Phalippou wrote in a 2009 paper that the typical private equity fund charged a whopping 7% intotal fees per year. CEM didn’t come up with a hard figure, but the CEM study is generally consistent withPhalippous’ grim reading. As Morgenson wrote:

CEM concluded that the difference between what funds reported as expenses and what theyactually charged investors averaged at least two percentage points a year. For a $3 billion privateequity portfolio, that would add up to $61 million.

And this estimate, CEM acknowledges, is probably low. It comes from Dutch pension fund data,and Europeans pay far less to private equity firms than pension funds in the United States typicallydo, investment experts say.

What is particularly disconcerting (and we’ve previously written about this sort of misguided reasoning atCalPERS) is that public pension funds are typically choosing to kid themselves about one of the most basic,visible fees they pay, the annual management fee. That charge is clearly set forth in the investmentdocumentation. But investors in most funds don’t pay that all of that fee in cash. Due to a combination of investoracquiescence and tax issues, when investors have pushed back against other fees, like transaction fees, themechanism for reducing them has been to rebate (or “offset”) those fees against the management fee. But whatdo the investors like CalPERS do? Treat the management fee as if it has been reduced since the cash paymentare lower. That is simply barmy. The management fee is unchanged, but part of the cash payment now comesdirectly from the portfolio companies (the effect of the rebates is to shift part of the payment to them) and thebalance from the investor.

A source for Morgenson’s story and a figure in past NC posts, CalPERS board member JJ Jelincic, pointed outthat this willful blindness about fees and expenses also means that funds like CalPERS aren’t able to do anadequate job of negotiating. And remember, the behemoths like CalPERS do have negotiating leverage.

Mr. Jelincic, who before joining the board was on the Calpers staff for 24 years, said in an interviewthat being in the dark on fees created problems for the overseers of the $300 billion pension fund.

“You don’t think to negotiate on fees that you’re not aware you’re being charged,” he said. “As atrustee I’m really concerned about not knowing what we’re paying on private equity. We may begetting a really good deal, we may be getting a really bad deal. I just don’t know.”

Warren Buffett explained this issue in colloquial terms in 2006:

To understand how this toll has ballooned, imagine for a moment that all American corporationsare, and always will be, owned by a single family. We’ll call them the Gotrocks…

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of itsmembers to try to outsmart his relatives by buying certain of their holdings and selling them certainothers.

The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocksstill own all of corporate America; the trades just rearrange who owns what. So the family’s annualgain in wealth diminishes, equaling the earnings of American business minus commissions paid.The more that family members trade, the smaller their share of the pie and the larger the slicereceived by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and,in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new “beat

my- brother” game. Enter another set of Helpers. These newcomers explain to each member of theGotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hirea manager – yes, us – and get the job done professionally.” These manager-Helpers continue touse the broker-Helpers to execute trades; the managers may even increase their activity so as topermit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the twoclasses of Helpers.

The family’s disappointment grows. Each of its members is now employing professionals. Yetoverall, the group’s finances have taken a turn for the worse. The solution? More help, of course. Itarrives in the form of financial planners and institutional consultants…

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse,and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results areoccurring because the existing Helpers – brokers, managers, consultants – are not sufficientlymotivated and are simply going through the motions…

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees– are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really justmanager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND orPRIVATE EQUITY…

And that’s where we are today: A record portion of the earnings that would go in their entirety toowners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers.Particularly expensive is the recent pandemic of profit arrangements under which Helpers receivelarge portions of the winnings when they are smart or lucky, and leave family members with all ofthe losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionallycrooked). A sufficient number of arrangements like this – heads, the Helper takes much of thewinnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it moreaccurate to call the family the Hadrocks.

Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings ofAmerican business. In other words, the burden of paying Helpers may cause American equityinvestors, overall, to earn only 80% or so of what they would earn if they just sat still and listened tono one.

Yet here we are, nine years later, and soi-disant fiduciaries have continues to allocate more and more money toalternative investment strategies like private equity, even as returns flounder. But that is because people likeBuffett mistakenly believe that these fidiciaries are in the game of delivering the best risk-adjusted returns for theirbeneficiaries. In reality, the name of the game is blame and liability avoidance, so hiring costly Helpers is afeature, not a bug.

CEM_article_-_The_time_has_come_for_standardized_total_cost_disclosure_for_private_equity