The SEC Is Bearing Down on Private Equity. Blame Public Pensions.

Regulators can no longer ignore private equity, now that public pension funds provide 35 percent of the industry’s capital, argues a new paper.

Brent Lewin/Bloomberg

Brent Lewin/Bloomberg

Public pension plans, which supply over 35 percent of the capital to private equity firms, have shaped the operations of the industry — and how it’s regulated.

In a new paper, William Clayton, an associate professor of law at Brigham Young University’s J. Reuben Clark Law School, argues that public pension plans’ presence in PE has opened the door for the Securities and Exchange Commission to regulate the industry, complicated contracts, and changed the balance of power in negotiations. The paper, titled “How Public Pension Plans Have Shaped Private Equity,” is set to be published in the forthcoming issue of the Maryland Law Review.

“The SEC’s approach to this industry has evolved over time, and there hasn’t been much reflection on what’s driving that,” Clayton told Institutional Investor. “I think public pension plans play an important role in that story.”

Indeed, just last October, SEC Chair Gary Gensler testified before the House Financial Services Committee, arguing that private companies should be required to disclose more information, in part because public pension funds would be able to make more informed investment decisions.

In the paper, Clayton uses the SEC’s three-part mission — “to protect investors, promote capital formation, and maintain fair, orderly, and efficient capital markets” — as an analytical framework. He added that public pension plans have “dramatically” affected how federal policymakers should consider the application of these elements to the PE industry.

For one, the “massive” amount of public pension plan money allocated to the private equity industry has disrupted the nature of contracts, including their “orderliness” and “efficiency.”

“The fact that there’s so much public money in the space that is managed by public governmental sources changes it,” Clayton said. “It’s not this pure, ideal, private contracting space that is assumed in academic models.”

Public investment in PE has resulted in more regulatory influence on contract terms, according to the paper.

“When each institutional investor has a different set of required terms that they are required to obtain, it becomes difficult to reflect those terms in the same document as a practical matter. This has contributed to a process that has been criticized as unnecessarily burdensome and costly,” wrote Clayton. Terms include customized reporting and information requirements, waivers of jury trials, as well as detailed policies on FOIA requests, political contributions, placement agents, and sovereign immunity requirements.

In the mid-2000s, as pensions began significantly increasing their investments in private equity, regulators started paying attention.

“Around the same time that all this public capital is flowing into the industry, you see the SEC’s relationship with the industry start to shift — around 2012,” Clayton told II.

Regulators have gotten more involved in private investments on the grounds of protecting investors and pensions’ beneficiaries, largely public employees, such as teachers and firefighters.

“In response to questions about why the SEC had dramatically expanded its private equity examination program and brought enforcement actions against private equity fund managers in the mid-2010s, the SEC repeatedly invoked the massive presence of public pension plans in the industry and the potential for negatively impacting pension beneficiaries and taxpayers,” according to the report.

Before the global financial crisis in 2008, the oversight of private investment funds was not a priority for regulators. Since then, Congress’ amendment to the Advisers Act, which regulates investment advisers, required PE managers to register with the SEC. In the early- and mid-2010s, the SEC established a unit specifically to watch over private funds.

“Public pension plans have helped to make what’s happening in the private equity space relevant for the SEC,” Clayton said.

For all the regulatory oversight, however, aggregate money from public pension funds has only increased competition and made it harder for individual pensions to get into the best funds or negotiate lower fees. According to the paper, institutional investors have long cited an “imbalance in bargaining power” resulting from private equity funds’ governance terms that are increasingly “extremely manager-favorable.” As institutional demand for private equity investments increases and an industry-wide perception that only a small number of managers are able to generate significant returns in the asset class, investors hesitate to negotiate aggressively for fear of being “frozen out” of funds, the paper argued.

As a result, the paper concludes that private equity is, in fact, “far more public than is commonly understood” and is “not the pure private market contracting setting that a surface-level view of the industry might suggest,” Clayton wrote.

Amy Lynch, founder and president of FrontLine Compliance, an institutional asset management consultant, said there’s no doubt that the sheer volume of money that public plans have poured into private equity funds has had an impact on the industry.

“When a public pension comes in and says ‘we’ll give you $75 million in your fund,’ they’re going to expect special treatment,” Lynch said. “So the private equity firms are having to acquiesce to the needs of these pensions.” Clearly, however, it’s worth it. Private equity and alternatives firm Blackstone is the largest publicly traded asset manager as measured by market cap, according to a list from CL-Media Relations. What’s more, 7 of the top 10 firms are in private markets, including KKR, Ares, Blue Owl, and Apollo.