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Time-Consuming, Complex, and Misconstrued: Why Pension Funds Can’t Put a Number on Private Equity Fees
The SEC and others are pushing for more transparency in private markets — but pension staffers worry about the consequences.
Days after Christmas, Erie Sampson, the ex-general counsel for the District of Columbia Retirement Board, made her move.
Disillusioned with how the $11.4 billion fund operated, she filed a lawsuit that aired her complaints, including concerns about the retirement board’s fee calculations, which she said “grossly” understated the costs paid by the fund.
Sampson alleged that when she asked the investment team to calculate total management fees, she was told that they were “unable” to calculate the total amount they paid to their managers.
Like many pension systems, the DCRB’s standard practice was to report the fees it paid to traditional investment managers, which included public equity, real assets, fixed-income managers, and “some nontraditional managers.” However, private market management fees, which are netted against investment income, were left out of the publicly reported expenses — an issue Sampson raised.
But this story isn’t about Sampson’s lawsuit, which was dismissed at the end of April. Instead, it’s about the problem her lawsuit presents: For public pension funds, private investment management fees are a minefield.
The predicament is not, as one might expect, that the fees are too damn high — even if fees are likely to come under more scrutiny with private investment returns expected to falter in the coming months.
The investment chiefs Institutional Investor spoke with stressed that the high price of private fund managers is worth paying. What they struggle with is determining what counts as a fee, ensuring that their calculations are accurate, being compared to peer funds, and negative public perception.
“People sitting inside pension funds struggle to calculate fees,” says Ashby Monk, a longtime pension researcher and academic at the Stanford Global Projects Center.
For some pension investment staffers, this isn’t easy to talk about publicly. At least, it isn’t easy to be completely candid about struggling to calculate the cost of running a fund.
One such investment team member at a public pension fund spoke to II under the condition of anonymity, breaking down how their fund thinks about costs. “The management fee is the most transparent,” the staffer says. “Then there are fund expenses, which technically are not a fee, but something that reduces their return.” These include travel expenses for conducting diligence on deals, technology costs, and legal fees, among other expenses.
Finally, there’s carried interest — the incentive fees that managers earn for good performance. In theory, those should match up to the carry fees a private-equity fund reports in the Institutional Limited Partners Association template. Used by many pension funds, the template requires private-equity firms to robustly report what they charge allocators. According to the anonymous allocator, though, these calculations don’t always line up.
Further complicating matters is the fact that some of their legacy managers aren’t subject to the ILPA template agreement, which was launched in 2016.
“I don’t think we’d be able to put together a number on carried interest we pay every year that we’d be comfortable with putting in a public document,” the pension staffer says. “If it turns out that it’s wrong, the scandal that would be is not worth it.”
In one pension chief’s view, allocators may be thinking of private-equity fees in the wrong way altogether.
“I think that the debate on private market investment fees demonstrates a fundamental misunderstanding of how this all works,” says Mark Steed, chief investment officer of the Arizona Public Safety Personnel Retirement System.
Here’s why: When an asset owner makes a capital commitment, the fee is included in that commitment. If PSPRS were to allocate $100 million to a private-equity fund, that number would include fees and expenses.
“If a portion of our capital is used as a ‘fee’ and is later returned as ‘return of capital’ with 8 percent interest, then what’s the wisdom in showing this as an expense?” Steed says. “Where do plans show that it came or comes back?”
In California’s tech-savvy hub San Jose, a team of pension staffers scan over the fund’s management fees in preparation for an annual report for board and City Council members. They reach out to the fund’s private managers, asking them to calculate management, incentive, audit, legal, and operating fees. This type of work — which may seem impossible to some of the fund’s understaffed peers — is all in the name of demonstrating exactly how much the city’s Police & Fire Department Retirement Plan and Federated City Employees' Retirement System are paying to their investment managers.
According to chief investment officer Prabhu Palani, it’s one of the more comprehensive pension fee reporting methods. Though the report is unaudited, it goes through two rounds of edits before it lands on Palani’s desk. He then checks the calculations to ensure accuracy.
“It’s a very time-consuming exercise because there’s no uniformity,” Palani says. “Luckily, I have the resources. I have a large enough team so that I can actually devote resources.”
The practice began soon after a 2014 vote required San Jose’s City Council to relinquish oversight of the pension funds, effectively granting the retirement boards independence. The measure received wide support from the public, including local newspapers, and ushered in an era of improved governance for both funds.
In the early days of the new governance structure, the board focused heavily on transparency, which included fee reporting. Years later, California would begin to push for clarity around fee reporting as well.
Enter California Assembly Bill 2833. Call up any California pension investment chief about transparency and odds are, this rule is the first thing they cite.
Passed in 2016, the law requires pensions to disclose annually at a board meeting exactly how much they pay in management and incentive fees to their alternative investment managers.
“The Californians are forced to do it pretty well,” Monk says.
Jonathan Grabel, chief investment officer at the Los Angeles County Employees Retirement Association, says the pension fund takes a “strict” interpretation of the law, reporting more than it has to with the goal of showing what the fund’s actual performance is. Understanding costs is part of LACERA’s ongoing strategic plan, and it’s something the fund has focused on at board meetings and offsite events. Even an intern project is focused on fee efficiency.
This focus on transparency, in tandem with actual fee reductions via co-investing, negotiations, and the removal of certain fund-of-fund fees, has kept LACERA’s board happy. At a June 8 meeting, board of investments chair Herman Santos praised Grabel: “This is something we can really be proud of . . . this is a victory lap.”
“It is not in response to a headline,” Grabel tells II. “LACERA and its boards believe in transparency.”
Grabel may have managed to avoid bad press — but others aren’t so fortunate.
Fee transparency, like CIO pay, can thrust public pensions into the spotlight, with local media, legislators, and laypeople turning a critical eye toward fund practices that investors immersed in the financial system’s excesses may deem par for the course.
“Challenges arise because a lot of people don’t understand the fees,” says Ajit Singh, chief investment officer at the Houston Firefighters’ Relief and Retirement Fund. “This is a complex structure.” He points to waterfalls and hurdle rates as certain concepts that may confuse industry outsiders.
Especially in years of high-flying returns like 2021, incentive fees can seem astronomical to folks not mired in the investment world. Sure, a private-equity fund may return upward of 50 percent. But to reporters, legislators, or even average citizens, the cost-benefit analysis may not be clear-cut.
“The problem with that is when legislators and outsiders look at incentive and carry, they think of it as a fee,” says one chief investment officer, who spoke on the condition of anonymity. “In a really strong year, when the funds are performing well, there’s going to be carry. Legislators tend to freak out about that.”
Calls for change follow. For instance, in 2017, the Pennsylvania Legislature began to examine fee transparency, issuing a nearly 400-page report on the subject in the years that followed. Soon after the report was published, then-state Treasurer Joe Torsella began to call for the state’s pension funds to divest from high-fee private-equity funds in favor of low-cost index funds. Torsella could not be reached for comment on this story.
“It’s good in theory for all stakeholders to have that information, but the unintended consequence is that the legislators and governing bodies are going to dictate that you can’t invest in these funds,” the CIO says.
Meanwhile, as a result of public outcry, the DCRB is changing how it operates. The pension is already in good shape — it’s fully funded and has generated an annualized gross return of 8.83 percent since October 1982. But since the lawsuit, the DCRB has actively been working toward change.
The fund issued a request for proposal to hire a consultant with expertise in investment manager fees and transaction cost verification, analysis, and management. The goal is to develop a new performance-fee validation system that will allow the board to report public and private management and incentive fees, as well as expenses, on a quarterly basis starting in fiscal year 2023.
But the Pennsylvania report revealed another problem for pension funds: the impossibility of comparing one to another. Besides each state having different laws, every fund reports fees differently too. The Pennsylvania report showed that the state’s Public School Employees’ Retirement System reports returns net of fees. Meanwhile, pension funds in Louisiana and New Jersey provide a separate report of fee terms, while the Nebraska Investment Council discloses those terms in performance reports prepared by its consultant. The California Public Employees’ Retirement System, the California State Teachers’ Retirement System, the Arizona State Retirement System, the South Carolina Retirement System, and the Texas County & District Retirement System also report on carried interest fees, according to the Pennsylvania pension’s report.
“When I report fees, it looks like it might be a larger number,” Palani says of San Jose’s practices. “But I include all expenses. A lot of my peers may not.”
Despite these challenges, Monk, who played a part in the creation of that Pennsylvania report, believes that fee transparency can force pension funds to rethink how they invest.
“My guess is that in many cases, you could generate the same return at lower risk and lower cost with an alternative strategy, but there is no incentive to do that unless you have that full picture,” he says. “You have to provide the full picture on risk, return, and cost of a strategy.”
For instance, if an allocator is paying high fees on an external manager, that investor “should know” that the manager is going to take that money and use it to build out capabilities that may allow it to charge more later on, Monk says.
“If you use that [money] internally, you may be able to generate lower fees,” Monk says. In other words: Bring more investments in-house, build up internal teams, and, ideally, replicate the Canadian model for managing pensions.
Although states are starting to follow California’s lead (Texas, according to Singh, is considering fee reporting laws), the Securities and Exchange Commission has also revealed a wide-ranging plan to bring more transparency to the $18 trillion private investment industry. The proposed rules, debuted in February, include provisions for private funds to provide investors with quarterly statements detailing fees, expenses, and performance.
“It will allow pension funds to look at what they’re invested in [and] analyze, on an apples-to-apples basis, return numbers around compensation,” says Jeremy Swan, managing principal at CohnReznick’s financial services practice. Some private-equity firms think this is “overkill,” though. “They provide this already,” Swan says. “It’s bespoke to what the LPs require. That’s where some of the concern comes in.”
According to Swan, the regulations could place an incredibly high burden on private-equity firms, particularly small ones that might need to shell out for auditing and reporting help.
Allocators, too, aren’t particularly pleased with the fee proposals. Because many rely on private contract negotiations to reduce fees, they believe the publication of contract information would inhibit their ability to do so. Some private fund advisers use pass-through models, where the fund pays for adviser expenses without charging a management fee, as Alaska Permanent Fund chief investment officer Marcus Frampton wrote in a comment letter to the SEC.
“The advantage of such a business model is that investors are charged only for the fees and expenses incurred by the adviser in connection with the conduct of its business rather than a flat management fee that may be in excess of the adviser’s cost of running the fund,” he wrote.
The comment period on the private fund rule closed in late June, with the SEC expected to issue a final rule in the months to come. The pension fund staffer interviewed by II is among those who will be waiting to see what the SEC says.
“If we look back, even after all of this, our private-equity funds have outperformed everything else,” the staffer says. “It’s like, are we willing to get punched in the face by high fees?”