Private equity investors are cautioned on the SEC website to be watchful of fees and expenses as well as aware of conflicts of interest. A lawsuit brought on behalf of Ohio Retired Teachers Association members demands that the $100 billion State Teachers Retirement System of Ohio stop stalling public records requests for teachers for more than a year and reveal the exact same information about its private equity holdings that the Securities and Exchange Commission (SEC) considers essential to safeguarding employees’ retirement savings.
STRS Ohio and its Wall Street investment advisers continue to be intent on maintaining secrecy regarding the tens of billions in state pension assets invested in more than a hundred of these expensive, high-risk private funds, despite regulatory concerns.
The SEC’s website currently offers an informative discussion of the risks of investing in private equity funds, as well as useful links to some enforcement actions the regulator has brought in connection with particular industry abuses.
The agency states up front that although private equity funds might receive advice from SEC-registered advisers, the funds themselves are not SEC-registered. Private equity funds are therefore exempt from the usual public disclosure requirements.
The organization specifically alerts investors about illiquidity, investment fees and expenses, and conflicts of interest under the heading “What should I know?”
Illiquidity
The SEC cautions that due to their long-term investment horizon, private equity funds are frequently illiquid investments that may require holding for a number of years before any return is realized. Investors’ ability to withdraw money from private equity funds is typically subject to restrictions, which are frequently 10 or more years long.
I’ve seen some funds that I refer to as “cradle-to-grave” funds that place a 50-year withdrawal cap on investors. Before you get your money back, you’ll be gone.
Fees and Costs
The SEC notes that an investor typically receives offering documents outlining important information about the investment and enters into various agreements as a limited partner of the fund when making an investment in a private equity fund. The terms of the investor’s investment, including the fees and expenses that will be incurred by funds and their investors, should be disclosed and governed by these offering documents and agreements. These are the exact same documents that members of the Ohio Retired Teachers Association have long demanded to see but that STRS Ohio and its Wall Street money managers have steadfastly refused to disclose. The SEC advises all investors, including those who participate in public pensions, to read carefully.
Active and retired teachers, as well as taxpayers, simply cannot assess whether STRS Ohio officials and the outside private equity advisers it hires are responsibly managing pension assets without access to these documents and agreements. One must question why there is such ferocious opposition to transparency if Wall Street and the pension system are both diligently carrying out their fiduciary duties.
Who or what is hiding?
Thankfully, the SEC provides a link to some enforcement actions it has brought involving fees and expenses that were incurred by funds and their investors without being sufficiently consented to or disclosed in response to the aforementioned query. The SEC advises investors to keep a close eye on the fees and costs associated with their investment.
Once more, STRS Ohio participants are unable to exercise due diligence if they are not given access to the “secret” documents pertaining to their retirement savings.
Competing interests
The SEC cautions that private equity firms frequently have interests at odds with the funds they manage and, consequently, the limited partners who have invested in the funds. Multiple private equity funds and a variety of portfolio companies may be managed by private equity firms. Usually, the funds pay the private equity company for advice services. The private equity firm may also receive payment from the portfolio companies for services like managing and keeping an eye on the portfolio company. The funds or the portfolio companies may also receive services from the private equity firm’s affiliates. To obtain informed consent, advisers are required to fully disclose all potential conflicts of interest involving the funds they manage and themselves as fiduciaries.
Again, the information that members of the Ohio Retired Teachers Association have long demanded to see and that STRS Ohio and Wall Street have steadfastly refused to disclose is information regarding all conflicts of interest, which the SEC advises all investors to read carefully. It is impossible to assess whether STRS Ohio representatives and the external private equity fund advisers are handling pension assets responsibly without access to this data.
Why is transparency so strongly resisted?
Who or what is hiding?
In relation to an adviser’s alleged failure to disclose certain conflicts of interest to the funds it manages, the SEC once more provides a link to specific enforcement actions. There is potential for advisers to gain from their many relationships, including those with affiliates and portfolio companies, at the expense of the funds they manage and their investors. The SEC advises investors to be aware of and vigilant about any conflicts that may or may not arise during their investment in a private equity fund.
Once more, teachers who are pension participants are unable to be aware of and vigilant about conflicts of interest disclosed in documents they are not permitted to access.
No Cap on Leverage
Even though the SEC website does not contain any cautions regarding the use of leverage or borrowing by private equity funds, every document I have drafted or reviewed over the course of my career for such funds allows for unlimited use of leverage. Unlimited leverage significantly raises the risk of loss, and even worse, in my experience, public pensions never properly monitor leverage in relation to private equity assets on a timely basis. In other words, public pensions are unaware of the current level of leverage in their private equity holdings.
Participants and taxpayers must closely watch the use of leverage because public pensions are already critically underfunded and are increasingly taking a risky bet on leverage to increase investment returns (and frequently, pension staff compensation). Stakeholders cannot assume Wall Street and pension officials are diligent.
Once more, participants in the STRS Ohio cannot be informed of and alert to leverage levels disclosed in documents that they, as well as likely pension officials, are not permitted to view.
Uncertainties in Valuation
Due to the illiquidity of private equity assets, advisers are given a great deal of freedom in determining the value of the assets they manage. In essence, advisers are free to set prices on their own, and there is no guarantee that the assets can or will be sold for those prices. Even worse, advisors face a conflict of interest when determining the value of assets under management because their asset-based fees rise in proportion to the assigned value.
Teachers and taxpayers are unable to assess whether the valuations are accurate or, more likely, inflated, as well as whether pension officials are meticulously monitoring portfolio valuations because STRS Ohio refuses to disclose to participants the type and amount of assets held in private equity portfolios.
The $440 billion CalPERS state pension sold a record $6 billion in private equity stakes to Wall Street last week, according to reports, at a 10% discount. That, in my opinion, amounts to a $600 million wealth transfer from workers to Wall Street. Discounts on secondary private equity sales can be much higher, up to 50%. In other words, private equity assets might be grossly overvalued, which would make public pensions seem better funded—and thus less underfunded—than they actually are. Pension stakeholders need access to information about private equity portfolios and corresponding values for their protection; however, STRS Ohio and Wall Street are battling to keep this information a secret.
I never imagined the day when government employees and retirees would be summarily denied access to prospectuses, offering documents, and agreements pertaining to the most expensive and risky investments in their retirement plans. I was a former SEC attorney.
Investors required to file a lawsuit to obtain these essential documents? I would have never foreseen it.
I’m hoping securities regulators will wake up, do their jobs, and compel disclosure rather than relying on the courts to bring back public accountability now that secrecy in public pension investing is the “new normal.”
