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Some Private Equity Firms Want More Opacity In Dealings With Pension Funds

Private equity firms are growing uncomfortable with the amount of information disclosed by pension funds about their private equity investments.

PE firms are cautioning their peers to make sure non-disclosure agreements are in place to prevent the public release of information that firms don’t want to be made public.

Stephen Hoey, chief financial and compliance officer at KPS Capital Partners, said this, according to COO Connect:

“We had correspondence with a municipal pension fund relating to the Limited Partner’s inquiry regarding the SEC’s findings from our presence exam. We objected to our correspondence with the LP of matters not relating to investment performance including notes taken by the LP representatives being submitted to reporters under the Freedom of Information Act (FOIA). It is our communications with LPs other than discussions about performance metrics that we object to being in the public domain.”

Pamela Hendrickson, chief operating officer at The Riverside Company, said PE firms should know exactly what pension funds are allowed disclose to journalists. From COO Connect:

“GPs should make sure their LP agreements and side letters are clear about what can be disclosed under a Freedom of information request. GPs must comply with any non-disclosure agreements they have with their portfolio companies and information provided under the Freedom of Information Act should be restricted to ensure that the GPs remain in compliance,” said Hendrickson.

It’s already very difficult for journalists to obtain details and data regarding the private equity investments made by pension funds.

But PE firms are worried that the SEC will crack down on fees and conflicts of interest:

The SEC has recently been questioning private equity managers about their deals and fees dating all the way back to 2007. There is speculation the US regulator could clamp down on private equity fees following its announcement back in 2013 that it would be reviewing the fees and expenses’ policies at hedge funds amid concerns that travel and entertainment costs, which should be borne by the 2% management fee, were in fact being charged to end investors.

“The SEC is taking a strong interest in fees, and this has become apparent in regulatory audits as they are heavily scrutinising the fees and expenses that we charge. Following the Bowden speech, we received a material number of calls from our Limited Partners whereby we explained our fee structure and how costs were expensed accordingly. We also pointed out that our allocation of expenses was in conformity with the LP agreements, which is the contract between the General Partner and a fund’s limited partners,” said Hoey.

COO Connect, a publication catering to investment managers, encourages PE firms to use non-disclosure agreements to prevent the public release of any information the firms want to remain confidential.

Photo by Truthout.org via Flickr CC License

Hedge Funds Feel “Pressure” To Reduce Fees

Some major hedge fund managers are feeling “pressure” to reduce fees according to the Wall Street Journal:

Two titans of the hedge-fund and private-equity world say they are growing more open to reducing fees in the face of rising scrutiny of the compensation paid to managers of so-called alternative investments.

[…]

Mr. [John] Paulson [founder of hedge fund firm Paulson & Co.] said he feels “pressure” to act in the wake of “enormous numbers in compensation” for hedge fund managers. Mr. Paulson, 58, earned a reported $2.3 billion last year, counting both fees and the appreciation of his own personal investment in his funds.

“Institutions are becoming a little more demanding…they are putting pressure on the management fee and the incentive fee,” he said Monday during a panel discussion at New York University’s Stern School of Business.

Joseph Landy, co-CEO of $39 billion buyout shop Warburg Pincus, echoed Mr. Paulson’s experience.

“There are a lot of private-equity managers out there who can make a lot of money before they return a dime to investors,” Mr. Landy said. “Most of the pressure [to reduce fees] has been on the actual annual management fee.”

Neither he nor Mr. Paulson, however, were too concerned about any widespread threats to their businesses.

“We came out relatively unscathed from the crisis. We’re doing pretty much the same things we did as before [with] very little restrictions on how we invest the money,” Mr. Paulson said.

Paulson said he think more hedge funds will start using “hurdles”, a fee structure which prevents managers from collecting performance fees until they’ve met a certain benchmark return. From the WSJ:

John Paulson, founder of $22 billion hedge-fund firm Paulson & Co., said he predicted more use of instruments known as hurdles, which bar managers from collecting their traditional 20% performance fee until they have earned a minimum return over a benchmark.

Traditionally, hedge funds are paid for any positive performance whatsoever–even if it falls well short of targets—in addition to a flat annual fee in the range of 1-2% for operating expenses.

Patriot News: Are Hedge Funds Right For Pennsylvania?

Last week Pennsylvania’s auditor general publicly wondered whether hedge funds were a sound investment for the state’s “already stressed” pension systems.

The crux of the auditor’s concern was the millions in fees paid by the system. In an editorial Monday, the Patriot News also questioned the fees incurred by hedge fund investments – including the fees that the public doesn’t know about. From the Patriot News:

The Pennsylvania State Employees’ Retirement System (PSERS) paid about $149 million in fees to hedge funds in fiscal year 2013, according to WITF, the public broadcasting station.

The Philadelphia Inquirer has noted that “It’s hard to know how much Pennsylvania SERS paid, since some SERS hedge fund fees aren’t included in the agency’s annual report.”

WITF also noted that it’s not clear what the pension fund got after paying all that money, which is the point raised by Auditor General DePasquale.

[…]

Pennsylvania has been one of the most aggressive states investing in “alternative” vehicles like hedge funds. In 2012, The New York Times reported that Pennsylvania’s state employees pension fund had “more than 46 percent of its assets in riskier alternatives, including nearly 400 private equity, venture capital and real estate funds.”

Those investments cost Pennsylvania $1.35 billion in management fees in the previous five years, according to the Times report.

The editorial wondered whether the state was really getting what it paid for performance-wise. From the Patriot News:

During that time, it appears Pennsylvania paid more and got less than other states did.

Over the five-year period, Pennsylvania’s annual returns were 3.6 percent. During that time, the New York Times report said the typical public pension fund earned 4.9 percent a year. And Georgia, which was barred by law from investing in high-fee alternative funds, earned 5.3 percent a year.

Georgia’s fees were a lot lower, too. For a pension fund about half the size of Pennsylvania’s, it paid just $54 million in fees over the five years. Pennsylvania paid 25 times as much for results that were significantly worse.

Pennsylvania’s two big pension funds are tens of billions of dollars short of being able to pay all the money they’ll owe to retirees.

One has to wonder whether one reason is that the funds are spending too much money on supposedly sophisticated investments that aren’t worth the cost.

It’s a question the Legislature needs to answer.

SERS allocates 7 percent of its assets, or $1.9 billion, towards hedge funds. PSERS, meanwhile, allocates 12.5 percent of its assets, or $5.7 billion, towards hedge funds.

North Carolina Pension To Stick With Hedge Funds As Major Union Calls For Divestment

A few days after CalPERS pulled out of hedge funds, the State Employees Association of North Carolina (SEANC) called on North Carolina’s pension fund to do the same.

The pension fund, however, has shown no willingness to follow in CalPERS’ path, and recently doubled down on its support of hedge funds as part of its portfolio.

Originally, SEANC released this statement:

“Other institutional investors around the world could potentially follow CalPERS’ lead and finally dump these high-risk funds,” said SEANC Executive Director Dana Cope. “Those who wait to cash in may find the money’s gone. That’s not a risk state workers are willing to take. It’s time to pull out of these investments now before the cart starts going downhill too fast for us to jump off.”

Hedge funds are notorious for high fees. Pension funds and investors pay these fees in hopes that the payoff will be higher, but for the past decade, hedge fund performance has been lacking. Cowell has the power to invest of 35 percent of the $90 billion state retirement system in “alternative investments,” a term that includes hedge funds.

But North Carolina hasn’t budged, and pension officials have supported their hedge fund allocation. From the News & Observer:

Kevin SigRist, chief investment officer of North Carolina’s $90 billion fund, said that the state is by and large pleased with the performance of its hedge fund investments and plans to stay the course.

North Carolina’s hedge fund investments generated an 11.48 percent return for the fiscal year that ended June 30, as well as a three-year return of 6.86 percent and a five-year return of 7.59 percent. That 11.48 percent return bests the 7.1 percent return that CalPERS reported from its hedge fund portfolio and compares to the state’s 15.88 percent overall return for its latest fiscal year.

“We would expect to continue to evaluate (hedge funds) and use them where appropriate and where we think there are benefits to the trust fund,” SigRist said.

[…]

SigRist said that the fact that hedge fund investments cut across asset classes is at the heart of why North Carolina doesn’t disclose how much of its pension fund is allocated to hedge funds – a practice that has drawn SEANC’s ire. Although the pension fund has stipulated the allocation to hedge fund strategies, he added, that’s only a piece of the pie because it’s based on an antiquated concept of what a hedge fund is.

Currently, North Carolina’s pension system has $3.9 billion in hedge funds, or 4.3 percent of total assets. They paid $91 million in fees to those funds in 2013.

Report: Maryland Fund Lost Billions Due To Underperformance

The Maryland State and Retirement Pension System returned 14.4 percent last fiscal year – a return that the Chief Investment Officer praised as “strong” and that doubled the fund’s expected rate of return of 7.75 percent.

But a new report from the Maryland Public Policy Institute claims that the returns weren’t good enough From the Maryland Reporter:

In a report, Jeffrey Hooke and John Walters of the Maryland Public Policy Institute say the failure to match the 17.3% return on investment made by over half the public state pension funds cost the state over $1 billion. As they have in the past, they also complained about the high fees paid to outside managers of some of the funds used by the State Retirement and Pension System, which covers 244,000 active and retired state employees and teachers and their beneficiaries

“As the table shows, the underperformance trend is not only continuing but worsening as the percentage divide widens,” said Hooke and Walters. “Part of problem may be due to the fund’s large exposure to alternative investments, such as hedge funds and private equity funds, that have tended to perform worse in recent years than traditional investments such as publicly traded stocks and bonds.”

A spokesman for the Maryland pension fund offered his response to the report:

[Spokesman] Michael Golden said the institute’s report was “flawed,” “not supported by facts,” and mischaracterized the agency’s investment performance.

“These returns have resulted in greater progress toward full funding of the system that was projected last year,” Golden said. The five-year return on investment was 11.68%, while the target for the fund is 7.7%.

[…]

Golden admitted that Maryland’s investment performance is “unimpressive” compared to other state funds.

“However, the reason for this ranking is not due to active management and fees,” Golden said. “After the financial crises of 2008-2009, the board determined that the fund had too much exposure to public equities, which historically has been one of the riskiest, most volatile asset classes, and wanted a more balanced and diversified portfolio.”

See the chart at the top of this post for a comparison between the returns of Maryland’s pension fund versus the Wilshire’s Trust Universe Comparison Service (TUCS), a widely accepted benchmark for institutional assets.

Pennsylvania Not Cutting Hedge Funds Despite State Auditor’s Skepticism

CalPERS’ decision to pull out of hedge funds is having a ripple effect across the country.

On Wednesday, Pennsylvania Auditor General Eugene DePasquale released this skeptical statement on the state pension system’s hedge fund investments:

“Hedge fund investments may be an appropriate strategy for certain investors and I trust that SERS and PSERS weigh investment options carefully,” DePasquale said in a statement. “But, SERS and PSERS are dealing with public pension funds that are already stressed and high fees cost state taxpayers more each year. I support full disclosure of hedge fund fees paid by our public pension funds and we owe it to taxpayers to ensure that those fees do not outweigh the returns.”

Spokespeople for both the State Employees Retirement System (SERS) and the Public School Employee Retirement System (PSERS) have now responded. The consensus: the pension funds will not be cutting their hedge fund allocations.

From Philly.com:

SERS has no plans to cut hedge funds further. “Hedge funds play a role in our current board-approved strategic investment plan, which was designed to structure a well-diversified portfolio,” SERS spokeswoman Pamela Hile told me. With many more workers set to retire, hedge funds (or “diversifying assets,” as SERS prefers to call them) combine relatively steady returns with low volatility “over varying capital market environments.” By SERS’s count “difersifying assets” are now down to $1.7 billion, or 6% of the $28 billion fund and returning 10.7% after fees for the year ending June 30, up from a 10-year average of 7.4%.

Says PSERS spokeswoman Evelyn Williams: “We agree with the Auditor General that hedge funds are appropriate for certain investors. Not all investors can or should invest in hedge funds. Clearly CALPERS reviewed their hedge fund allocation and acted in their own fund’s best interests.

“PSERS also sets our asset allocation based on our own unique goals and issues. We do not have any immediate plans to change our hedge fund asset allocation at this time… PSERS’ hedge fund allocation provides diversification for our asset allocation and is specifically structured so it does not correlate with traditional equity markets…PSERS hedge fund allocation has performed as expected and provided positive investment returns over the past fiscal year, one, three, and five years.”

SERS allocates 7 percent of its assets, or $1.9 billion, towards hedge funds. PSERS, meanwhile, allocates 12.5 percent of its assets, or $5.7 billion, towards hedge funds.

Photo by TaxRebate.org.uk

Pulitzer Prize Winner: Hedge Funds Not Worth The Risk For Pensions

David Cay Johnston, former Pulitzer prize-winning reporter for the New York Times and lecturer at Syracuse University, has written a column calling for pensions to stop risking assets with hedge funds.

He says the nature of hedge funds make the investment “not suited” for pension funds. First, he takes hedge funds to task for their fee structure. From the piece, published on Al-Jazeera:

Hedge funds charge hefty fees. Many hedge funds charge what is known in the trade as 2 and 20. That is for a 2 percent annual management fee, or $20,000 per $1 million, and 20 percent of all gains. Julian Simon’s Renaissance Technologies charges a 5 percent base and 44 percent of gains. From 1982 through 2009, when it averaged extraordinary 35 percent annual returns after expenses, that was a great deal, but since then, Simon has underperformed the market.

Compare these numbers with the very well-managed ExxonMobil pension fund, which its latest disclosure reports show has overhead charges of less than $1,200 per $1 million. Vanguard 500 investors pay as little as $500 annually to manage $1 million.

To get a better sense of the numbers, consider a year when the market return is 5 percent and a hedge fund earns that. On a $1 million investment, after a 2 percent management fee and a 20 percent profit performance fee, the hedge fund investor will be ahead by $19,200, or less than 2 percent; the Vanguard investor will be ahead by $49,950, or almost 5 percent.

The other facet of his argument is that hedge funds, while not necessarily a bad investment for other entities, are not a “prudent” investment for pension funds to make. From the editorial:

Hedge funds simply are not appropriate for taxpayers and public-sector workers. They are, rather, for wealthy speculators willing to take big risks in the hopes of earning big rewards while being able to tolerate the chance that an investment will shrivel or even be wiped out.

Pension money should be invested prudently. “Prudent” comes from the word “provident,” meaning to prepare for the future. And while its origins are in religious concepts, failing to prudently handle earthly money can turn the end of life into hell.

Given survivor benefits in pension plans, these pools of money should be treated as widows-and-orphans money. Under ancient and well-tested principles, the money of such vulnerable people must be invested with exceptional care to safeguard from loss. That means investment-grade bonds (more on that below) and either blue chip stocks or broad indexes.

Only with the rise in the last six decades of modern portfolio theory — investing in many different arenas to spread risk — have we gotten away from the idea that for widows, orphans and pensioners, only high-grade corporate bonds and a few blue chip stocks paying big dividends are appropriate investments.

The rest of the piece can be read here.

Europe’s Largest Pension Is “Extremely Happy” With Hedge Funds

Eduard van Gelderen, the newly appointed CIO for ABP, Europe’s largest pension fund, yesterday gave his first interview since taking the job.

ABP is the pension fund for Netherlands’ public workers and controls over $360 billion in assets.

In the interview, van Gelderen addressed the trend of some pension funds scaling back their hedge fund allocations – and said his fund will have no part in it. From Chief Investment Officer:

“No,” says Eduard van Gelderen, the man overseeing investments for ABP, Europe’s largest pension fund. “No. Absolutely not. We are extremely happy with them [hedge funds].”

[…]

“[For us], hedge funds are taken care of by New Holland Capital”—an independent holding that span out of APG almost a decade ago—“and we are extremely pleased with the track record they have shown over the last years.”

At the end of 2013, ABP had assets of around €288 billion, of which it had a 5% strategic allocation to hedge funds, according to its annual report. This allocation outperformed its benchmark by 619 basis points last year and van Gelderen—who took over as CIO from Angelien Kemna on September 1— is resolute that hedge funds will remain a part of the portfolio APG manages for Europe’s largest pension.

ABP’s hedge fund portfolio is more than four and a half times larger than CalPERS’ portfolio was before it pulled out of the asset class.

Read the full interview here.

Photo credit: “EU-Netherlands” by NuclearVacuum. Licensed under Creative Commons Attribution

Advisors Question Hedge Fund Fee Structure

In light of CalPERS’ recent pullback from hedge funds, scores of investment consultants are coming out of the woodwork advocating for changes to the “2 and 20” fee structure traditionally used by hedge funds.

Towers Watson research chief Damien Loveday told the Wall Street Journal yesterday:

“We believe a better way of tackling fees is by assessing the skill managers offer to clients, rather than paying for market-based returns. ‘Two and 20’ should not be the norm.”

Kerrin Rosenberg, an executive at the consulting firm Cardano, shared the sentiment:

“If ever there was a moment to get rid of ‘two and 20’ forever, this is it.” He backed Towers Watson’s initiative, noting that many hedge funds were out to survive, rather than prosper.

Just because consultants think one way doesn’t mean pension funds will think the same. But it’s important to note that these firms frequently advise pension funds on investment decisions—so it’s safe to say the funds are hearing the same anti-fee sentiment that we are.

Last week, a major Dutch pension fund shut out hedge funds and cited one reason: the fees. From the Wall Street Journal:

Last week, PMT, the Dutch pension fund with €56 billion ($71.7 billion) under management, said it would close its €1 billion hedge fund portfolio, adding that although hedge funds were only about 2% of assets, they collected 32% of the investment fees it paid.

A spokeswoman for the fund said: “The hedge fund investments were expensive if you relate the cost to what the funds delivered. We found that we did earn from hedge funds, but we did not earn enough versus the risks and the costs.”

To be fair, it seems hedge funds have budged just a bit from the “2 and 20” scheme. According to Preqin data, fees have fallen to around 1.5 percent of assets and 18.7 percent of performance.

Public Pension Funds Drive Venture Capital Boom, But Performance Is An Issue

The venture capital industry is becoming a major force again, and pension funds are the major driver of the resurgence. From Businessweek:

Public pension funds—the state-run investment pools responsible for the retirement benefits of nearly 20 million Americans—have quietly been funding the recent boom in venture capital. The investment pools are made up of tax dollars and contributions from state employees. For the last few years, they have made up the biggest single source of funds flowing to venture capital, according to the most recent Dow Jones Private Equity Analyst Sources of Capital survey. In 2014, they contributed 20 percent of the sector’s overall haul, down slightly from a 25 percent contribution in 2013.

Indiana’s Public Retirement System allocates (PDF) 1.6 percent ($363 million) to venture capital, which is on the higher end as a percentage of assets; the California Public Employees’ Retirement System (CalPERS) allocates a more typical half percent of assets, although the fund is so big that this meager fraction totaled $1.8 billion in 2013. The amounts are small enough that if pension funds’ entire venture capital investments were to evaporate, pensioners would still be all right. In most states, pension obligations are guaranteed by state constitutions. If the investments—in venture capital or anything else—don’t pay off, taxpayers are on the hook for the shortfall.

But there’s a problem: some of the best venture capital funds don’t want to do business with public pension funds. From Businessweek:

Because public pensions must be transparent about their investments, which are subject to the Freedom of Information Act, many top-performing venture capital funds won’t accept pension money; they don’t want to publicly disclose their portfolios. This makes public pensions pick from other—often lesser-performing—funds.

Like hedge funds and other kinds of private equity, venture capital funds charge an annual management fee of 2 percent, plus 20 percent of profits. Performance is an open question. Many funds fail to perform (PDF) as well as an Standard & Poor’s 500-stock index fund. Diane Mulcahy,senior fellow at the Kaufmann Foundation, has observed that many venture capital funds aren’t profitable and that steady fee income diminishes the funds’ incentive to find profitable investments.

Other institutional investors are funding the VC resurgence, as well. Endowment funds provided the VC industry with 17 percent of its capital in 2014, according to the Dow Jones survey. Corporate pension funds accounted for 7 percent, while union pension funds accounted for 2 percent.

Photo by c_ambler via Flickr CC License

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