Harrison Fiduciary

Fiduciaries must drill down on Expenses

Investment managers and service providers to qualified retirement plans must disclose the fees they charges to the plan fiduciaries of the investing plans.  The Department of Labor launched a huge project many years ago focusing on these fee disclosures which culminated in a Final Regulation being issued in 2012.

ERISA lawyers, plan sponsors and services providers have devoted endless hours to compliance with the 408(b)(2) requirements.

Where have the Private Equity firms been?   And, where have the fiduciaries been?

Gretchen Morgenson reported yesterday, Pension Funds Can Only Guess at Private Equity’s Cost, that with respect to “rates of return and hidden costs”, private equity funds are as “impenetrable as a lockbox”.

Why are plan fiduciaries still guessing?

Many private equity funds implement restrictions with respect to the character of their investors so as to avoid certain requirements of ERISA.  Notwithstanding these limits, however, many ERISA qualified funds, as well as public retirement funds, do in fact, invest in private equity funds.   The fiduciaries of these plans have a statutory duty to determine that compensation paid to service providers is reasonable.   The disclosure regulations are designed to facilitate this determination.

According to Morgenson a few public investors, namely the Treasurer of the State of South Carolina, and a member of CalPERS, have tried to obtain data and information to assess whether the fees paid to private equity firms constitute reasonable compensation.   But, obtaining this data can be a challenge.

Furthermore, the relevant accounting rules are not clear.

Despite the opacity surrounding these fees, Morgenson reports that consultants and business academics have begun challenging the accuracy of the fee disclosures.  Morgenson links to a recently released study by CEM Benchmarking,  based in Toronto which addresses many of the complexities and deficiency with respect to recent fee disclosures.

All ERISA fiduciaries are on Notice.  It is your obligation to dig deep to understand the fees associated with a private equity investment.  Any fiduciary who does not have the expertise to make these determinations, should hire an expert for assistance.  Failure to do so could be a breach of fiduciary duty.

Given the resistance by Private Equity firms to these disclosures, the requests must be persistent, consistent and demanded by all investor fiduciaries.  Plan participants deserve as much.

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Seems Like Some Fiduciaries May Be Asleep at the Switch

The SEC is attempting to cast some sunlight on to the tangle of fees charged by private equity firms.  The Deal’s Done. But not the Fees, Gretchen Morgenson.  My question, as if often the case is, “Where are the plan fiduciaries?”

Moregenson points out that in addition to the typical “2 and 20” fee arrangement (2% management fee, 20% performance fee), private equity advisory firms charge investors a host of other fees, many of which are buried deep in disclosure and other documents.

The SEC, apparently, is now hip to these tricks.

Morgenson notes that private equity investments constitute $3.5 trillion of the $64 trillion asset management industry.  The Investment Company Institute reports that as of December, 31, 2013, total US retirement assets were $23 trillion. With respect to these assets, managers must not only abide by the rules of the SEC, but also ERISA (the Employee Retirement Income Security Act of 1974).  Admittedly, many private equity funds are structured in a manner designed to avoid ERISA, however, not all are so structured.

ERISA imposes a regulatory regime which is materially different than the regulatory regime imposed by the securities laws. Whereas the securities laws rely heavily upon the “sunshine” of disclosure, ERISA places affirmative duties on fiduciaries with respect to the investment and monitoring of plan assets.

Therefore, the SEC’s efforts should be supplemented by the Department of Labor.  While the SEC can direct its attention on the advisors, the DOL can focus on plan fiduciaries.

The questions for the plan fiduciaries are simple:

1. Were they aware of theses intricate fee arrangements?
2. Did they analyze and review the various fees?
3. Did they conclude that the fees are reasonable and sign-off on the reasonableness of the fees?

ERISA requires that fees paid out of plan assets must be reasonable.  In fact, a couple of years ago new regulations were issued related to plan expenses.  Mutual funds and various other plan service provides have been jumping through hoops to comply with these new regulations.  What about private equity funds?

Another ERISA concern revealed by Morgenson relates to various relationships which might give rise to conflicts of interest.  Again, ERISA takes a different approach than the securities laws.  Under the securities laws, generally, disclosure is sufficient to “cure” a conflict of interest.  The thinking is that once effectively disclosed, sophisticated investors can consent to these conflicts.

Not so under ERISA.

ERISA contains a set of requirements which preclude a series of transactions known as “Prohibited Transactions”.  The types of transactions are fairly explicit, and, simply put, they are prohibited, not allowed, barred.   It’s really plain english.   Disclosure and consent are not remedies.  Conflicts of interest clearly constitute Prohibited Transactions.

Allowing a plan to engage in a prohibited transaction constitutes a breach of fiduciary duty under ERISA.  Therefore, plan fiduciaries typically are vigilant in detecting these prohibitions.

At a minimum, in light of Morgenson’s article, and the SEC’s questioning, plan fiduciaries need to examine whether in fact a plan’s private equity investments is subject to ERISA.  If it is, then further diligence may be necessary.

These concerns are not intended to disparage private equity investments.  Private equity managers have delivered consistent returns for their investors over the past decades.  But, like any investment, past performance is not a guarantee of future results.  Private equity investments clearly can play a role within a larger portfolio of plan investments.

However, private equity investment structures need to pass the same regulatory scrutiny imposed upon all other advisors and services providers to retirement plans.

Morgenson’s article suggests that possibly plan fiduciaries may have been asleep at the switch.  Her article puts fiduciaries on notice as to where they should be directing some attention.

Any fiduciary not up to the task of demanding information and asking hard questions of private equity advisors should delegate that task to fiduciaries who are prudent experts.  Plan participants and beneficiaries deserve no less.

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Let’s Remember Who Owns the Assets

“At base, having a small elite with vast wealth is good for the poor and middle class”, explains Edward Conard, former partner of Mitt Romney and author of the soon-to-be published, Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong. Conard’s views are explored in an article in yesterday’s Magazine Section of the New York Times, by Adam Davidson, The Purpose of Spectacular Wealth, According to a Spectacularly Wealthy Guy.

As befits a private equity guy, and a graduate of an Ivy League business school, Conard’s argument is simply that the rich are smarter than you and me, and the “poor and middle class” would be in a better place if they, the elite, were left alone to run it.

Let’s for a moment assume that Mr. Conard and his various colleagues in the super elite are very smart,  there is, however, one glaring factual inaccuracy which woefully undermines his argument.

Davidson, after illustrating Conard’s enthusiasm about the virtues of eliminating a fraction of a penny on the cost of every can of soda, further explains that according to Conrad there are other investor looking to make similar “micro improvements”; “They are also wealthy investors like him who are willing to risk their own money to finance improvements that may or may not work.”

Wait a second.  “Willing to to risk their own money.”  Let’s stop and pause.  I would venture a guess that Mr. Conard never risks his own money in his deals and potential improvements.   Or, as I’ll explain in a minute, if he invests his own money, then likely it is all the “house’s” money anyway.  So, it is not really much of a risk.

I’ve never met Mr. Conard, but I’m going to assume for a moment that Mr. Conrad is an archetype of a prevalent, albeit elite, cohort pounding the streets of New York in the early 1980’s.  Armed with a business degree from Harvard, but probably not much capital of his own, he first landed a job at Bain & Company, then moved along to a stint at Wassserstein Perella, and then landed back at Bain Capital.  While I’m sure that he made a very good salary and received good bonuses in his pre-Bain Capital days, the odds are pretty slim that he would have amassed a large enough fortune to become an “investor willing to risk [their] own money to improvements that may or may not work.”

Instead, he became a hard working, no doubt diligent private equity guy in the early days of the private equity bonanza.  Eventually, he made a fortune, not by putting his money at risk, but rather by putting other people’s money at risk.  The classic OPM game.

Private equity typically works as follows.  A Private Equity Firm (PEF) creates a partnership, it raises money from investors as Limited Partners, and then typically creates an entity to serve as the General Partner.  The General Partner is usually thinly capitalized (at least compared to the size of the entire fund), and its stake holders are typically insiders at PEF.  As a last step, the General Partner, on behalf of the fund, enters into a management agreement with PEF.  Included within these inter-locking relationships are various fee structures which compensate  PEF and the General Partner.  This compensation consists of the holy grail of all fees, the “2 & 20”, a 2% management fee and a 20% carried interest.  This is how fortunes are built in private equity.

Once the capital is raised from investors, the fund then goes out and borrows additional capital, usually multiples of the original equity investments.  That’s why these transactions use to be called leveraged buyouts.  In fact, most of the money “put at risk to finance improvements that may or may not work” is borrowed money …. and, the investors, including the General Partners are not on the hook if they lose it.

With Mitt Romney’s presidential bid, the whole discipline of private equity has come under scrutiny and no doubt will be dissected under a microscope in the coming months.  I’m not interested in getting into the argument as to whether private equity is good thing.  That is a subject for another time.

However, I am objecting to the notion that professionals such as Mr. Conard create a false narrative suggesting that they are great investors putting their money at risk.  No doubt, after 15 years of managing private equity deals in a wild bull market, private equity professionals have likely amassed great fortunes.   And, no doubt, they do re-invest in their own deals.  However, as I said above, they are essentially investing with “house money”… it’s easy to double-down, once you’ve assured yourself a nest egg (with multiple homes and private planes), to leave money in the deals.

The real investors are not the Ivy League MBA’s.  Instead, the real investors are you and me.  A significant portion of the capital for private equity comes from pension plans, both public and private.  In fact, public pension plans tend to be some of the most coveted clients for private equity firms.

The reality is that the true investors, people with money at risk, are not an elite group of risk assessing and risk taking investors.  Instead, they are hard working employees of large corporations and public entities.  These are the same employees who stand by helplessly as their jobs are eliminated or they learn that their pension plans are underfunded by staggering amounts.

These are the real investors in “improvements that may or may not work”.  And, these are the real investors who have funded the private equity industry.

Don’t get me wrong, some of my best friends are private equity professionals.  They are hard working, some of them are charitable and they are good citizens.  And, some firms have generated significant returns for their investors.  This is good and beneficial.  But, let’s not glorify them into a power wielding elite who “know” best for American.

I am further skeptical about an elite which potentially doesn’t understand  the distinction between personal assets and client assets.  In my judgment it is enough to disqualify someone from the elite.

Warren Buffet, arguably the greatest allocator of capital ever, always acknowledges that he invests capital on behalf of the Berkshire shareholders.   Go back to his oldest shareholder letters and he refers to shareholders as his partners.  He means this not in a legal sense, but it an ethical sense.

If Mr. Conard is hell bent on supporting an elite of master investors, then lets make sure that this elite embraces the proper values and behavior which in fact would be best for the poor and middle class. Let’s create an elite of financial experts who also understand and abide by fiduciary principles.  Professionals who at all times know that they work for plan participants and beneficiaries, and subordinate their self-interests to the interests of the clients.  Professionals who tolerate no conflicts of interest, and importantly, who don’t rig the game for outsized profits for their own benefit.  Yes, we may need an elite, but let’s have an elite of ethical and prudent behavior.

As a fiduciary, I recognize that my prescription may be viewed as self-serving, but one can only wonder if certainly elements of the Financial Crisis may have been avoided or tempered, if the leadership of the financial community took their roles as fiduciaries seriously.

Let’s judge the elite by their values and ethics, not by the size of their assets.

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