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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A Never Ending Source of Fees for the Pension Industrial Complex

Roger Lowenstein refers to our public pension system as The Great American Ponzi Scheme.  While supportive of the policy needs to provide pensions to public workers, I suspect that he comes to his Ponzi Scheme conclusion because of the vast gaps in funding of many state and municipal plans. Many current retirees enjoy healthy payments, while the system remains significantly underfunded.  A little bit like the Madoff investors who took out big returns as other investors were making additional contributions.

With respect to the funding issues, Lowenstein is right on point.  And, the funding issue is probably the biggest challenge facing the public system.  However, Lowenstein overlooks another critical dynamic of the pension system; that is, the investment of retirement assets and the fees paid to all of the various vendors.  Again, in the aggregate, the funding issue looms larger.  But, every dollar paid to a vendor is one less retirement dollar paid to retirees.  Research shows that these fees have a significant impact on investment returns.

If the funding system is a ponzi scheme, then the investment process for public plans is also, in many cases, a sham of another sort.

Last spring I spoke about fiduciary matters at a conference sponsored at Harvard Law School for trustees of public pension plans. The vast majority of the participants were policeman, fireman, teachers and other public employees who serve as trustees for the their retirement plans.  After spending a day working in small workout groups with the conference participants, I was struck by two significant insights:  1) the vast majority of these trustees are earnest and take their responsibilities very seriously and 2) notwithstanding this earnestness, they are no match for Wall Street.

I suspect that for some of these trustees, their formal education may have stopped at high school.  And particularly for teachers, their college careers were directed to towards degrees in education.  In contrast, the investment management industry is filled with algorithm yielding MBA’s and finance PhD’s from Ivy League schools.  In fact, one session of the conference was devoted to a liability-matching strategy so loaded with math and investment jargon that I’m convinced that my CFA partners would have been challenged to translate the strategy so that I could digest it.

This is not the exception, but the rule.  Investment concepts and the intricacies of investment products have become so extraordinarily complicated that even the best intention plan trustee cannot understand the fundamentals.   And yet, public funds continue to direct assets to the latest hedge fund or strategy pumped out by the investment management industry.

Sanity must be injected into the system.  Not only are public pension funds under funded but,  their assets no doubt are invested in expensive products, the majority of which produce average returns.  The math is not good.   Average returns and high expenses mean overall lower returns for retirees.

For the past 20 years the investment industry has fed at the trough of the $ trillions held by public pension plans.  The industry has profited beyond its wildest dreams.  Unfortunately, the retirees have not been so fortunate.

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