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:
- Were they aware of theses intricate fee arrangements?
- Did they analyze and review the various fees?
- 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.