When it comes to high private equity fees, it takes two to tango.
Public pensions’ lack of strong governance is at least partly to blame for poor negotiation of private equity fund terms: So reads the conclusion of a strongly worded report from Paul Rose, professor of business law at Ohio State University’s Moritz College of Law.
“Pension funds may pay many millions for external managers to access investments that could reasonably be made in house.”“As strong returns have become harder to achieve, some pension funds find themselves in the difficult position of having to expose their lack of diligence in negotiating for more appropriate fee arrangements,” Rose stated.
He criticized the politicization of pension funds, which he argued had led to states reducing contributions—and the short-term cost to taxpayers—during periods of strong market performance. Having failed to make hay while the sun was shining, they then failed to increase contributions when investment returns declined.
“As a result, funds have to seek alpha to make up the difference, and have had to turn to private funds to make up the difference,” Rose wrote. “This creates a sellers’ market for private fund managers, in which they are able to charge higher fees to desperate pensions.”
In a separate article published in November, Rose and the US Treasury department’s Jason Seligman had argued that the lower a public pension’s funding level, the higher its exposure to alternative asset classes was likely to be.
A lack of professionalism and inability (or unwillingness) to pay market rates for qualified staff can also hamper pensions’ ability to drive down fees, Rose said.
“As a result, instead of paying in the hundreds of thousands for qualified market professionals, pension funds may pay many millions for external managers to access investments that could reasonably be made in house,” he added.
Public pensions are also not held to account in the same way as their private sector peers, Rose claimed. In part, this is due to damage to defined benefit pensions being hard to prove—even a concrete loss does not change the promises made to members.
In addition, many state retirement systems are legally classified as “arms of the state,” Rose said—citing a 2005 case involving the Michigan Judges Retirement System—and as such are subject to sovereign immunity.
“The consequence of the few rulings on fiduciary duties is that… there is no practical way for pension fund beneficiaries to remedy the breach of those duties,” Rose said. He called for legislation to allow pension fund members to take legal action against perceived breaches.
Earlier this year, Jon Grabel, CIO of the New Mexico Public Employees Retirement Association, said accepting excessive fees was an “abdication” of fiduciary duty. “We have a duty to make sure we’re getting our money’s worth in pursuit of our mission, and when somebody says, ‘Just trust us,’ to me, that’s a tell,” Grabel said.
Public funds should make immediate efforts to improve their governance structures, Rose concluded, which would “help limit inappropriately high private fund fees.”
Read Rose’s full article, “Public Fund Governance and Private Fund Fees.”