Firms Paid Millions to Manage RI Pension Money They Didn’t Have
Thursday, July 09, 2015
In the memo, intended as a rebuttal to a report by Forbes.com critic Ted Siedle, Chief of Staff Andrew Roos, revealed that the state had paid almost $5 million in management fees in fiscal year 2014 to private equity firms on as much as $246 million in pension funds that had not actually been transferred over to their control. Roos presented his figure to refute the far higher estimate of $30 million that Siedle claimed in his report. (See below for the memo and the report.)
‘A common industry ruse’
The situation stems from how pension funds and other institutions invest money in private equity firms. A pension fund may commit to investing a certain amount but provide only a portion of it in the initial years. The management fees, however, are based off the amount committed, not how much money has been provided so far. (See below slides for how much individual firms got.)
“It’s a common industry ruse that prudent pension fiduciaries should avoid,” Siedle said in an interview.
A Magaziner spokeswoman did not specifically comment on whether the new Treasurer thinks the state should be paying management fees for money that is not actually under management. But in his memo, Roos disputed the assertion that the managers are effectively being paid for “doing nothing”—as Siedle says. Instead, Roos says those managers are conducting research before calling in the capital that was promised to them.
The $5 million figure is a “high-end estimate” that assumes a 2 percent management fee, according to Shana Autiello, spokeswoman for Magaziner. She said the office believes the number is, in fact, “far lower” because not all private equity firms charge 2 percent and some waive the management fee or reduce it on capital commitments that are unfunded.
GoLocalProv’s own estimate pegs the figure at a minimum of $2.6 million in 2014. That calculation is based solely on what the Treasurer’s office has released on management fee rates for private equity firms and the amount of unfunded commitments owed to each firm. And that accounts for only 38 out of 62 firms for which the Treasurer’s office has disclosed the management fees.
Debate over transparency
In his memo, Roos faults Siedle for not relying on documents on the Treasurer’s Web site as a source for his calculations. But Siedle says those documents are not the primary sources needed to verify the actual cost of the fees—such as limited partnership agreements and fee invoices.
He requested the requisite records but was quoted a requisition fee that he says was prohibitive—along with a disclaimer that any documents provided to him might be redacted. “This was effectively a freeze and effectively a withholding,” Siedle said. “Because they refused to provide the actual documents I was forced to rely on information gathered from alternative sources.”
If Magaziner believes his figures are wrong, Siedle added, he should make public the documents that prove it.
Asked to respond, Autiello noted Magaziner’s publication of management, performance fees, and other expenses incurred by the pension system—“something that very few others have done.” “While Treasurer Magaziner is committed to continuing to improve transparency, he is also bound by the contracts that the state has signed,” she added.
Siedle maintains that the Treasurer can get out of those contracts.
A common practice for private equity, but not other managers
Normally, management fees are based under assets under management, according to Bing-Xuan Lin, a finance professor at the University of Rhode Island. But that typically doesn’t apply to private equity firms. “The vanilla contract is 2 percent on committed capital and 20 percent on performance,” Lin said.
A spokesman for the Private Equity Growth Capital Council, a trade association, said the arrangement is an incentive for money managers. “LPs, [Limited Partners] such as pension funds, incentivize private equity managers to locate the best returns for them. Every LP approaches this differently, but typically LPs pay management fees on committed capital in order to incentivize PE managers to find the best deals,” said the spokesman, James Maloney.
“All of this is negotiated and explicitly agreed upon in the limited partner agreement (LPA), and it allows the GP [General Partners] necessary time to locate quality deals and not deploy capital too quickly,” Maloney added.
Mike Riley, local private equity and hedge fund investment manager, agreed. “An advisor charges a fee even if he has a lot of cash and doesn’t like the market. The same goes for fee based brokers and mutual funds. As the investor, I don’t get a ‘discount’ on fees for idle cash. They have control of my money unless I redeem the investment. With a capital commitment I have use of my own cash until the PE firm needs it. That's a little better for me,” said Riley, also a GoLocalProv MINDSETTER.
Highlighting high fees
For Riley, the larger issue is not when the management fee kicks in, but the high rate itself.
“I don’t have a problem with fees on committed capital I do have a problem with ‘high fees’ in whatever form. Two percent is just wrong for a management fee. But again I don’t make a distinction between managed cash, or employed capital once I have chosen a manager. As a money manager I would personally charge a much lower fee for committed and not yet employed capital,” Riley said.
On this point the Treasurer’s office agrees: “We agree strongly that the fees charged by private equity funds to pension systems are too high,” said Autiello.
But Riley blames the high fees on what he describes as a risk-averse bureaucratic mentality at the state Treasurer’s office.
He said he once submitted a proposal to the state pension fund, which was referred to a consultant. He did not make the cut-off because he didn’t have enough assets under management.
“So I could have charged zero and have a superior product and track record but have no chance of managing state pension money. The system is a cover-your-ass ‘no headline’ bureaucracy. There is absolutely no incentive to take chances on new managers or ‘cheap’ managers. As citizens we have only ourselves and our bureaucracy to blame,” Riley said.
Weighing fees against performance
For Lin, that leads to a critical question: is the investment in high-fee alternative investments worth it or are more traditional low-cost investment vehicles the way to go?
Maloney cited a report issued by his group that shows that the median benchmark return for private equity was 12.8 percent over 10 years—not counting venture capital. Pension funds are the single largest investor class—accounting for 44 percent of the money invested in private equity firms—an indicator that they recognize how strong the returns are, Maloney said.
Autiello said that trend has held here. “It is also worth noting that Rhode Island’s private equity holdings have been the best performing asset class in the portfolio, returning an average of 10.06 percent net of all fees and expenses over the past 10 years, versus the total portfolio’s average return of 6.41 percent,” she said.
But Lin questioned such claims. He said the performance of private equity firms was not much better than the average mutual fund. “Generally how you choose the timeframe you can always window dress—choose a window you want,” Lin said.
Lin cautions against allocating too much to alternative investments like private equity firms. “Ten to 20 percent would be high,” he said. (Though he added that any allocation should also take into account what other pension funds are doing.)
The state currently has 26 percent of its pension funds in alternative investments, like private equity, according to the Roos memo. That memo also notes that the national average for public pension funds is 23 percent.
Tips on potential corruption at the local or state level, misspending, abuse of power, and other issues of public interest can be sent to [email protected]. Follow Stephen Beale on Twitter @bealenews
Related Slideshow: Pension Fund Management Fees
Below are 38 private equity firms which were paid management fees for money state pension fund has yet to invest with them. For each firm, the firm name or individual fund name is listed, along with the following: the total money the state has committed to investing with them, the amount the state has provided, the amount the state has yet to provide, the management fee rate, and the amount in management fees the firm was paid for the money that it had not yet been provided. Figures are for fiscal year 2014. Data were obtained from publicly available documents from the state Treasurer’s office.
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