The Myth of Private Equity

The book explains what private equity investments really are and why public pension plans, including New Jersey’s, are attracted to them.

Frnachot’s campaign contributor reports are dominated by a motley collection of liquor firms, government contractors, and real estate developers. Many of these same entities participate in industries that the comptroller’s office is supposed to regulate. Despite his influence at the pension fund, financial firms and financial executives are far down the contributor list. This reality may reflect federal regulators that curtail earlier pay-to-play schemes, whereby money managers donated to state political campaigns to secure contracts from state pension funds. The inability to extract campaign contributions from money managers might explain Franchot’s indifference to the pension fund’s investment policy. (pages 5-6)

Following in the comptroller’s footsteps, many Maryland politicians have already concluded that the pension fund, while large and fiscally important, is an obscure topic to most voters. Instituting reforms requires heavy efforts to educate and then convince their colleagues, the press, and their constituents. So why bother? (page 6)

As is the case in many large organizations, the staff provide direction to the board, rather than vice versa. (pages 10-11)

Both the union and ex-officio trustees speak little at the meeting, a custom one union official relayed to me in February 2018 as resulting from the fact, “they lack expertise, and they don’t want to be embarrassed by asking the staff what sounds like a stupid question.” (page 13)

The trustees are passive figureheads, listening to what staffers tell them to do. Inertia is the modus operandi. (page 14)

The customary viewpoint is that today’s cash-strapped state pension funds will receive unlimited taxpayer lifelines in the future. (page 14)

Of the various pages in the agenda, not one indicates that Maryland, like several states, passed laws to keep private equity fee arrangement secret. In fact, the industry’s influence is so pervasive that the Government Accounting Standards Board (GASB) allows states to ignore most private equity fees altogether for record keeping purposes. Meanwhile, the Financial Accounting Standards Board, a sister agency of the GASB, endorses an unusual provision that permits state plans to price their hard-to-sell private equity investments as if the funds traded publicly, like Amazon or Exxon stocks. (page 15)

This first buyout boom represented more than simple corporate machinations. It was an underpinning for the 1980s culture of greed, a profoundly troubling time in America, when prominent businesspeople compiled wealth and defined success by the shuffling of assets instead of the development of new and innovative products. (page 19)

Hedge fund managers, like buyout fund executives, cultivate an aura of mystery and expertise, suggesting that they also have a magical elixir that delivers premium results. The facts tend to speak otherwise. For example, the State of New Jersey pension plan invested in over eighty hedge funds covering a wide style range during the last five years. A 60-40 index handily beat the hedge fund returns. (page 27)

At first glance, it seems odd that a fiduciary investor, in those early days of PE, considered a leveraged buyout fund to be a suitable investment. first, the fund itself was a blind pool, so investors committed money without advance knowledge of the fund’s acquisitions. Historically, Wall Street considered blind pools to be speculative ventures. For LBO blind pools, managers provided investors with a general statement regarding likely assets and objectives, but the fiduciary institutions relied almost totally on the managers’ reputations, since the LBO business model and track record were thin. Second, the buyout premise was to load up acquisitions with debt, which, on its surface, sounded risky. Thirdly, the fund required investors to sign a ten-year, no-cut contract with the manager, who thus earned a ten-year stream of fees, whether the fund ever made a profit. (page 29-30)

And, as the PEW Foundation explains, the states followed suit. “Before the early 1980s, many public retirement plans were bound by strict regulations limiting their investment options. State plans, for example, were previously limited in their investment options by restrictive ‘legal lists’ that were also used to regulate insurance and savings banks, for which safety was the principal concern. But these restrictions were gradually relaxed in states in the 1980s and 1990ws, allowing pension plans much more latitude to invest in a broad variety of financial instruments.” This change promoted a long-term shift in state pension plans away from conservative bonds and into equities and alternatives. (page 32)

The main result of the industry’s navel gazing was the successful rebranding of debt laden takeovers into private equity, a term that conveys a softer image and a more constructive tone than leveraged buyout. (page 35)

LBO funds collectively control over seven thousand companies, including many established firms, such as PetSmart and Staples. (page 37)

Noam Chomsky’s media analysis, which suggests that the status quo is the objective viewpoint for career-concerned journalists (and their employers). (page 39)

Another beneficiary is cash-strapped state government. By investing in PE, the state employee pension plan is able to forecast higher future returns (with no guarantees) than a conventional portfolio, and the plan’s actuary will bless the forecast. Even though the returns may not be realized, the actuary gives the government the legitimacy to devote less cash to current plan contributions and to assert plan solvency. This tactic frees up monies for other state budget items. (page 40)

Institutional investors desire careful, studied deliberation from an LBO manager prior to the fund’s purchase of a company. However, what the investors get instead is a fund implementing a spray-and-pray tactic, whereby the manager doesn’t quite know what works, so it makes ten or twelve bets and counts on a few bringing home the bacon. (p0age 72)In

The industry must perpetuate the story line of higher returns to stay in business. Otherwise, why would a rational person invest in an LBO fund versus a public stock portfolio? The former has a ten-year lock-up, expensive fees, and obscure mark-to-market practices. Because the funds’ investments are not publicly traded on a stock exchange, an investor is never quite sure how the fund is doing until perhaps 90 percent of the underlying deals are sold. A public stock, on the other hand, has instant liquidity – the investor can sell at any time at the indicated price per share. Moreover, a public index fund charges a tiny fraction of buyout fund fees, so more of the money is put to work in an index fund. (page 73)

In other words, depending on the years chosen, the foundation for a trillion-dollar industry’s marketing fanfare rests on the narrow shoulders of a ten- to twelve-year performance span, which is now over fifteen years old, or several lifetimes in financial circles. And this measurement is done against public market returns with no bonus provided to the buyout investor for their ten-year contractual period of illiquidity. If one adds the requisite 3 percent premium, as recommended by many experts, for the PE investor’s inability to sell, the LBO industry’s justification for existing is tenuous indeed. Why hasn’t this dearth of positive results been more highly publicized? For close to two decade, most of the business media has followed a self-imposed blackout on research undermining the LBO industry’s performance claims. (pages 75-6)

Buy way of definition, an unsold portfolio gain is when the fund invests in the equity of a portfolio company for $100 million. Five years later, the fund appraises its equity position at $150 million. The implied gain is $50 million ($150 million – $100 million = $50 million), although the profit remains unrealized and may just be a twinkle in the eye of the fund manager. (page 78)

The State of New Jersey’s $75 billion pension plan provides the best fee information among its peer group. (In 2016, I was a paid consultant for the New Jersey State employee unions on pension investments.) For the five years ended June 2020 (the latest information available at this writing), the 8 percent benchmark (of the 2/20/8 structure) for PE was two points lower than the S&P 500’s 10 percent annualized return, which meant the PE funds locked in big fees by piggybacking the stock market results. Since private company valuations follow public company share prices – the 2 percent difference provided a windfall for New Jersey’s PE portfolio over the five years, the managers pulled out $615 million in carried interest fees and $1.3 billion in total fees. Surprisingly, in fiscal 2020, when the PE portfolio yielded just 0.2 percent and the S&P 500 returned a much higher 9.5 percent, New Jersey paid out $113 million in PE performance fees. (page 121)

When Wall Street-savvy executives sit on these institutional boards, invariably they are from the PE, hedge fund, and active management spheres. In my survey of the top nonprofit foundations and the largest state pension funds, I could not find one principal involved in index funds. The executives have the societal status, philanthropic resources, or pol;itical fundraising ability to secure such sinecures. (page 137)

Despite their allegiance to the free market side of this model, Wall Streeters are not above asking for government interference when it suits their interests. The 2009 and 2020 federal bailouts of the financial system provide ample evidence of this dichotomy. (pages 154-5)

Several print reporters who cover the retirement plan beat and who reviewed organized labor’s passivity with me, ascribe the indifference to Wall Street’s wining and dining of union officials. My impressions are different. I believe those union officials, who are in a position to know, believe that state and municipal legislatures, where they exercise a high degree of political influence, will make up future pension plan cash shortfalls by increasing the existing levels of government cash contributions. As a result, in their collective opinion, substandard investment performance is not something for union members to worry about. (page 157)

In July 2020, Jay Clayton, the SEC chairman, gave a full-throated endorsement to a new policy at the Department of Labor. The department now allows 401(k) sponsors to introduce buyout funds into the $7 trillion individual retirement market, saying such a move increases investor choice. As the preceding narrative demonstrates, exposing widows and orphans to this largely unregulated, illiquid, and secretive investment option lacks prudence. (page 167)

In 2014, the Ninth Circuit Court of Appeals ruled in Obsidian Financial Group v. Crystal Cox that bloggers are journalists and entitled to the constitutional protections of journalists. Obsidian is a financial advisory firm that sued blogger Crystal Cos for defamation. (page 177)

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