It would be useful to know whether PE investments outperformed the S&P 500 net of fees. Portfolio level ESG outcomes would also help PE address their perceived ESG problem.
Part 1 discussed the ESG problem with PE. In part 2 here, I look at the current state of disclosures, review current policy proposals to address these issues and suggest new ones.
The state of PE disclosures
1. Do we have a list of pension fund’s PE investments?
As per the Pensions and Investments magazine, the five largest defined benefit pension funds in the US are (i) CalPERS (AUM of $494 billion); (ii) CalSTRs (AUM of $312 billion); (iii) New York State Common (AUM of 267 billion); (iv) Florida State Board (AUM of $199 billion); and (v) Texas Teachers (AUM of $196 billion). I focus on defined benefit plans because defined contribution plans such as the Federal Retirement Thrift System are not active in private equity but such access is controversial.
I went to the websites of these five funds to look for a list of their private equity investments. CalPERS is a leader in this regard and has a great list of its investments where it discloses the name of the fund, vintage year or the year in which CalPERS’ first cash flow for the investment occurred, capital committed, how much of cash was put into the fund by CalPERS for management fees and investments, how much cash taken out of the fund as distributions by CalPERS, the reported value of the invested capital, net IRR (internal rate of return reported by the fund) based on CalPERS’ actual cash flows and the reported value of the invested capital, and the investment multiple, defined as cash out and remaining value of investments divided by the cash in.
CalSTRS appears to report one IRR number of its PE investments but does not report details like CalPERS. NY State Common lists its PE investments as of March 31, 2022 in its annual financial report. The fund reports the date, amount committed, contributed, cumulative distributions, market value and total value. Fund of funds related to PE are also listed with the name of the fund, the manager, commitment in dollars and their broad strategic focus (e.g., European buyout). In its annual report, the Florida State Board does list its PE investments. They report the market value of the fund as of 6/30/21, net contributions and transfers, investment gain or loss and market value as of 6/30/22. I could not find a list of private equity investments for the Texas Retirement System. Phalippou (2022) analyzes CalPERS’ and Florida State Board’s IRR data and argues that their PE performance is actually no different from what one could have obtained by investing in the public stock market.
In sum, the state of disclosure of PE funds supported by the top five pension funds is mixed but somewhat better than what I had expected. Non disclosers might want to consider CalPERS’ role model in disclosing IRR, Multiple of Money (MoM), before and after fees and most important, how much the PE investment outperformed a standard market index such as the S&P 500.
2. Do we see the list of companies supported by the PE held by state pensions funds?
Things start getting murky here. The three largest funds in which CalPERS is invested in, when I accessed the website on July 18, 2023, were (i) Carlyle Partners V, LP (investment = $1.76 billion); (ii) California Emerging Ventures II, LLC (investment = $1.71 billion); and (iii) Insight Venture Partners Growth-Buyout Co-investment Fund (B), L.P. (investment = $1.63 billion).
I could not access the list of actual companies that Carlyle Partners V, LP and Berkshire Fund VII has invested in although I am sure someone with better database access such as a pension fund can get such a list. The link related to California Emerging Ventures II on CalPERS’ website leads to list of 34 investments made by version I-IV of California Emerging Ventures and the three biggest investments there include Vector Capital IV, LP and Third Rock Ventures and Berkshire Fund VII. Vector Capital lists several investments it has made but it was not clear which of that fall under Vector Capital IV. Third Rock Ventures appears to focus on biotech-based medicine.
3. When we have a list of companies, can pension funds see their financial statements and ESG outcomes?
In the best-case scenario, the trail seems to stop with a list of companies that PE invests in. I am not sure whether CalPERS and the other public pension funds ask for and look at the GAAP based audited financial statements of the specific companies that these funds invest in (“G” in PE ESG). It turns out that many of the stated shenanigans such as excess leverage, sale-leasebacks, dividend recapitalizations, onerous management fees, and related party transactions would have to be fully disclosed if these companies produced such statements. Do pension funds get information about the boards of directors for these PE funded companies (the “G” of ESG) so that they can look for compromised directors or on executive compensation, as they do in public equity?
I am also not sure whether pension funds get data on customer outcomes or worker outcomes in the companies they indirectly fund such as deaths in nursing homes, minimum staffing requirements in health care businesses, graduates of for-profit colleges who are unemployed 12 months after graduation, instances where pension liabilities have been transferred to the PBGC on account of bankruptcy (also, the “S” in PE ESG).
The policy fixes going forward:
4. Do public pension funds have the means or the incentives to actively monitor PE funds?
Hypothetically speaking, even if public pension funds did get detailed financial statements and information on customer and worker outcomes, do the state pension funds have the resources (time, expertise, and money) to serve as ESG stewards given the huge amount of data that needs to be collated, digitized, and processed. Do the state pension funds even have the incentives to do anything about it? The deal teams are incentivized to meet or exceed a financial benchmark that are at times based on historically extractive practices. How would returns change if they weren’t so extractive? And if there is no way of quantifying and analyzing the risk of negative externalities to portfolios, or assessing and quantifying positive externalities, as well, then how can the presumably lower returns from more sustainable PE be justified? On top of that, ESG teams in institutional investors, are evaluated on KPIs and metrics that may or may not be integrated with the KPIs and metrics on which the investing team is evaluated.
5. So, what has been done?
The SEC has recently worked on the private fund rules and updates to form PF. The first set relate to proposed but not yet finalized rules, under release Nos. IA-5955, and
· Requires private fund advisers registered with the Commission to provide investors with quarterly statements detailing information about private fund performance, fees, and expenses.
· Requires private fund advisers to obtain an annual audit for each private fund and cause the private fund’s auditor to notify the SEC upon certain events;
· Requires private fund advisers, in connection with an adviser-led secondary transactions, to distribute to investors a fairness opinion and a written summary of certain material business relationships between the adviser and the opinion provider;
· Prohibits all private fund advisers, including those that are not registered, from engaging in certain activities and practices that are contrary to the public interest and the protection of investors (including charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services such as accelerated monitoring fees, fees associated with an examination or investigation of the adviser; seeking reimbursement, indemnification, exculpation, or limitation of its liability for certain activity; reducing the amount of an adviser clawback by the amount of certain taxes; charging fees or expenses related to a portfolio investment on a non-pro rata basis; and borrowing or receiving an extension of credit from a private fund client); and
· Prohibits all private fund advisers from providing certain types of preferential treatment to certain investors regarding redemptions from the fund or information about portfolio holdings or exposures. It also would prohibit all private fund advisers from providing other preferential treatment unless disclosed to current and prospective investors.
The comment period on the proposed rules has closed. These proposed rules, if passed, should hopefully address at least some of the concerns raised, such as transparency in fair values of portfolio companies, IRR calculations, related party sales of businesses, fees charged, and abuse of preferential treatment to certain investors. More important, the auditors opining on these disclosures will face litigation related incentives to impose some discipline on the “bad” PE funds.
The second set of rules, Release IA-6297, which have already been adopted touch on the systemic risk imposed by the PE system and:
· Requires current reporting by large hedge fund advisers regarding certain events that may indicate significant stress at a fund that could harm investors or signal risk in the broader financial system, including certain extraordinary investment losses, significant margin and default events, terminations or material restrictions of prime broker relationships, operations events, and events associated with withdrawals and redemptions;
· Requires quarterly event reporting for all private equity fund advisers regarding certain events that could raise investor protection issues; and
· Requires enhanced reporting by large private equity fund advisers to improve the ability of the Financial Stability Oversight Council (FSOC) to monitor systemic risk and improve the ability of both FSOC and the Commission to identify and assess changes in market trends at reporting funds.
· The amendments will also require large private equity fund advisers to report information on general partner and limited partner clawbacks on an annual basis as well as additional information on their strategies and borrowings as a part of their annual filing.
6. What more needs to be done?
The proposed and enacted SEC rules are a great step in the right direction but suffer from a few limitations. First, they don’t cover all the topics I raise. Second, the information is not necessarily going to be available to the public. Third, the proposed rules, even if enacted, will probably get litigated and it is not obvious what set of final rules get promulgated.
So, what kind of data should asset allocators ask for from PE firms. Two non-profits, Predistribution Initiative (PDI) and Impact Frontiers, together have launched a project identifies these issues and recommends disclosures for LPs specifically on these topics. In particular, the disclosures ask for data on:
· Compensation ratios such as the GP’s compensation to that of the mean and median worker including that of contracted labor;
· Fees charged to LP companies and portfolio companies;
· Policies and value associated with sale-leasebacks and asset stripping;
· Policies and value associated with leverage including debt to assets, debt to EBITDA, dividend recapitalization, credit ratings, covenant breaches, staff laid off during restructuring;
· Policies and approaches related to tax structuring of funds;
· Policies and approaches related to acquisitions, add-ons, roll-ups, non-compete agreements, inter-locking directors and potential anti-competitive practices;
· Report on lobbying and political spending during the year;
· Data on how the PE entity balances IRR and long term sustainability outcomes related to
· Policy on stakeholder engagement to assess positive and negative impacts of investment on systemic/systematic risks;
· Policy and approach to DEI (diversity, equity and inclusion);
· Policy and approach to measuring and managing ESG and/or impact in the portfolio throughout the investment process.
These proposed disclosures sound like a great place to start. To this excellent list, I would add a Compensation and Disclosure Analysis section (CD&A) like disclosure, that we find in the proxy statements of public companies, for the top five officers of a public pension fund. I am particularly interested in how the Chief Investment Officer (CIOs) of a public pension fund is evaluated and compensated. Time and again, I heard that CIOs of public pension funds are paid on relatively short-term results whereas the pension constituents have a much longer investment horizon, of say 30 plus years. Even the best possible disclosures cannot solve the fundamental mismatch in the horizons of the CIO with that of the workers or savers contributing to the pension fund.
7. Engagement reports
The Big Three asset managers, BlackRock, Vanguard and State Street, post extensive information on their websites about their voting and engagement policies with public equity companies. Public pension funds might want to consider engagement policies and reports modeled along similar lines to summarize how they govern or engage with PE companies in their portfolios.
8. What about ESG reports put out by PE firms?
The top three PE firms (and I am sure others as well), KKR, Blackstone and Apollo, have started releasing their own ESG reports. These are a useful first step but are simply too aggregated and high level to enable pension funds or us, the investing public, to link specific funds to the E, S and G outcomes of individual portfolio companies.
In sum, I am sure we have good PE and bad PE. The state of current disclosures makes it hard to tell which is which.
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