Private capital can be a time bomb for public pension plans

Two years ago, when the economy was a runaway train, so were the returns on private equity investments. Among the biggest winners were the big public pensions, which had invested a staggering $500 billion out of a total of $4.5 trillion in private equity: one dollar in 10.

But now that stock prices are plummeting, experts worry private equity returns won’t be far behind. Accusations are flying that private equity firms are concocting elaborate fiction to hide their losses.

“Everyone is happy to play along until the music stops,” said Eileen Appelbaum, co-director of the Center for Economic and Policy Research. “We could be reaching a dangerous and scary point.”

Private equity firms make money by buying companies, restructuring them, and trying to sell them for a profit. But until the sale, and in some cases even after, it is the private equity firm that declares what the company is “worth”.

Even though the value of publicly traded companies has plumbeducatethose valuations have remained high, making those estimates seem increasingly fanciful.

“It’s getting ridiculous,” said Jeffrey Hooke, a tenured professor at the Johns Hopkins Carey School of Business. By one count, “In the first three quarters of 2022, the stock market fell 24%, while private equity said we only fell 7%. It does not make any sense. It seems to be totally illogical and inflated.”

TOAt some point, companies need enough cash to pay investors. In a doomsday scenario, the stock market will not recover and it will be impossible for companies to maintain the fiction.

The head of Europe’s largest asset manager, Amundi, last year compared the market to a “pyramid scheme” in part because many private equity firms are selling portfolio companies to each other as a way to keep their prices inflated.

If the unthinkable happens, it won’t just be people in the private equity industry who will suffer. Millions of Americans who have a public pension plan could be directly in the blast radius.

Public pension funds have been increasing your investments in private equity for nearly a decade. With the aging workforce, low-risk investments and contributions from younger workers are not enough to fund benefits for all retired or near-retirement teachers, firefighters, transit workers, and other public sector professionals. . The deficit nationwide stands at a staggering $1 trillion, leading pension officials tasked with closing the gap to turn to riskier alternative assets like real estate, private loans, hedge funds, and private equity.

Private equity firms, for their part, smelled their desperation and exploited it to pocket billions of dollars in fees. Firms typically charge a 2% management fee regardless of whether an investment pays off or not, meaning a failed $1 billion investment would still result in a $20 million windfall for the equity firm. private. When the investment makes money, your fee increases to 20% of the earnings.

At least, that’s the industry standard. Wall Street has amassed so much political power in state capitals that many states have laws upholding the terms of their investment relationships. a secret. In a recent example of his political might, Indiana exempted private equity firms from a proposed ban on investing state funds with firms that have made ESG commitments. Conservatives have derided ESG, or responsible environmental, social and governance investing, as “woke investing,” so it’s notable that they offer such an important loophole.

The industry and its lobbyists have deep ties cultivated to the officials who vet and approve investments, dangling everything from private sector jobs to paid luxury travel. In one particularly egregious example, a firm called Apax Partners helped pay a pair of Michigan officials to fly to Florence and explore the Tuscan countryside on vintage Vespas, according to Bloomberg. In Kentucky, which has the worst-funded pension in the country, hedge funds and private equity firms were able to compensate $1.3 billion in investments over a five-year period by paying just $12 million to influential brokers, The Intercept reported. The first of those investments was in a hedge fund that closed two and a half years later.

They are often courting outmatched trustees. Unlike other countries, overseeing a public pension in the US does not require accounting or finance experience, and the position is often political. 2011 sec rule prohibited people who work in finance from making campaign donations to public officials, such as governors or state auditors, who decide where to invest the pension funds. But the rule only applies to direct contributions, not outside groups like super PACs. And as soon as the rule went into effect, executives began find ways around it.

It’s not hard to see why experts warn that private equity investments are bad business for the public. The process is captured. Investments are risky. Pensions typically agree to lock in your money for at least 10 years, with the only performance updates coming in the form of estimates generated by the private equity firm itself.

It is this last factor that has experts so concerned. “The public is the one who will carry the bag,” Hooke said. “When this is resolved, state governments and university endowments will have to cut benefits or increase taxes or employee contributions.”

Frightened by recent warnings, some public pension funds are climb again future private equity investment. But they are already locked into billions in existing commitments. The goal of the Maryland State Retirement Fund is reduce its private equity portfolio to 16% from nearly 22%.

“Everyone has had Kool-Aid by now,” Appelbaum said. “They can’t leave immediately. They can only, as these commitments mature, choose not to reinvest.”

Hooke largely blames regulators for runaway valuations.

“Basically, the two supervisors are not supervising,” Hooke said. One is the US Securities and Exchange Commission, which only nominally oversees the private equity sector. “They have not said anything about these huge and inexplicable differences in yields. They’re supposed to be the sheriff on duty, but they’re not there.” In the meantime, auditors have told him they don’t have the bandwidth to delve into these assessments, he said. “In a way, they just seal the values.”

That leaves only the investors themselves to ask the tough questions, and they are incentivized not to. In recent years, skyrocketing prices for private equity have allowed state pension funds to post some of the highest returns in their history..

“Eventually,” Hooke said, “Though everyone is enjoying their false happiness—the returns made the pension funds look better and better, everyone gets promotions and raises—eventually, the chickens will come home to roost.”

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