Firms Paid Millions to Manage RI Pension Money They Didn't Have

Firms Paid Millions to Manage RI Pension Money They Didn't Have

Private equity firms have been paid millions to manage a quarter of a billion dollars in pension funds they did not yet have, a top staffer for state Treasurer Seth Magaziner disclosed in a June 10 memo to members of the State Investment Commission.

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’

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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.

“The $30 million number cited by Mr. Siedle is clearly wrong, as total management fees paid out of the system were $8 million and total fees on committed capital could not have exceeded $5 million. While we agree with his larger points that there needs to be more transparency and lower fees in private equity, we do not believe he is helping to advance this cause by publishing incorrect numbers,” Autiello said.

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.

That Magaziner has withheld records on fees undercuts his claims to be a transparency reformer in contrast with his predecessor, now-Governor Gina Raimondo, Siedle said. “He’s really an apologist for Raimondo’s secrecy scheme and is … not reforming anything,” Siedle said. “He claims to be the prince of transparency and, in fact, he’s the prince of darkness.”

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.   

Autiello said pension funds benefit in other ways. By committing to a certain amount to be invested, but not providing it all at once, she said the state can put the pending funds to good use in the interim. “When capital is committed but not called, the state can continue to invest it in stocks, bonds and other vehicles, so that it can continue to earn a return on that capital until it is called,” Autiello said.

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.

“In the real world, talented managers get higher fees and more favorable terms. Smaller or untested managers cut deals. The way the state pension fund operates there are substantial hurdles to pass not based on performance but size. In the ‘cover your ass’ mentality, the so called ‘professional consultants’ are also covering their own collective asses. The big asset managers know this and charge healthy fees,” Riley said.

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.

Siedle’s latest report, released last month, notes the state’s private equity investments have had a 10.8 percent annual return—but he calls that a massive underperformance given than the target, or “benchmark” was 15.7 percent. (Siedle looks back over just five years, not the ten years that Roos says is preferable.)

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