Private equity firms and other private funds typically charge investors, including public pension funds, multiple opaque fees–such as management fees, transactional fees, monitoring fees, and performance-based fees. These fees include the passively-named “carried interest,” which is in fact a share of the profits that the general partner of a private investment fund is entitled to keep. All of those additional costs weigh down returns and they can significantly dampen results.
Despite these fees’ significant effects on portfolios, many are not clearly disclosed. A 2015 report by CEM Benchmarking Inc. (“CEM”), an independent global benchmarking and research organization, estimates that approximately half of the private equity fees incurred by U.S. pension funds–including carried interest, monitoring costs, and other portfolio company fees–are not being disclosed.
Recently, there has been a trend towards more transparency in the disclosure of these investment-related fees, driven by states and public pension funds requiring fund managers to clearly disclose expenses. This transparency trend has led to efforts to create uniform disclosure requirements nationwide. In addition to openness, uniformity would further the added goal of creating a level playing field among states and pension funds so that funds that are reporting more muted results are not doing so because they include fees and expenses in their calculations that other funds do not. As this trend has gained momentum, however, it has run into concerns that, while increased disclosure is important, requiring hedge funds and private equity funds to disclose certain information could lead to some of those funds withdrawing investment options due to reticence about sharing too much information, to the extent that fee disclosures in and of themselves are considered sensitive by the funds; a reduction in investment options would limit pension funds’ investment opportunities
In July 2015, a coalition of 13 state treasurers and comptrollers (from the District of Columbia, California, New York, Virginia, Wyoming, South Carolina, Rhode Island, Vermont, New York City, Nebraska, Oregon, Missouri, and North Carolina) collectively representing over $1 trillion dollars in assets issued a public letter to the Securities and Exchange Commission (the “SEC”) calling for it to require private equity general partners to make more transparent and frequent disclosures on fees and expenses, including carried interest, to limited partners. The letter noted that while U.S. public pension funds invest approximately 9.4 percent of their portfolios in private equity and that those investments have outperformed other asset classes, their cost structures are more complicated and complex than public asset classes. The authors noted that without industry standard-disclosure practices, “management fees reported by state pension funds often do not reflect total management fees accrued by private equity firms” and that those states that disclose more comprehensive fees and expenses are put in the inequitable position of being at a disadvantage when compared with other states with less disclosure. In light of that, the authors concluded that “increased disclosure transparency [would] provide limited partners with a stronger negotiating position, ultimately resulting in more efficient investment options” and that state pension funds had “a fiduciary obligation to achieve these goals,” making more robust disclosures in the public interest.
The disadvantage for funds that have more comprehensive reporting is not a hypothetical problem without real-world corollary. For example, as reported by CEM, the South Carolina Retirement System (“SCRS”), which invests a significant amount of its assets in alternative investments, has been characterized as being subject to some of the highest fees in the country as compared to other public pension funds. However, CEM found that this perception was actually created because SCRS was reporting more costs than many other funds (as opposed to incurring more costs).
The Institutional Limited Partners Association’s (“ILPA”) Fee Transparency Initiative, an industry effort to establish comprehensive standards for fee and expense reporting among institutional investors and fund managers, released a proposed standardized reporting template for such fees and expenses in January 2016. The ILPA reported that the “[t]emplate mark[ed] the industry’s first attempt to unify and codify the presentation of fees, expenses and carried interest information by fund managers to Limited Partners.” The template is an effort to increase transparency and consistency in order to create that level playing field that pension fund leaders identified in their letter to the SEC. To date, 53 institutional investors have endorsed the template, with many of those requiring general partners with whom they invest to use it.
Efforts for increased disclosure and transparency have been undertaken in some individual states as well. For example, in May 2015, Rhode Island General Treasurer Seth Magaziner put forth his state’s “Transparent Treasury” initiative, which includes the requirement that money managers agree to disclose information about performance, fees, expenses, and liquidity before overseeing state investments, including the investments of the Rhode Island Employees’ Retirement System. Further, this past September, a bill sponsored by California Treasurer John Chiang was signed into law in California that will require greater reporting of investment fees as of January 1, 2017. Similar legislation is in process in Illinois, but is on hold until after this month’s elections.