University endowments, insurance funds and retirement funds serving teachers and firefighters are urging the Securities and Exchange Commission to move forward with a proposed rule that would ensure private-fund investors receive annual audits and quarterly statements. The rule, which has been heavily criticized by the private funds and Republicans, would also prohibit fund managers from passing along certain legal costs and limit the funds’ ability to insulate themselves from lawsuits.
Many pension plans are having a hard time meeting their payout obligations to members, the result of decades of underfunding, benefit overpromises and unrealistic demands from unions. This year’s simultaneous decline in stocks and bonds has only made matters worse. To compensate, many pension plans are increasingly putting their money into private-market investments like hedge funds, private-equity funds and private-debt funds.
Private-fund managers control more than $18 trillion in assets from pension plans, sovereign-wealth funds, endowments, insurers and family offices. They pool investor money and lock it up for years at a time in private-equity funds that buy and overhaul companies, private-debt funds that make loans to companies or other similar investment vehicles. They operate with far less government oversight than publicly traded companies or mutual funds.
Support from investor groups is key for the SEC initiative, which has garnered forceful pushback from Republicans, private-equity firms and hedge funds. These critics argue the proposed disclosure requirements are unnecessary because institutional investors are large and sophisticated enough to demand whatever information they need from private funds.
State and local retirement systems and other government investment funds control more than $5 trillion in combined assets. But they say that as capital has flooded into private markets in recent years, fierce competition over in-demand managers leaves them at a growing disadvantage.
“A frequent refrain that the [New York State Common Retirement Fund] receives in response to its request for improved fund terms that would benefit all investors is: ‘respectfully declined,’” the fund’s chief investment officer wrote in a comment letter to the SEC.
Private-fund managers say the proposed rules would lower returns for the very investors rallying in support. A letter by the American Investment Council, the private-equity industry’s main trade group, said the “paternalistic” plan would “curb the entrepreneurialism, flexibility, and investment returns that make private funds an increasingly attractive option.”
Pension funds, anxious to drum up enough cash to cover the promises they made to investors, hope that the potentially higher returns offered by hedge funds and private-equity firms will help close funding gaps and limit how often they have to take the politically unpopular step of increasing retirement contributions from state and local governments and their workers. Pension plans’ private-equity holdings alone likely equate to about half a trillion dollars, according to data from Preqin and the Federal Reserve.
At the Ohio Public Employees Retirement System, where private equity represents 12.5% of total assets and has outperformed the system’s broader portfolio, Executive Director Karen Carraher expressed support for most aspects of the SEC proposal. She said it would reduce investors’ need to painstakingly negotiate basic disclosures from private funds and help them more easily spot self-interested behavior by private-fund managers.
The investment chief of one major U.S. pension plan told The Wall Street Journal it takes his accounting staff approximately six months to extract and standardize information from private-fund managers’ reports to compare and track costs.
SEC Chairman Gary Gensler told reporters last month that the proposal is about efficiency. “If I know you’re paying one thing for a cup of coffee and I’m paying the same price, that transparency helps price formation in capital markets,” he said. The Democratic-controlled commission approved the proposal by a 3-to-1 vote in February, signaling a strong chance that a final version will be adopted. The agency recently extended the comment period for the proposal to June 13 amid pressure from some lawmakers and industry groups.
Pension funds make less money on their private-equity investments than other types of institutional investors do. The average annualized return for big public pension plans for the 20 years ended June 30, 2021, was 11.8%, according to an analysis of data from the Boston College Center for Retirement Research on the five largest plans with July 1-June 30 fiscal years. Annualized returns for private-equity funds tracked by the data-analytics firm Burgiss for the same period were 13.4%.
In a poll of 100 in-house attorneys representing private-equity investors, 84% said they accept unsatisfying terms in at least some funds they invest in, out of fear that pushing for better terms will cause their institution to lose access to the fund manager or be allocated a smaller share of the fund. More than one-third of the lawyers polled came from public pension funds.
“This is what you’re hearing from investors: ‘We’re nervous about losing our allocation so we don’t want to be the squeaky wheel,’” said William Clayton, a professor at Brigham Young University’s law school who conducted the poll at an October conference and made the data public in a comment letter.
In addition to imposing disclosure requirements, the SEC proposal would ban private-fund managers from charging investors for the costs of regulatory exams, investigations or SEC settlements and fines. And it would prohibit contracts between institutional investors and private-fund managers in which investors agree not to sue for certain types of negligence and breaches of fiduciary duty. Florida laws ban some such contracts.
Jeremiah Williams, who represents investment managers for the law firm Ropes & Gray LLP, co-wrote a comment letter pushing back against some of the prohibitions. He said immunity against low-level lawsuits can help free up managers to take risks that result in higher returns.
“It doesn’t strike me as particularly unfair that people who have had the strongest performance are the people who are able to negotiate terms that are to their benefit,” Mr. Williams, who is also a former member of the SEC division of enforcements’ asset-management unit, said in an interview.
Another provision in the SEC rule would target private-fund managers using debt instead of investor cash as the initial funding source for new ventures, a practice that can make returns look higher than they are. The rule would compel managers to calculate returns over the longer period beginning with the borrowing, not just the shorter period beginning with the drawdown of investor capital.