As public officials
across America prepare to funnel even more of
government workers’ savings to private equity moguls, an alarm just sounded for
anyone bothering to listen. It is a warning that Wall Street executives want
you to ignore as they skim fees off retirement nest-eggs – but the longer the
warning goes unheeded, the bigger the financial time bomb may be for workers,
retirees, and the governments that pay them.
Earlier
this month, Pitchbook — the premiere
news outlet for the private equity industry — declared that “private equity returns
are a major threat to pension plans' ability to pay retirees in 2023.”
With
more than one in ten public pension dollars
invested in private equity assets — and with states continuing to keep their
private equity contracts secret — Pitchbook cited
a new study finding that losses from the investments may be on the horizon for
retirement systems that support millions of teachers, firefighters, first
responders, and other government employees.
“Private
equity returns get reported on a lag of up to six months, and with each update
in 2022 values were coming down — which means 2022 numbers were including
overstated private equity asset valuations and 2023 numbers are going to
incorporate those losses,” noted the study from the Equable Institute.
To
comprehend this time bomb, you have to understand private equity’s business
model.
In general, private
equity firms use pension money to buy up and restructure companies to then sell
them at a higher price than they were purchased. In between buying and selling,
there are no transparent metrics for valuing
the purchased asset — private equity firms can manufacture an alleged value to tell
pension investors (and there’s evidence they inflate valuations when
seeking new investments).
In a
story about an investor receiving two different valuations for the same
company, Institutional
Investor underscored the absurdity: “Everyone Wants to
Know What Private Assets Are Really Worth. The Truth: It’s Complicated.”
Meanwhile,
valuation and fee terms in contracts between private equity firms and public
pensions are kept secret, exempt from open records laws. With
that in mind, the new warnings are simple: Private equity firms may have told
their pension officials that their assets were worth much more than they actually are, all
while the firms were skimming billions of dollars of fees off retirees’ money.
If
writedowns now happen, it could mean that when it’s time to sell the assets to
pay promised retiree benefits, pension funds would have far less money
available than private equity firms led them to believe. At that point, there
are three painful choices: cut retirement benefits, slash social programs to fund
the benefits, or raise taxes to recoup the losses.
Signs
of a doomsday scenario are already evident: Some of the world’s largest private
equity firms have been reporting big declines in earnings,
and federal regulators are reportedly intensifying their scrutiny of the
industry’s writedowns of asset valuations. Meanwhile, one investment bank reported that in its 2021
transactions, private equity assets sold for just 86 percent of their stated
value last year.
But
while pensioners may be imperiled, Wall Street executives are protected thanks
to their heads-we-win-tails-you-lose business model: Some of the firms managing
pensioners’ money are reporting asset losses for investors, while raking in even more fees from investors and continuing to raise executives’ pay.
Meanwhile,
even as some sophisticated private investors rush to get out of private equity,
the world’s largest private equity firm, the Blackstone Group, recently
reassured Wall Street analysts that state pension officials will continue using
retirees’ savings to boost revenues for private equity firms, hedge funds, real
estate funds, and other so-called “alternative investments.”
“The
desire for alternatives remains very strong,” said Blackstone president Jon
Gray in an investor call last week. “Here in the U.S., New York’s state
legislature actually increased the allocation for the big three pension funds
here by roughly a third.”
Gray
was referring to New York Democratic lawmakers passing legislation
significantly increasing the amount of retiree money that pension officials can
deliver to Wall Street. The bill was championed by New York City
Comptroller Brad Lander, just weeks after the Democrat won office promising he
would be “reviewing the funds’ positions with risky and speculative assets
including hedge funds, private equity, and private real estate funds.”
New
York Gov. Kathy Hochul (D) quietly signed the legislation on the
Saturday before Christmas, just weeks after the Wall
Street Journal reported that analysts have started warning
pension funds of looming private equity losses. New York lawmakers
simultaneously rejected separate legislation that would have allowed
workers and retirees to see the contracts signed between state pension
officials and Wall Street firms managing their money.
The
Empire State is hardly alone in continuing to use retirees’ money to enrich the
planet’s wealthiest financial speculators — from California to Texas to Iowa, pension funds controlling hundreds
of billions of dollars of workers’ retirement savings are planning to dump more
money into private equity, while keeping the terms of the investments secret.
While globetrotting to elite conferences in exotic
locales, pension officials have defended the high-fee investments by parroting
Wall Street executives’ claim that private equity reliably outperforms low-fee
stock index funds. At the same time, those officials continue to conceal the
terms of the investments, raising the question: If the investments are so
great, why are the details being hidden?
Perhaps
because the investments aren’t as wonderful as advertised: In a landmark study entitled “Private Equity Returns
& The Billionaire Factory,” Oxford University’s Ludovic Phalippou
documented that private equity funds “have returned about the same as public
equity indices since at least 2006,” while extracting nearly a quarter trillion
dollars in fees from public pension systems.
In
all, a Yahoo News analysis found
that pension systems had paid more than $600 billion in fees for
hedge fund, private equity, real estate and other alternative investments over
a decade. “The
big picture is that they’re getting a lot of money for what they’re doing, and
they’re not delivering what they have promised or what they pretend they’re
delivering,” Phalippou told The
New York Times in 2021.
Even
some on Wall Street admit the truth: A J.P. Morgan study in 2021 found that
private equity has barely outperformed the stock market, but it remains unclear
whether that “very thin” outperformance is worth the risk of opaque and
illiquid investments whose actual value is often impossible to determine —
investments that could crater when the money is most needed.
While
the warnings have not halted the flood of pension cash to private equity, they
have broken through in at least some corners of American politics. For
instance: The Securities and Exchange Commission is right now considering new
rules to require private equity firms to better disclose the fees they are charging.
Similarly,
Ohio’s Republican Auditor Keith Faber just issued a report sounding an alarm about state
pension officials keeping their private equity contracts concealed from
retirees and the general public — a practice replicated in states across the
country.
In
New York, Democratic Assemblyman Ron Kim is preparing to reintroduce his bill ending the open
records exemption for private equity contracts. And following a pension corruption scandal in
Pennsylvania — whose state government oversees nearly $100 billion in pension
money — there’s a potential financial earthquake: During his first week in
office, Gov. Josh Shapiro (D) promised to reprise his move as a
county executive and push to shift pensioners’ money out of the hands of Wall
Street firms, which raked in more than $1.7 billion in fees in a
single year from one of the state’s pension funds.
In
perhaps the harshest language ever uttered on the topic by any governor,
Shapiro told his state’s largest newspaper: “We need to get rid of these risky
investments. We need to move away from relying on Wall Street money managers.”
Shapiro
could face opposition not only from private equity moguls and their lobbyists —
but also from the pension boards’ union-affiliated trustees. As the Philadelphia
Inquirer reported: “Union members [on the boards] have
mostly favored the old strategy of private investments, even when challenged by
governors’ reps and the last couple of state treasurers.”
When
investment returns were somewhat better, that unholy alliance between some unions
and Wall Street firms flew under the radar, even as pension funds were ravaged
by fees. Same thing for pension funds’ overall investment strategy that has
been sending more and more retiree’ savings to private equity firms.
But
with warnings of writedowns and losses getting louder — and with Wall Street’s
own trade publications sounding alarms — the dynamic could change. Better
late than never — though the later it gets, the bigger the risk for millions of
workers and retirees.
-David Sirota, The Lever
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