What public pensions should (and shouldn’t) disclose about their private equity investments

May 06, 2014

Dan Primack was a senior editor at Fortune from 2010 to 2016. He was also the author of Term Sheet, Fortune's daily newsletter about deals and dealmakers.

FORTUNE -- America's public pension systems invest billions of dollars into private equity and venture capital funds each year, typically disclosing such commitments during open board meetings. After that, however, the veil of secrecy begins to descend. In most cases, public pensions never disclose how each fund performs, instead reporting only aggregate portfolio returns. Few disclose the amount of fees paid to each fund manager, let along what the fees are for. And in only a few cases can the public learn if the funds were raised via a third-party intermediary (i.e., "placement agents), even though past experience has shown that a small subset of such folks are prone to engaging in kickback schemes.

Usually the level and frequency of disclosure is mandated by local law, or lack thereof. And occasionally we'll see differences even within a state, where the teachers' retirement system may provide info that the the public university endowment does not.

It is time for this pension patchwork to end. Public pensioners and taxpayers deserve to know the basics of where their money is going, and whether or not it really is working for them. Preferably this could be done at the state level but, if it takes federal regulation or legislation, so be it.

What's key here is defining what types of information should and shouldn't be publicly disclosed. I know there is a knee-jerk reaction by some to argue that all of it should be put online, and let the chips fall where they may. Or to keep it all behind the curtain, in order to protect "trade secrets." Both sides of that argument contain merit... to a point.

Types of information that should be publicly disclosed.

Fund commitments: This is the amount of money a pension system agrees to invest in a given fund. This one isn't too controversial as commitments are usually discussed and voted on in open meetings and recorded in public minutes. Plus, they often are referred to in comprehensive annual financial reports (although sometimes the manager is listed there without the dollar amount). In short, pensioners deserve to know who is managing how much of their money.

Fund performance: This is the internal rate of return (IRR) generated by a fund, plus cash-in and cash-out. Years ago it was unheard of for such information to be publicly-disclosed, with private equity and venture capital firms insisting that their performance was proprietary. If others knew how they were doing, they could no longer do it (at least not as well). But then there was a bunch of legal wrangling in states like California and Texas that made it more common (at least six states that I know of). And, more importantly, I've never heard a single PE or VC executive argue that their performance suffered for it (and only a tiny handful that have rejected pension money from such states, mostly from the VC sphere). To be sure, there are some perception dangers here. Private equity and venture capital fund returns typically experience the so-called J-curve, which means that performance often looks negative in the first couple of years, because money has been invested without any incoming returns or valuation mark-ups. The risk, of course, is that unsophisticated journalists or pensioners could easily misconstrue such data. My preferred solution would be for pensions to follow the Massachusetts model, of only disclosing performance data on funds raised at least five years ago (although I'd probably amend that to three years, given the recent acceleration in fundraising cycles). This provides visibility without sacrificing legitimacy.

Fees: Many public pensions that currently disclose performance do so net of fees, so that there aren't any "hidden" costs, but few actually disclose how much in fees they are actually paying each fund manager. They should. Perhaps the policy could be to disclose the base fees that almost every fund has -- annual management fees plus percentage of carried interest -- plus the percentage of ancillary fees that accrue to limited partners. Plus the total paid each year. Certain pensions and funds may worry that providing such information would let certain pension systems (or other institutional LPs) realize that they negotiated a bum deal. For example, one mention may pay a 1.5% management fee while another pays a 2% fee. But this should be a rare event as most PE and VC firms still follow "most-favored nation" status, only making exceptions for particularly large commitments. And a small pension investing $10 million should understand that it may not be getting the same deal as a large pension committing $500 million -- just like everyone realizes that you get more for your money if you buy in bulk.

Placement agents: If a private equity firm uses a third-party intermediary to help raise capital from a public pension, that agent and their fee should be made public. Most states that have experienced kickback scandals already do this, and more fortunate states shouldn't wait to mandate such disclosures in the future. Please note here that I don't advocate a ban on placement agents, since most of them serve a legitimate function, both for GPs and LPs. Just a public accounting of their use.

Types of information that should not be publicly disclosed.

Underlying portfolio information: Public pensions typically invest in VC and PE funds as blind pools, knowing only what type of investments will be made (sector, geography, average deal size, etc.). They do not know what actual companies will be in the portfolio yet, since those deals get made after the fund is raised. The identities of those companies, how much was paid for them and other financial data related to them should be kept private (unless the companies or investment firms choose to disclose). This goes to the heart of private equity investing -- the intrinsic value of being privately-held rather than publicly-held. Whether a VC-backed startup or mature PE-backed company, there is major competitive advantage in not having your earnings and other financial data in the public sphere. Moreover, many private equity deals involve drastic operational restructurings that could, in any given quarter, inaccurately make a company look like it's circling the drain. And certain firms really do use techniques that legitimately could be viewed as "trade secret." It is here that pensioners must trust their fiduciaries, since the pension systems do receive confidential quarterly information on underlying portfolios (reporting is not uniform, but the types of information to be provided are typically pre-negotiated between LP and GP).

Fund economics: While it is important that pensioners know how much money a venture capital or private equity fund is making in aggregate, they need not be privy to how that money is allocated within the firm. Any more than a pension would get to know how much the CEO of a privately-held vendor makes, compared to that vendor's vice president. To be sure, fund economics can cause friction within VC and PE firms, but that is something for investment staff to ferret out before making their recommendations. Personal compensation is a touchy thing for many people, and disclosing it in this case likely would cause certain VC and PE firms to stop taking public pension commitments.

In general, private equity is no longer the secretive business that it once was. Most deals and fundraisings are announced, industry executives regularly appear on television and a few firms even have listed stock on public exchanges. But the perception of shadows continues to exist, in large part because neither state legislators nor private equity organizations have been proactive in removing the "confidential" stamp from information that never needed it in the first place. Information that the public has the right to know, particularly when judging the abilities and decision-making of their chosen fiduciaries. It's time for that to change.

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