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Unlimited Leverage, Outlandish Fees, Conflicts Of Interest And Questionable Valuations

The SEC’s website warns private equity investors to be vigilant about fees and expenses, as well as alert to conflicts of interest. A lawsuit filed on behalf of members of the Ohio Retired Teachers Association demands that the $100 billion State Teachers Retirement System of Ohio end a year-plus of stonewalling teacher public records requests and disclose the very same information about its private equity holdings which the SEC considers vital to protecting workers’ retirement savings. Brushing regulatory concerns aside, STRS Ohio and its Wall Street investment advisers remain intent upon maintaining secrecy regarding tens of billions in state pension assets invested in over a hundred of these costly, high-risk private funds.

In order to better educate investors, the SEC’s website today provides an informative discussion of the risks of investing in private equity funds, with helpful links to certain enforcement actions the regulator has brought related to specific industry abuses.

At the outset, the agency notes that although private equity funds may be advised by advisers that are registered with the SEC, private equity funds themselves are not registered with the SEC. As a result, private equity funds are not subject to regular public disclosure requirements.

Under What should I know?, the agency specifically warns investors about illiquidity, investment fees and expenses and conflicts of interest.


The SEC warns that because of their long-term investment horizon, an investment in a private equity fund is often illiquid and it may be necessary to hold the investment for several years before any return is realized. Private equity funds typically impose limitations on investors’ ability to withdraw their investment—often 10 or more years.

I’ve seen some funds which I refer to as “cradle-to-grave” that limit investor withdrawals for as much as 50 years. You’ll be dead before you get your money back.

Fees and Expenses

When investing in a private equity fund, the SEC notes that an investor usually receives offering documents detailing material information about the investment and enters into various agreements as a limited partner of the fund. These offering documents and agreements should disclose and govern the terms of the investor’s investment throughout the fund’s life, including the fees and expenses to be incurred by funds and their investors. These materials, which the SEC advises all investors (including participants in public pensions) read carefully, are the very same documents which members of the Ohio Retired Teachers Association have long demanded to see and STRS Ohio and its Wall Street money managers has steadfastly refused to disclose.

Without access to these documents and agreements, it is simply impossible for active and retired teachers, as well as taxpayers, to determine whether STRS Ohio officials and the external private equity advisers it hires are prudently managing pension assets. One has to wonder: if the pension and Wall Street are diligently fulfilling their fiduciary duties, why the fierce opposition to transparency?

Who’s hiding what?

Thankfully, the SEC answers the above question by providing a link to certain enforcement actions the agency has brought involving fees and expenses that were incurred by funds and their investors without being adequately consented to or disclosed. Investors should be vigilant about the fees and expenses incurred in connection with their investment, says the SEC.

Again, STRS Ohio participants cannot be vigilant if they’re not allowed to see the “secret” documents related to their retirement savings.

Conflicts of interest

Private equity firms often have interests that are in conflict with the funds they manage and, by extension, the limited partners invested in the funds, warns the SEC. Private equity firms may be managing multiple private equity funds as well as a number of portfolio companies. The funds typically pay the private equity firm for advisory services. In addition, the portfolio companies may also pay the private equity firm for services such as managing and monitoring the portfolio company. Affiliates of the private equity firm may also play a role as service providers to the funds or the portfolio companies. As fiduciaries, advisers must make full disclosure of all conflicts of interest between themselves and the funds they manage in order to get informed consent.

Again, information regarding all conflicts of interest—which the SEC advises all investors read carefully—is the very information which members of the Ohio Retired Teachers Association have long demanded to see and STRS Ohio and Wall Street has steadfastly refused to disclose. Without access to this information, it is impossible to determine whether STRS Ohio officials and the external private equity fund advisers are prudently handling pension assets.

Why the fierce opposition to transparency?

Who’s hiding what?

Once again, the SEC provides a link to certain enforcement actions, related to an adviser’s alleged failure to disclose certain conflicts of interest to the funds it manages. Through its various relationships, including with affiliates and portfolio companies, there exists opportunity for advisers to benefit themselves at the expense of the funds they manage and their investors. It is important for an investor to be aware and alert about the conflicts that exist, or that may arise, in the course of an investment in a private equity fund, says the SEC.

Again, teachers participating in the pension cannot be aware of and alert as to conflicts of interest disclosed in documents they are not allowed to see.

Unlimited Leverage

While the SEC website does not include warnings about use of leverage or borrowing by private equity funds, all such fund documents I have drafted as a lawyer, or reviewed over the course of my career, permit unlimited use of leverage. Unlimited leverage greatly increases risk of loss and, worse still, in my experience public pensions universally fail to adequately monitor leverage on a timely basis related to private equity assets. That is, public pensions have no idea just how highly levered their private equity portfolios are at any given moment.

Given that public pensions are already severely underfunded and are increasingly turning to leverage in a desperate gamble to boost investment returns (as well as ooften pension staff compensation), it is critical that participants and taxpayers themselves monitor use of leverage. Stakeholders cannot assume pension officials and Wall Street are diligent.

Again, STRS Ohio particpants cannot be aware and alert as to leverage levels disclosed in documents they, as well as likely pension officials, are not allowed to see.

Valuation Uncertainties

Given the illiquid nature of private equity assets, advisers are permitted tremendous latitude in how they value the assets they manage. Basically, advisers are allowed to unilaterally determine values and there is no assurance the assets can or will be sold at those values. Worse still, advisers are subject to a conflict of interest in valuing assets under management because the greater the assigned value, the higher the asset-based fees they are paid.

Since, STRS Ohio refuses to disclose to participants the nature and amount of assets held in private equity portfolios, it is impossible for teachers and taxpayers to determine whether the valuations are appropriate or, more likely, inflated, as well as whether pension officials are diligently monitoring portfolio valuations.

This past week, it was reported that the $440 billion CalPERS state pension sold a record $6 billion in private equity stakes to Wall Street at a 10 percent discount. That amounts to a $600 million transfer of workers’ wealth to Wall Street, in my opinion. Discounts on private equity secondary sales can be far greater, as much as 50 percent. In short, private equity assets may be grossly inflated, thus making public pensions appear better funded, i.e., less underfunded, than they really are. For their protection, pension stakeholders need access to information regarding private equity portfolios and corresponding values—they very information STRS Ohio and Wall Street are fighting to keep secret.

As a former SEC attorney, I never thought I’d see the day when government workers and retirees were summarily denied prospectuses, offering documents and agreements related to the costliest, riskiest investments in their retirement plans.

Investors forced to sue to get these fundamental documents? I never would have predicted it.

Now that secrecy in public pension investing is the “new normal,” I’m hoping securities regulators will wake up, do their jobs and compel disclosure, as opposed to leaving it up to the courts to restore public accountability.

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