Congress aims to reduce regulatory scrutiny of private equity firms, exposing public employees and tax payers alike
To the casual observer, the investment returns recently announced by the California pension system might seem like cause for celebration. The state’s investments in firms that buy private companies generated a 20 percent return in 2014.
California’s $30 billion worth of private equity investments did not come cheap, incurring almost $440 million worth of annual management fees paid to financial firms. But the double-digit gains helped the system generate some of the best overall pension returns in the nation — positive news for taxpayers and for state workers who rely on the system in retirement.
Across the United States, similarly robust returns have proven key elements in the Wall Street sales pitch that has persuaded state and city pension overseers to entrust vast sums of money to private equity managers. The private equity industry has successfully portrayed itself as no less than a savior for underfunded pension systems. By one estimate, $260 billion of public money is now under the management of these firms.
But as Congress now considers reducing regulatory scrutiny of private equity firms, one problem complicates the narrative: A lot of the gains the private equity industry purports to have achieved are of the on-paper-only variety. Far from cash in the bank, they are instead estimates of the value of assets that have yet to be sold. Not only that, the estimates are largely self-reported by the private equity firms themselves — and new research suggests that the firms may be embellishing those estimates.
That is the conclusion of a paper by investment banker Jeffrey Hooke and George Washington University researchers. They essentially created a portfolio of publicly traded companies that they say closely resembles the kinds of privately owned companies that private equity investors buy. They then weighted their portfolio’s returns to reflect the same level of debt that private equity firms typically impose on their portfolio companies.
The researchers argue that their portfolio should show roughly the same returns as the private equity industry. Yet the private equity industry’s stated returns were noticeably less volatile than the publicly traded companies’ returns. The researchers assert that this suggests the private equity industry uses its latitude to self-value its own portfolios in order to make its returns look “smoother” than they actually are.