Two years ago, when the economy was a runaway train, so were the returns on private equity investments. Among the biggest winners were large public pensions, which had invested a staggering $500 billion out of a total $4.5 trillion in private equity — one dollar out of every 10.
But with stock prices now plummeting, experts are fearful that private equity returns are not far behind. Accusations are flying that private equity firms are spinning an elaborate fiction to hide their losses.
“Everybody is happy to go along with the game until the music stops,” said Eileen Appelbaum, the co-director of the Center for Economic and Policy Research. “We could be reaching a dangerous and scary point.”
Private equity firms make money by buying companies, restructuring them and trying to sell them at a profit. But until the sale, and in some cases even after, it’s the private equity firm that declares what the company is “worth.”
Even as the value of publicly traded companies has plummeted, those valuations have stayed high, making those guesstimates look increasingly fanciful.
“It’s getting ridiculous,” said Jeffrey Hooke, a senior lecturer at the Johns Hopkins Carey Business School. By one count, “In the first three quarters of 2022, the stock market fell 24%, while private equity said we only dropped 7%. It doesn’t make any sense. It seems to be totally illogical and inflated.”
At some point, firms need enough cash to pay back investors. In a doomsday scenario, the stock market won’t recover, and it will become impossible for firms to keep up the fiction.
The head of Europe’s largest asset manager, Amundi, last year likened the market to a “pyramid scheme,” in part because so many private equity firms are selling portfolio companies to one another as a way to keep their prices inflated.
If the unthinkable happens, it won’t just be people in the private equity industry who suffer. Millions of Americans who hold a public pension plan could be squarely in the blast radius.
“Everybody is happy to go along with the game until the music stops.”
Public pension funds have been ratcheting up their investments in private equity for almost a decade. With the workforce getting older, low-risk investments and the contributions of younger workers aren’t enough to fund benefits for all of the teachers, firefighters, transit workers and other public sector professionals who are at or near retirement. The nationwide shortfall stands at a staggering $1 trillion, leading pension officers who have an obligation to close the gap to turn to riskier, so-called alternative assets like real estate, private loans, hedge funds ― and private equity.
Private equity firms, for their part, smelled their desperation and exploited it in order to pocket billions of dollars in fees. Firms typically take a 2% management fee whether or not an investment pays off, meaning a $1 billion failed investment would still result in a $20 million windfall for the private equity firm. When the investment earns money, their fee balloons to 20% of the profits.
At least, that’s the industry standard. Wall Street has amassed so much political power in state capitals that many states have laws that keep the terms of their investing relationships a secret. In one recent example of their political might, Indiana exempted private equity firms from a proposed ban on investing state funds with firms that have taken ESG pledges. Conservatives have derided ESG — or responsible environmental, social and governance investing — as “woke investing,” so it’s notable that they would offer such a major loophole.
The industry and its lobbyists have cultivated deep ties to the officials who vet and approve investments, dangling everything from private sector gigs to lavish paid trips. In one particularly egregious example, a firm called Apax Partners helped pay for a pair of Michigan officials to fly to Florence and explore the Tuscan countryside on vintage Vespas, according to Bloomberg. In Kentucky, which has the worst-funded pension in the country, hedge funds and private equity firms were able to net $1.3 billion in investments in a five-year period by paying just $12 million to influential middlemen, The Intercept reported. The first of those investments was in a hedge fund that folded 2 1/2 years later.
They’re often courting outmatched trustees. Unlike in other countries, overseeing a public pension in the U.S. doesn’t require a background in accounting or finance, and the position is often a political one. A 2011 SEC rule banned people working in finance from making campaign donations to public officials, like governors or state auditors, who decide where to invest pension funds. But the rule only applies to direct contributions, not outside groups like super PACs. And no sooner had the rule taken effect than executives started finding ways around it.
It’s not hard to see why experts warn that private equity investments are a bad deal for the public. The process is captured. The investments are risky. Pensions typically agree to lock up their money for at least 10 years, with the only performance updates coming in the form of guesstimates generated by the private equity firm itself.
It’s this last factor that has experts so worried. “The public is who’s going to be holding the bag,” Hooke said. “When this shakes out, state governments and university endowments will either have to cut benefits or increase taxes or employee contributions.”
Spooked by recent warnings, some public pension funds are scaling back future private equity investments. But they are already locked into billions in existing commitments. Maryland’s state retirement fund is aiming to cut back its private equity portfolio to 16% from almost 22%.
“Everybody has already drunk the Kool-Aid,” Appelbaum said. “They can’t get out immediately. They can only, as these commitments mature, choose not to reinvest.”
“The public is who’s going to be holding the bag.”
Hooke largely blames regulators for the runaway valuations.
“Basically, the two supervisors aren’t supervising,” Hooke said. One is the U.S. Securities and Exchange Commission, which is only nominally supervising the private equity sector. “They haven’t said anything about these vast, unexplained differences in returns. They’re supposed to be the sheriff on the beat, but they’re not there.” Auditors, meanwhile, have claimed to him they don’t have the bandwidth to dig deeply into these valuations, he said. “They sort of just rubber-stamp the values.”
That leaves only the investors themselves to ask hard questions — and they are incentivized not to. In recent years, sky-high private equity prices have allowed state pension funds to post some of their highest-ever returns.
“Eventually,” Hooke said, “Even though they’re all enjoying their phony happiness — the returns made the pension funds look better and better, everyone gets promotions and raises — eventually, the chickens will come home to roost.”
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