By Chris Jurgens, Senior Director, Reimagining Capitalism
This week the Securities Exchange Commission (SEC) adopted a set of rules aimed at bringing about greater transparency, competition, and efficiency in the $25 trillion market for private funds.
The new rules apply to private equity, venture capital, and hedge fund managers — asset classes that conjure up images of Wall Street financiers and Silicon Valley scions. But in reality, this market is fueled by millions of American teachers, firefighters, and other public servants.
More than 5,000 public pension funds collectively manage $5.6 trillion in retirement savings for nearly 27 million Americans. Such pension funds have significantly increased their investments in private funds from about 5% of their portfolio in the 1990s to over 30% today. They are by far the largest block of investors in private equity in particular — with an estimated $480 billion invested in this asset class as of 2022.
These Americans’ retirement security is increasingly tied to a private funds market that has grown rapidly, but has remained stubbornly opaque, inefficient, and structurally biased to favor the interests of powerful Wall Street private fund managers over those of middle-class retirement savers and pensioners.
The new SEC rulemaking is a win for America’s retirement savers, as it addresses four structural challenges of the private funds market that hinder efficient competition and harm their interests: lack of transparency, high fees, an uneven playing field, and conflicts of interest.
Well-functioning financial markets run on the efficient flow of information. Investors like pension funds need timely, accurate, and standardized data on the financial performance, fees and terms of different investment products, so that they can make sound decisions about where to invest. Today’s private funds market, however, is opaque. There is virtually no standardized or mandated reporting, and the information that investors are able to obtain from private fund managers is often limited and hard to compare. For example, private funds use multiple metrics to measure financial performance, with some measures being notoriously manipulable and misleading when compared to how returns are benchmarked in public markets.
The new SEC rule will bring more transparency to this market by mandating standardized, timely reporting of financial performance, fees, and expenses on a quarterly basis — enabling pension funds to better compare fund financial performance on an ‘apples-to-apples’ basis, and more accurately benchmark fees and terms. This should enable more capital to flow to the highest performing fund managers, and away from underperforming firms, resulting in better returns for retirement savers, and a more competitive private funds market that more efficiently allocates capital to the highest performing investment opportunities.
The second major challenge addressed by the SEC lies in the stubbornly high fees paid by pension funds to private fund managers. Recent analyses show that the combination of expenses, management, and performance fees in the private equity asset class are on the order of magnitude of 6%, over 100 times higher than the costs of investing in publicly-traded index funds. And the SEC estimates that total fees paid by pension funds and other investors to private fund managers may be over $200 billion per year.
High fees are compounded by unfavorable investment terms. In a 2023 ILPA survey, 97% of investors in private equity reported that the terms they are offered by fund managers had gotten worse over the last three years.
This unfortunate combination dilutes the returns of retirement savers, funneling more of their hard-earned deferred wages out of pension funds and into the coffers of private equity and hedge fund managers — arguably the most richly compensated profession in all of America.
The new SEC rules help address this challenge by mandating greater transparency on fees, and banning private fund managers from passing on certain costs to their pension fund investors, which will enable pension funds to more accurately assess the costs of private fund investment opportunities, more effectively negotiate with fund managers on fees and terms, and get a better deal for their beneficiaries.
Driving even a marginal reduction in fees would result in tens of billions of additional dollars flowing to American retirement savers, rather than to Wall Street.
The third core challenge: the market for private funds today is essentially “built on discrimination”, favoring the biggest players with the most market power. The largest private fund managers have significant structural negotiation advantages over investors seeking access to their funds. And on the pension fund side, plans serving the largest jurisdictions — and that can write the biggest checks — have more leverage to negotiate favorable terms than those serving smaller populations, say a rural state like Montana. This unfairly disadvantages Americans who happen to be represented by smaller pension funds.
The new SEC rules will help ensure a more level playing field for all investors. For example, the rules will require fund managers to disclose preferential terms negotiated by one investor — often in the form of side letters — and to give other investors the right to those same terms. This will help address some of the structural negotiation advantages that major fund managers have over individual pension plans. And it will help ensure that a worker represented by a small municipal pension fund can get a comparable deal to one represented by a large state like California or New York.
The last challenge the new SEC rule seeks to address are the conflicts of interest between pension plans and private fund managers. For example, private equity firms are increasingly engaging in the dubious practice of selling a company from one fund it manages into another fund has an interest in, a so-called “adviser-led secondary transaction.” Such transactions involve a clear, inherent conflict of interest — as the fund manager is acting as both the seller and buyer of the asset. The SEC rule requires fund managers in this position to obtain a third-party valuation or fairness assessment. This requirement and other conflict-focused provisions in the new SEC rules are squarely in line with the Agency’s investor protection mandate, and help to ensure that pensioners don’t get ripped off.
Taken as a whole, the common sense set of reforms approved by the SEC this week lay the foundation for a better functioning private funds market. They are aligned with the SEC’s mandate and authority to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
They are by no means a radical set of reforms. On the contrary, we agree with advocacy groups like Americans for Financial Reform and Better Markets who make the case for a more ambitious set of private markets reforms. But we believe this rulemaking is a meaningful step towards regulating an industry that has proven adept at evading it, and towards a private funds industry that is more transparent and accountable.
In this context, the time is ripe for pension funds to speak out on why these reforms matter to their millions of beneficiaries — and for all those who care about building a fairer financial sector to make the case that private funds industry must serve the interests of investors and the public interest — not just those of Wall Street.