Mirabile dictu, is a revolution against private equity secrecy starting on the other side of the pond, meaning in of all places, finance-dominated England?

We’ve been writing off and on for two years about some of the many less-than-savory practices in private equity, including charging fees that investors had no idea existed; cleverly giving investors the impression that the fund managers are bearing costs that are actually eaten by the fund; widespread, dubious metrics for calculating returns; questionable accounting practices at the portfolio company level. Private equity looks like a high end version of the mortgage servicing industry, where the agents are lining their pockets at the expense of their principals in a big and often not kosher way. As the SEC’s Drew Bowden put it:

[A] private equity adviser is faced with temptations and conflicts with which most other advisers do not contend. For example, the private equity adviser can instruct a portfolio company it controls to hire the adviser, or an affiliate, or a preferred third party, to provide certain services and to set the terms of the engagement, including the price to be paid for the services … or to instruct the company to pay certain of the adviser’s bills or to reimburse the adviser for certain expenses incurred in managing its investment in the company … or to instruct the company to add to its payroll all of the adviser’s employees who manage the investment.

In the US, despite the SEC having issued an uncharacteristically blunt warning about the range and severity of the problems it is seeing in private equity, investors are not making remotely adequate responses. These private equity limited partners, after a flurry of alarm, upset phone calls, and in some cases, issuance of formal questions to fund managers, appear to be siding with the private equity firms. Yes, the general partners look to be making some strategic concessions so everyone can save face, witness private equity kingpin Blackstone’s announcement that it is ditching termination fees. But that falls well short of the level of behavior change needed.

Why are US investors so craven? The single biggest investor group is public pension funds, providing 20-25% of total industry funds under management. Private pension funds contribute roughly 10%. Fund of funds, which consist of about 15% of industry assets, have a mix of smaller institutions (small public and private pension funds, endowments, foundations, as well as wealthy individuals). Fund of funds’ raison d’etre is investing in the private equity industry, so they aren’t going to rock any boats. But the public and private pension funds collectively have clout, and individually, large and/or marquee investors like CalPERS and Harvard do as well. So why are they apparently sitting pat?

As bizarre as it may seem, the limited partners, are afraid of private equity firms, both institutionally and personally. Institutionally, the limited partners think they need to be in these strategies and won’t be allowed if they take a tougher line with the funds. Individually, I’ve been told by people involved at more than one public pension fund that the staff are afraid that the general partners can get them fired and have enough connections to get them blackballed in terms of future employment in the financial services industry. No one can give an example of this having actually occurred, mind you, but the fear seems to be pervasive.

By contrast, investors in the UK appear to be less intellectually and practically captured, as the row over secrecy indicates. From the Financial Times (hat tip CT):

Anger has erupted over the practice of asset managers coercing pension funds into signing non-disclosure agreements. Pension schemes argue it is uncompetitive and prevents them from securing the best deals for their members. The imposition of confidentiality agreements means pension funds are not able to compare how much they are being charged by fund managers, potentially exposing them and their scheme members to unnecessarily high fees. The practice is of particular concern with respect to public sector pension plans, which are effectively funded by the taxpayer. David Blake, director of the Pensions Institute at Cass Business School in London, said: “Local authorities are not allowed to compare fee deals, and that is an outrage. It should be made illegal that fund managers demand an investment mandate is confidential.”

Yves here. Before we get any further, I can tell you hell will freeze over before you see a comparable story run in the US. Just look at the first sentence, which correctly depicts investors as being coerced into signing confidentiality agreements that are clearly overreaching and unjustifiable, as we and other writers, including Gretchen Morgenson and David Sirota, have explained. You’d never see that characterization in a mainstream US publication.

Admittedly, the article focuses on only one of the bad results of the lack of transparency, namely, the inability to shop fees. There are plenty of others, including hiding that the general partners have contracted out of having a fiduciary duty, weak oversight, appallingly low disclosure of ongoing expenses, lack of audit rights, particularly regarding the investee companies, and lack of independent valuations.

Another striking element is that someone affiliated with a major business school would dare attack the private equity industry. In the US, PE firms and the big partners as individuals are such significant donors to business schools that nary a bad word dares be said. Moreover, business school professors make more consulting that they do from their putative day jobs, which means that there are large disincentives to alienting potential meal tickets. By contrast, the private equity beachhead is less well established in the UK, so some experts there are willing to cross swords with the industry.

A third difference in coverage with the US is you see no effort at the ridiculous defense made here, that the agreements contain trade secrets and thus there are legitimate reasons for confidentiality. The best defense the industry “mouthpiece” (note the pink paper’s use of a derogatory term!), Daniel Godfrey, chief executive of the Investment Management Association, can offer is that companies have the right to try to keep things secret. But he lost what little credibility he had before that in questioning whether secrecy requirements were “common practice” in private equity. Let me clue you in: they are pervasive. If you don’t agree, you don’t get to participate.

Godfrey cutely suggests that if investors don’t like what the private equity firms they don’t have to invest. That conveniently ignores the fact that correctly or not, private equity funds are treated by many investors as an asset class, which mandates the investors have to take part.

But the investors in the UK are proving to be smarter and more protective of their beneficiaries than their US counterparts. Again from the Financial Times article:

Critics believe the non-disclosure agreements allow fund managers to overcharge some of their pension fund clients significantly. Research published in the FT last year, for example, showed the Staffordshire public pension fund paid £7.2m in fund management fees in 2011/12, while Devon’s public pension fund spent just £2.7m for almost identical investment contracts. The UK’s National Association of Pension Funds, which represents more than 1,300 schemes with over £900bn of assets, has raised the issue with the Financial Conduct Authority, the regulator. Paul Lee, head of investment affairs at the NAPF, said: “The growing prevalence of non-disclosure agreements [makes it] hard for pension schemes to know if they are getting a good deal or not. [They are] unhelpful to the proper functioning of a competitive market.”

Yves again. So we see a major industry body taking on private equity secrecy frontally, by going to the authorities. By contrast, all you see from the milquetoast ILPA (the Institutional Limited Partners Association) are face-saving statements of things they’d like to see happen that never go anywhere.

Mind you, this attempt by the National Association of Pension Funds to end private equity secrecy may not succeed. But the fact that they are willing to engage in this important fight shows how cowardly their US counterparts are.