Great debate: Is carry actually an expense?

Kentucky Retirement Systems saw its total expenses almost double after its board determined carried interest is an investment cost.

“If you’re just comparing us to our peers, we’re garbage,” Kentucky Retirement Systems CIO David Peden told Buyouts.

Investment expenses — the amount Kentucky pays investment firms and custodians for managing state money — almost doubled year over year. But its costs did not rise because of some massive investment initiative. Instead, the ballooning costs reflect a change in the way the $15.7 billion retirement system treats private equity firms’ share of investment profits, otherwise known as carried interest.

Kentucky’s allocation to private equity and other alternative investments has been dogged by controversy over its costs for years, and the negative attention eventually compelled its board to direct its staff to treat carry as an investment expense, rather than a profit-sharing agreement.

The shift differs from the way in which most U.S. pensions account for carried interest, and gives the appearance that Kentucky’s investment program is almost twice as expensive as those of its peers. In fact, many retirement systems do not know how much carry their managers take, and only a handful view it as a cost.

“Our performance isn’t any different than it has been,” said Peden. “All it becomes is an emotional tool, or a tool to make an emotional argument.”

It’s an argument playing out within public pensions across the country. The private equity industry delivered strong returns for U.S. retirement systems, outperforming the Russell 3000 and S&P 500 benchmarks by approximately 5 percentage points on a 10-year basis, according to Private Equity Growth Capital Council (PEGCC) data. Private equity commitments are more expensive than most investments and often feature complicated fee arrangements, and different stakeholders — pension investment staffers, trustees, fund managers — have their own ideas about what constitutes a cost, how it should be disclosed, and who should bear its burden.

“There’s an evolving and diverse set of views on whether or not carried interest should be called a fee, but those working on the front lines managing these investments do consider it to be profit share, and not guaranteed money to be received by the GPs,” said Jennifer Choi of LP trade organization the Institutional Limited Partners Association (ILPA).

In labeling carried interest an expense, Kentucky’s board took an extreme approach, which resulted in “a tremendous amount of work” for the state’s investment staff, Peden said.

Like most U.S. public pensions, Kentucky previously reported its private equity returns as net of all carried interest, fees and expenses. Assessing its GPs’ share of the profits required going back through old financial statements to calculate changes to each fund’s gross valuations over time. The difference between those valuations and previously reported net returns gave staff a ballpark figure for what each GP took out in carried interest.

Those totals were then added to Kentucky’s overall expenses, which resulted in higher reported costs. Returns, meanwhile, stayed the same, said Peden. Hence, “we’re garbage.”

“We would prefer to not be spending staff time on such a project,” Peden added. “We would prefer to spend time on investments looking forward. But we long ago lost that argument, in terms of whether carried interest is a fee or a revenue sharing. We’re just trying to comply [with] the wishes of the people we’re accountable to.”

Reviews aplenty

Investment staffers at other retirement systems may have similar work cut out for them. Earlier this year, the $282 billion California Public Employees’ Retirement System and the $184 billion California State Teachers’ Retirement Systemlaunched reviews of their private equity programs over questions about carried interest and more granular expenses, like fees charged to underlying portfolio companies.

Smaller pensions are also reassessing their private equity portfolios. In August, the board of the Los Angeles County Employees Retirement Association directed staff to put other investment priorities on the back burner to conduct an analysis of old capital calls and distribution notices “to verify that charges and proceeds are in compliance with governing fund documents,” according to pension documents. The State of Wisconsin Investment Boardrecently hired Ernst & Young to review its private equity portfolio and come up with best practices for reporting fees and expenses.

Those pensions have a lot of work ahead of them, several sources told Buyouts. One advisor to several major U.S. public pensions compared breaking down private equity’s costs and expenses to “performing open heart surgery.”

“The reason why this is all happening is we had a downturn. So all of a sudden people started to look at what was in the PE portfolios,” he said. “That opens up the question: What’s offset? What were you paying for?”

While the economic downturn provoked LPs’ initial calls for lower costs and greater transparency, sources pointed to two recent events as having a profound impact on how boards regard carried interest, as well as the high costs associated with the asset class.

The first occurred in May 2014, when the SEC’s former Director of the Office of Compliance Inspections and Examinations Andrew Bowden said “more than half” of private equity firms the agency had examined up to that point had violated the law or had material weaknesses in their handling of fees and expenses. Bowden’s remarks, along with subsequent SEC enforcement actions against firms like Kohlberg Kravis Roberts & Co and Lincolnshire Management, risked severely damaging private equity’s reputation among public pension board members, said panelists at Pension Bridge’s Chicago conferencethis summer.

The second event occurred a little less than a year later, in April 2015, when officials at CalPERS said they could not track the amount of carried interest taken by its private equity managers.

Even though most sources believe carried interest is difficult to track, given the variety of ways firms report their distributions and capital calls, many sources were surprised by the pension’s admission. With a $29 billion private equity portfolio, CalPERS is considered one of the industry’s most sophisticated LPs, and is widely believed to have access to more GP information than most investors.

“When they first told me they weren’t tracking carried interest, I didn’t believe them,” CalPERS board member J.J. Jelincic told Buyouts. “They [staff] have said they are going to report it for the first time, coming out sometime in the fall.”

CalPERS’ April admission triggered a wave of negative press coverage, which led to questions about fees and carried interest at other pensions. Although Kentucky’s push for transparency occurred earlier, Peden views his board’s attempt to get a better handle on costs to be in line with CalPERS’ efforts. And much like Kentucky’s board members, Jelincic considers carried interest to be a fee, and a failure to account for all fees violates the board’s fiduciary duty.

“I would hate to have someone call me into court, [where] I have to say, ‘Yes, I’m paying reasonable fees. I don’t know what they are, but they’re reasonable,’” Jelincic said. “I’m not sure how defensible that is.”

GPs generally consider carried interest to be a profit-sharing agreement, and most have been forthcoming with data on carried interest and fees when LPs request it, several LP investment staff sources said.

“Carried interest is not a fee,” PEGCC spokesman James Maloney said in a statement. “The 20 percent carried interest retained by managers of private equity funds is a form of profit sharing that is simple to understand, fully disclosed, and easily and accurately calculated from audited financial statements provided by the fund manager.”

Carry can be tracked

The variety of ways in which firms report their distributions and capital calls makes it difficult for LPs to track carried interest, to say nothing of the fees charged to underlying portfolio companies. Some firms disclose the information in annual financial statements, others in distributions, and still others in reports called “partnership capital statements,” which break down fund interests for each LP.

It’s not impossible, however. In an April white paper, CEM Benchmarking cited the South Carolina Retirement System Investment Commission (RSIC) for its “good faith effort to collect, check for reasonableness and report full investment costs.”

South Carolina’s annual report lumps management fees, carried interest and other expenses together as “investment management fees and expenses,” according to pension documents. After South Carolina hired CEM to assess its portfolio in 2013, CEM found the pension’s costs amounted to 1.03 percent of its portfolio’s AUM, considerably more than the 0.61 percent averaged by its peer group, according to pension documents. The difference amounted to approximately $109 million in excess costs.

However, CEM also found South Carolina reported “more costs than other funds rather than incurring more costs,” researchers wrote in an April 2015 white paper, thereby making it almost impossible to compare its investment costs with those of other retirement systems. Indeed, according to CEM’s white paper, U.S. reporting standards allow many public funds to exclude material costs related to their private equity portfolios.

In CEM’s white paper, South Carolina provides a critical example of how pensions can capture and disclose information about carried interest, regardless of whether they regard it as a cost.

“No matter how you categorize it, it’s a huge amount of money that the investor doesn’t get to keep,” said Mike Heale of CEM Benchmarking, adding while CEM considers carry to be cost, “we’re not dogmatic about the definitions; it’s the disclosure [that matters].”

The New Jersey Division of Investment’s annual report (released in January) revealed its general partners took $91.3 million in carried interest last year. Although New Jersey doesn’t strictly define carried interest as a cost, the division’s management thought it best to be as transparent as possible given the amount of attention fees and other costs have attracted.

“Get it out of the way, put it out there,” said Tom Byrne, the chairman of New Jersey’s State Investment Council. “I think a lot of people appreciate that the majority of performance fees — in a good year — reflect good performance.”

ILPA and standardization

All of the above points to a need for standardization in how managers and LPs report their costs, sources said. Earlier this year, several state treasurers issued a letter to the SEC calling for regulatory oversight of a standardized reporting metric, as “states that voluntarily disclose more comprehensive accounts of total fees and expenses are put at a disadvantage in state-to-state comparisons,”according to the letter.

It remains unclear whether the SEC will step in, though such an effort would likely have a profound impact on how firms and LPs define and quantify private equity’s costs, multiple sources said.

In the meantime, ILPA is working with its members on a new reporting template to facilitate transparency and disclosure around several areas related to fees and expenses, including “all monies paid to the fund manager,” according to a press release issued by the industry group in early September.

“Under the updated guidelines, individual LPs would be provided detailed, periodic balances for their share of paid and accrued fees and GP incentive compensation,” the press release said. “LPs would also receive a clearer picture of manager compensation received from other sources, such as portfolio companies and affiliated entities.”

Several sources said they expect ILPA to release its template in the next few weeks. Should it take root with industry LPs, standardization would go a long way in easing the burden on public pension staffs, many of which lack the resources or personnel to adequately recalibrate their reporting templates on their own.

To that point, Kentucky found it challenging to quantify expenses that managers charged to their funds’ underlying portfolio companies, which are often used to offset management fees paid by LPs, said Peden. While he expects the process to become more streamlined as Kentucky makes new commitments, the effort remains a work in progress.

“We’re trying to, but that’s still difficult,” Peden said. He added that GPs tend to vary in the way in which they report things like offsets to LP management fees. “If ILPA’s successful, it may come to an end.”

A handful of sources were skeptical of how far ILPA can go with its new template. While the industry group can offer a standardized template, it can’t force LPs to use it. And previous efforts to standardize capital call and distribution templates have been met with mixed results.

Others, however, are optimistic.

“The next step is to try to get them adopted,” said Heale, who worked with ILPA on the new template. “The issue is certainly much more prominent today that it was several years ago. Timing is everything, and I think the timing is right.”