Private Equity Firms Hidden Fees:

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1 Private Equity Firms Hidden Fees: Do you know what your pension fund is paying? presented by Kimberly Donaldson Smith Partner NCPERS 2015 Public Safety Employees Pension & Benefit Conference

2 DRAMATIC GROWTH IN ALTERNATIVE INVESTMENTS Assets under management invested in alternatives grew to $7.2 trillion in * Growth rate more than double that of traditional asset classes. * Survey of institutional investors indicated growth trend will continue. * * McKinsey & Company, The $64 Trillion Question: Consumer in Asset Management (Feb. 2012)

3 DO PENSION TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? Probably not The SEC began the Presence Exam Initiative in 2012 which has focused on how private equity funds disclose the allocation of fees and expenses to investors, with particular areas of concern including hidden fees, payments to consultants or operating partners and expense shifting.

4 DO PENSION TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont.) In June 2015, the SEC charged Kohlberg Kravis Roberts & Co. with misallocating broken deal expenses to its affiliated hedge funds. KKR settled for $30 million. SEC Press Release The SEC brought and settled similar enforcement actions against Clean Energy Capital LLC, SEC Rel. No (Feb. 25, 2014) (misallocation of fees and expenses including salaries, bonuses, benefits and rent), and Lincolnshire Mgt. Inc., SEC Rel (Sept. 22, 2014) (misallocation of fees and expenses including administrative expenses, salaries, bonuses and overhead).

5 DO PENSION TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont.) Why Not? The hedge fund business model and practices have included systemic weaknesses concerning investor rights and disclosure: Conflicts of interest and incentives to manipulate costs and expenses Limited Partnership Agreements historically include grey area definitions regarding expenses, broad limits on fiduciary duties and poor information rights for investors Lack of transparency after due diligence and closing

6 DO PENSION TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont.) Fuzzy accounting rules relating to investment related costs do not provide strict mandate for required disclosures.

7 SHOULD TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? Yes Trustees have fiduciary duties of loyalty and due diligence. In July 2013 the Maryland Public Policy Institute issued a report on Wall Street fees and investment returns of Maryland and 49 other state pension funds. The report concluded that the pension funds of the top ten states in terms of Wall Street fees had a lower pension fund performance over the preceding five years than the bottom ten states.

8 SHOULD TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont d) The issue of outsized and undisclosed fees has been raised as a red flag in the national media and has led to charges by the SEC against hedge funds and investigations of several pension funds by government agencies and pensioners. KKR, Clean Energy Capital, Lincolnshire: As discussed above, these three investment advisors reached settlements with the SEC regarding misallocation of fees and expenses.

9 SHOULD TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont.) CALPERS: A 2015 New York Times article revealed the CALPERS disclosed it was not aware what it was paying certain Wall Street managers. CALPERS CEO stated that the fees CALPERS was paying to private equity funds were not explicitly disclosed or accounted for. We can t track it today. This startling revelation prompted a former lawyer with the SEC and pension fraud investigator to begin an investigation into the fees CALPERS is paying.

10 SHOULD TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont.) Rhode Island: According to the former SEC attorney who is investigating CALPERS fees, the Rhode Island public employee pension fund incurred $2 billion in preventable losses from investments in outside real estate, private equity, and hedge funds. New Jersey: Before turning to alternative investments, the state pension funds were spending less than $10 million a year. By 2013, costs had soared to $140 million to alternative managers, with nearly half going to hedge fund managers. One investment manager, Och Ziff Capital, alone collected $48 million in management and fund fees.

11 SHOULD TRUSTEES KNOW WHAT THEIR PENSION FUNDS PAY IN FEES FOR ALTERNATIVES? (cont.) In August, 2015, retired Kentucky teachers filed a class action against the Board of Trustees of The Kentucky Teachers Retirement System on behalf of the teachers asserting claims for breach of fiduciary duty and mismanagement which include allegations concerning private equity investments. Weick, et all v. Board of Trustees of The Kentucky Teachers Retirement Sys., et al, C.A. No. 3:15 CV 692 DJH (W.D. Ky. Aug. 24, 2015).

12 HOW SHOULD TRUSTEES GAIN INFORMATION REGARDING FEES? With current investments, understand what you know and do not know regarding costs and disclosure. What is included in the management fee? Are consultants or operating partners paid from the management fee or expensed to the portfolio company or fund? Does your pension fund have information rights as an investor?

13 HOW SHOULD TRUSTEES GAIN INFORMATION REGARDING FEES? (cont.) With new investments, understand the cost structure and what will be disclosed. As a trustee, do you understand the express terms of the deal and are you comfortable with the pension fund s rights under the deal concerning information rights and disclosure?

14 for additional information contact : Kimberly Donaldson Smith kimdonaldsonsmith@chimicles.com NCPERS 2015 Annual Conference and Exhibition