While public pension funds face dire financial circumstances due to the impact of COVID-19 on the economy, the fees paid to private equity firms reflect another reason public pensions may be losing money at a record rate. According to recent research by Stanford University, some pension funds pay more than others through privately negotiated fee structures with private equity firms—resulting in an overall loss of an estimated $45 billion.
Public pension funds are increasingly moving their assets into private equity—a tactic used by fund managers to project higher short term gains to offset long term concerns over a lack of pension funding. This strategy might work in the short term, but when an economic downturn hits, the results can be disastrous for public pensions. At the same time, this research also suggests that the different fee structures paid by different pensions for the same services depends on the size, relationship, and governance of the pension.
The research claims that public pensions could have made up to $8.50 more per $100 invested if they had a similar fee structure to other public pensions with the same private equity firm. Even after controlling for size, the research demonstrated that these fee disparities remain, suggesting a variety of possible reasons. First, public pensions may prefer certain fee structures depending on their level of risk aversion. They may also prefer certain private equity firms because they have information about that firm’s effectiveness. Second, private equity firms may consider public pensions to be more costly to run due to public disclosure requirements, convincing them to charge higher fees. At the same time, private equity firms may give certain funds fee breaks if they already have an existing positive relationship with the pension or its managers.
These fee disparities do not reflect malpractice on the part of public pension managers. The practice of investing increasing amounts into private equity, however, is purely a result of poor long term fund management. Managers feel the need to invest in riskier options to produce return estimates that look more favorable for the fund to make up for losses. In this case, the drive for investing in riskier private equity options also creates losses through exorbitant fees. These are all aspects of an investment strategy that public pension managers need to keep in mind when deciding where to allocate their funds.