What is private equity and why are Pa. lawmakers concerned about the tens of millions of dollars of your money tied up in it?

*This story was updated to correct the spelling of Eileen Appelbaum’s name.

Private equity has become a prime punching bag on the presidential campaign trail when candidates are talking income inequality or trying to score political points.

It’s also become a source of concern for some in Pennsylvania, including state Treasurer Joe Torsella, whose office has taken to social media to complain about the practices of some private equity firms.

https://twitter.com/PATreasury/status/1161477601438949376?s=20

But what does a private equity firm do? And why has its work, which attracts rich individuals and well-endowed institutions, become a source of controversy?

What is private equity?

Private equity refers to firms that buy stakes in a company that is not listed on the stock market, or one that has been taken off the public market by the firm.

In practice, that usually means a group of financial whizzes, acting as the firm’s “general partners,” seek out big money investors, known as “limited partners.”

According to federal regulations, these investors must be either wealthy — with a net-worth of $2.1 million or more  — or groups that need to grow their assets “such as insurance companies, university endowments and pension funds.”

According to Katey Bogue, the head of private markets for financial analytics firm eVestment, these funds yield far greater returns than a traditional passive investments — such as stocks and bonds. 

“You are paying for someone else to make good investments,” Bogue told the Capital-Star. 

These good returns come by investing beyond the Dow Jones, instead finding potential diamonds in the rough among new or failing companies and turning their fortunes around.

What’s in it for the firm is a big payoff. 

They are typically paid what is known as “two and 20.” The private equity firm gets a 2 percent management fee up front, and then reaps 20 percent of the profits if the investments go well.

The deal is typically laid out in a binding contract that can last for as long as a decade, Bogue said. 

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The returns are often concentrated on the backend of the contracts, which can fit a pension fund’s financial timeline to meet future retirees’ monthly payments.

Bogue said most studies have found that private equity is “generally out-performing other investment opportunities by quite a bit.”

So, the investment is attractive to pension funds, particularly an underfunded pension such as  Pennsylvania’s.

Facing nearly $70 billion in unfunded pension obligations for roughly 800,000 current and retired teachers and state employees, both of Pennsylvania’s public pension funds invest in private equity.

And they appear successful.

For example, the state’s public school employees pension system, PSERS, reported a $1.3 billion return on private market investments in 2017 — while paying $537 million in fees.

Overall, PSERS Spokesperson Steve Esack noted that on average, distributions from private equity “have been over 1.5 times greater than the contributions made to acquire those same investments,” and beat the stock market by 10 percent.

And Pennsylvania isn’t alone in seeking retirement investments in private equity.

A 2019 report by eVestment found that private equity made up 27 percent of all new investments by selected U.S. and U.K. public pension funds — the highest total of any type of investment.

But are there risks?

Some concerns are basic, such as a lack of flexibility and transparency, according to Eileen Appelbaum — a noted private equity critic at the Center for Economic and Policy Research, a progressive Washington D.C.-based think tank.

“You invest in the stock market, you buy stocks,” Appelbaum said. “If one turns out to be a dog, you sell it.”

Once the money has gone to a private equity firm, however, a pension fund cannot cash out if the enterprise goes sour, Appelbaum said.

Bogue argued that the inflexibility can be good. She said that by letting money managers stay at work through a financial blip such as a recession, the managers can sometimes net better returns than the market.

But Bogue also said there is “a lack of standardization within the industry” on “what you need to report and exactly how it needs to be done.” Even the numbers that are reported, she added, might be hard for a pension to accurately analyze.

For example, Appelbaum points out that private equity companies commonly use the internal rate of return to measure their success. But “there is no academic, finance professor who uses” it, meaning pensions could be getting duped without even knowing it.

And then there are the fees and extra expenses that firms charge as the cost of doing business. For example, the 2018 pension report prepared by Torsella and noted pension hawk Rep. Mike Tobash, R-Schulykill, estimated that the two state pension systems have paid $12.4 billion in fees or carried interest to money managers since at least 1980. 

Torsella has amplified his skepticism from his Twitter account. It’s been mirrored by an irreverent, staff-run account.

Private equity can be a boon to a struggling company by pooling capital, taking it to the next level, and selling it. But too often, private equity firms instead buy companies, load them with debt, and pay themselves off in secret while decimating a firm and a community.

— Joe Torsella (@JoeTorsella) August 13, 2019

https://twitter.com/PATreasury/status/1165782916871462913

‘Vulture Capitalism’

The sharp political attacks from Torsella and others stem from how and where private equity firms spend the invested billions.

Firms typically turn a profit by purchasing distressed companies to turn them around — or wring every last drop of profit out, depending on your viewpoint.

Appelbaum subscribes to the latter.

She pointed to what happened at Toys R Us as a prime example. Private equity firms such as KKR and Bain Capital — Utah Sen. Mitt Romney’s old firm — bought the brand, loaded the company with debt, and made Toys R Us pay back its new owners with generous management fees. 

Under financial strain, Toys R Us went bankrupt. It’s where the accusations of “vulture capitalism” come from, and it’s popped up in the retail and media industries.

“If you invest in a publicly traded company, the [Securities and Exchange Commission] requires a bunch of things be available to you, all kinds of information that investors need,” Appelbaum told the Capital-Star. “When you invest in private equity, you don’t know anything about the companies that private equity has bought.”

Private equity backers claimed in an October report that their management has brought $600 billion in wages to 8.8 million workers. But some, such as 2020 Democratic presidential candidate U.S. Sen. Elizabeth Warren, of Massachusetts, fired back that the calculations were skewed by including the multimillion-dollar pay of private equity firm executives, according to CNBC.

Appelbaum also points out that pensions, through private equity, might be invested in something politicians, the public or beneficiaries find problematic — say guns, fossil fuels or a foreign country.

For example, a 2010 Pennsylvania law already bans the state from investing in businesses linked to Sudan or Iran.

If the investment is just a stock, the pension can then sell those assets, Appelbaum said. But while investing in private equity, the investment is stuck.

Private equity firms, such as PSERS’ $1 billion partner Platinum Equity, fire back that they try to pass along good business tactics to the companies they invest in.

“What we do at Platinum is, in a responsible way, transform companies into market leaders that exhibit the best and most responsible business practices,” Mark Barnhill, of Platinum, told the Capital-Star earlier this year.

Pressure from critics seems at times to be breaking through. For example, PSERS approved a $300 million investment into Platinum this year. That was over the objection of Torsella and advocates who pointed to lawsuits against Platinum companies that provided prison phone calls or collected student debt.

But the other state pension system, SERS, did not make an investment, with one board member saying that in 20 years of service, they’ve “never seen the amount of negative press on a firm that I’ve seen here today.”

The balancing act between the need to provide solid financial returns for pensioners now, and keeping investors’ money clean, is not lost on some of the less-vocal members of the pension board either.

“The challenge is how you deal with the fiduciary responsible [of a pension], without having concerns about some of the activities of private equity,” Rep. Matt Bradford, D-Montgomery and a PSERS board member, told the Capital-Star.