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Public Pension Portfolios vs. Hedge Funds

A group of local pension plans has a strategy to fight 2-and-20 fees and lower the costs of private equity investments.

A decade ago, officials overseeing public pension plans usually met their investment mark in a traditional, low-risk way: By applying a 60/40 formula, they invested a portion of a plan's assets in equities and a slightly smaller portion in bonds. Yields were good. Everyone was happy.

Today, for a variety of reasons, 60/40 formulas aren't bringing in as much money as they used to. To boost returns, many pension officials are eying alternative investments, such as private equity, commodities and hedge funds. Those returns promise to be much more favorable to the bottom line, but there's a catch: The 2-and-20, which asks investors to pay a flat management fee of 2 percent of assets plus 20 percent on whatever profits are generated by the investment. For many pension plans, these fees eat up the higher returns.

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Girard Miller, a former Governing columnist and now chief investment officer for the Orange County Employees Retirement System (OCERS), has been trying to do something about it. With the backing of his board, he has partnered with several other California pension plan CIOs in an effort to bring down the high fees. I caught up with a very busy Miller last week to find out more about the strategy and the implications it has for other public pension funds. What follows is a transcript of our conversation, edited for clarity and brevity.

How have public pension plans been dealing with the fees they pay on their investments?

Public pension funds over the last 30 years have worked fees on traditional investments down to rock-bottom levels. However, what has happened in the past 10 years or so is that public funds have migrated toward alternative investments, and those instruments have a much higher fee structure -- more than three times the fee for traditional investments. Public funds have found they can't negotiate the fees, that the deal is "take it or leave it." A big fund with over $100 billion in assets has some pricing power. But OCERS has $11 billion, and if we put out $50 million in different investment buckets, it doesn't buy you negotiating leverage. The hedge funds tell me, "We love you, public funds. Others pulled their money out [when the economy turned down in 2008] but pension funds stuck with us. We would like more of your money, but the fees are still 2 and 20."

On top of that, there's a transparency issue with private equity investment. It's very difficult if not impossible to get information from underlying general partners as to what their fees actually are. They don't disclose it and it doesn't show up in any way we can put into an audited pension report.

What pushed OCERS to address the fee issue?

In 2013, our board identified fees as one of its top issues. They told me to work with my colleagues in the pension community and find a way to put together our assets, giving us more autonomy to make our own decisions, but giving us better market power by bundling money into an request for proposals (RFP) process.

At a California Association of Public Retirement Systems' semi-annual workshop for CIOs, we decided the area where we could do the most good fastest was in private equity. The largest funds like the California Public Employees' Retirement System and Los Angeles County invest directly in private equity, but the rest of us do it through a fund of funds that someone else puts together that gives us access to top managers and diversification. But we typically pay 2-and-20 on most underlying investments, and many smaller plans pay another 100 basis points or more on invested capital for putting together a fund as a vehicle to get into the market. By the time you take all those fees out, even if the underlying investors are making a 20 percent return, you're not doing much better than the S&P stock index.

So we conducted a market survey and asked people in the industry: Would we get a better price on fees if we put out a collaborative RFP and brought you a bundle of assets? The industry response was favorable. With that, we prepared the RFP, we sent it out and in mid-January we had 14 proposals from leading managers of fund of funds. We have since narrowed it down to three. We'll make a final decision by the end of March. All three are top performing managers and are offering fees that are way better than any of us have seen before. Instead of me doing $50 million, the group should raise $300 million to $600 million every year for the next three years, and that's attractive to have that kind of commitment in capital.

Are there legal obstacles to your collaborative effort?

Years ago, when CIOs from several big state pension funds suggested putting together investments to get better fees, some attorneys raised a yellow flag about antitrust. They frightened people away. OCERS is the first to officially grab the bull by horns and say, "Let's wrestle this bogeyman down to the ground." We asked our attorneys for a legal analysis and they told us that it's a false issue. However, before we go public with the winning product, we CIOs agreed we are going to require an independent legal opinion on antitrust.

Are there political issues in getting so many pension funds to agree on a plan?

This is not like one big, pooled fund. Each pension plan has freedom of choice in terms of how it allocates its money within the private equity investments. There will be a core option to do a standard investment -- a 'training wheels' product. The program will be open to lots of smaller plans that have been shut out of the market because of complexity and cost.

This deal still has to be sold to every individual pension fund, though. Will they willingly accept the best recommendation at the CIO level or have a beauty contest to see if they can pick a better manager than we did? No one is obligated to go with the winner we select.

What kind of feedback are you getting from fund managers?

One of the finalists told us, "This is a game changer." It can move the market to a new price structure. We will also require the winner to have much greater transparency of underlying fees than has ever been done before. Somebody has to deliver the message to the private equity industry that the opaque price structure has to change.

Penelope Lemov is a GOVERNING correspondent. She was GOVERNING's health columnist and was senior editor for several award-winning features.
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