Opinion: Do “ethical” pension funds have a private equity problem?

These days, managers of public pension plans like to brag about their “ethical” investment policies, for example when it comes to the environment or “diversity, equity and inclusion”.

Meanwhile, they are pouring billions of dollars into secret private equity funds in search of additional profits.

Now comes even more evidence that some of these private equity managers are in turn using that money for the opposite of ethics.

“Private equity participation leads to a 147% increase in the percentage of … financial advisers at fault” in the companies they take over, report researchers Albert Sheen, Youchang Wu, and Yuwen Yuan of Lundquist College of Business University of Oregon. And the number of incidents of misconduct per advisor increases by 200% after a private equity buyout, they add. “The increase in faults is stronger in firms with higher post-buyout growth in assets under management per advisor and is concentrated in firms whose clients include retail clients.”

Repetition: After private equity takes control of a financial advisory firm, the number of incidents of misconduct per broker is typically treble.

The research is based on a study of 540,000 individual financial advisers at more than 14,000 companies registered with the Securities and Exchange Commission between 2000 and 2020, including 275 companies that were taken over by private equity funds. Researchers reviewed customer complaints and disciplinary actions disclosed by the SEC.

Private equity is the hottest major asset class for large pension funds and other institutional investors precisely because private equity managers have been so successful in extracting incremental profits from the companies they buy. .

According to the new study, private equity funds are most likely to buy financial advisory firms with good ethical histories — those with few customer complaints or regulatory penalties — and then send the ruthless figure out. ‘Alec Baldwin of “Glengarry Glen Ross” to increase sales.

“While the misconduct rate of acquired companies is only about 40% of the industry average before the takeover, it becomes comparable to the industry average after the takeover,” the researchers found. Private equity managers “choose targets with untapped ‘margin for misconduct’ and exploit the opportunity to make a profit, perhaps at the expense of clients,” they write. “While PE targets consultancies with above-average balance sheets, the intensity of misconduct at these firms converges towards the industry average post-acquisition.”

In the parlance of the most ruthless investors, any company that has very few customer complaints and ethical sanctions is “almost certainly leaving money on the table.” By “benchmarking” misconduct against the industry average, new owners can “transform assets,” “generate alpha,” and “capture untapped economic potential,” while shifting responsibility for ethics to regulators governments and to the “market”, i.e. to customers. .

But customers are in a better position to protect themselves when a product is simple and depends on loyal customers. Someone who tries to make extra money by selling, for example, rapidly collapsing hammers will quickly go bankrupt. In contrast, note the Lundquist researchers, “Financial advice is an opaque and complicated commodity for many that is purchased infrequently, and so there may be scope to take advantage of customers… Increasing company profits charging extra fees or placing customers in unduly expensive financial products can outweigh the costs of occasional violations and associated penalties.

The latest study adds to growing evidence that private equity managers conduct unethical business practices where they find an opportunity. Studies published last year found that increasing private ownership of care homes leads to lower standards, higher costs and more deaths. Other research has shown that private equity takeovers can be detrimental to employee morale and quality of life, and deteriorate customer outcomes.

Organizations representing the private equity industry did not immediately respond to requests for comment.

The results should not be a surprise. People running private equity partnerships are given huge, lopsided incentives to ruthlessly squeeze profits at all costs: most of their pay comes from a share of the incremental profits.

In the meantime, they’ve also been rewarded by Congress — both parties — with lavish tax breaks on that salary, breaks unavailable to the middle class. Thanks to the so-called “deferred interest loophole”, a private equity partner can earn $10 million or even $100 million in one year, pay almost no federal taxes at the time, and years , even decades later, only paying discounted “capital gains” tax rates.

Compare and contrast that with other high earners, such as doctors, lawyers, and big business owners, who pay up to 37% in federal income tax. Not to mention the nurse in the hospital or on the bus who pays a tax of 15 cents on the first dollar he earns.

But given the huge benefits private equity managers shower on the rest of us, who’s to say they don’t deserve it?