28/11/2008

Executive summary

(i.) This paper investigates the regulatory, financial and governance issues associated with pension funds’ investments in private equity funds. The relationships between pension funds and private equity houses date back to the origin of the industry in the 1980s in the US and have cemented over the years. The recent boom in the private equity business in 2003-2006 was accompanied by regular reports in the media about such investments benefiting from “superior” returns than traditional asset classes. Despite the media visibility however, the real performance of such funds has lately become a hotly debated issue. Recent academic work has tended to contradict the rosy picture presented by the industry. And indeed, the performance of the private equity industry does not follow a classic risk distribution pattern between the most performing and the least performing funds. Standard risk management techniques are not valid to monitor investments in private equity investments, which require ad hoc procedures. This in turn leads to additional, burdensome back-office and hence requires enhanced in-house expertise.

(ii). The success of private equity takes place in a broader process of risk diversification. Pension funds across the OECD have moved away from traditional bond and equity portfolio to a more diversified composition. This diversifying frenzy has come at the cost of an increasing complexity of the funds’ asset risk management, as well as of the monitoring procedures by supervisors. In other words, we are now witnessing an “arms race” between the funds and their regulators; the recent tendency to invest in private equity is the latest manifestation thereof.

(iii). Modern trade union policy with regard to pension funds’ investments recognises the need to ensure “stewardship of workers’ capital” which draws on the broader move toward “shareholder activism”, with the specific purpose of defending worker’s rights and trade union values. While in principle applying the concept of stewardship of workers’ capital to private equity represents an opportunity, there is little doubt that it might, concomitantly, generate important complications, notably because of the un-regulated nature of the private funds. Workers’ capital strategies were designed for listed equity, in particular in the case of large multinational enterprises with relatively diluted ownership structures, and not for the weak regulation of private equity funds, and their un-listed portfolio companies. In particular, the Limited Partnership (LP) agreements that rule the private equity funds run counter to the reforms and changing practices adopted in the past decade to ensure more responsible and active investors. Compared with shareholder activism in listed equity AGMs, the private equity LP is a return to the stone age of governance.

(iv). Efforts are underway to promote trustee education and awareness about private equity investments. However, recent parliamentary debates have shown that there are limits to what can be achieved on a voluntary basis. Re-regulation of private equity is needed. It is yet too early to draw definitive conclusions on the sudden deepening of the financial crisis on 15 September 2008. In principle, 100% ownership of a company can only play in favour of effective stewardship of workers’ capital. It is clear however that without the creation of a new agenda on financial regulation, the transactions costs of applying stewardship of workers’ capital to private equity funds, and to other lightly regulated investment funds, will remain high, if not prohibitive.

This paper was drafted by Pierre Habbard, Policy Advisor, Trade Union Advisory Committee to (TUAC) the OECD. www.tuac.org

The views expressed in this paper are those of the author and do not necessarily reflect those of the TUAC or its affiliated organisations.

This paper was prepared as part of a project financed by the Hans Böckler Foundation. www.boeckler.de