Hearing of the Senate Finance Committee. Subject: "Carried Interest Part III: Pension Issues"

Interview

HEARING OF THE SENATE FINANCE COMMITTEE
SUBJECT: "CARRIED INTEREST PART III: PENSION ISSUES"

SEN. CHARLES GRASSLEY (R-IA): Yeah. Thank you, Senator Baucus.

Earlier this year, Chairman Baucus and I asked the Government Accountability Office to look into pension plan investments in hedge funds. Since making that request, we've been studying the tax treatment of carried interest. One argument against making any changes is based upon what Senator Baucus spent so much time raising the questions about -- legitimately so -- is the concern of higher taxes on fund managers, if it's going to be passed on to make pension funds' returns somewhat less.

In response, Chairman Baucus and I intend to update our request, asking the Government Accountability Office to examine pension plan investments in hedge funds and other alternative investment funds like the private equity funds.

So I'm glad for today's hearings because, as has been made very clear, we need some facts on this. Media reports and some of our preliminary findings indicate that pension plans only invest a small percentage of their portfolio in private equity and hedge funds.

There are some outliers, however -- that is, that there are some pension plans that have an alarming amount of plans' assets invested in these risky investments and in funds that are not registered with the SEC. This ought to give all of us some pause.

I hope our witnesses today will inform the committee about the decision-making and due diligence process associated with pension investments in private equity and hedge. This includes the thought process that is required of those representatives of pension funds who serve in a fiduciary capacity.

The economics of the decision to invest plan assets in particular investments must also be considered. Balancing risk and return and the cost associated with an investment in one financial instrument over another is an aspect that cannot be overlooked. Investment decisions are generally based upon net returns; net returns means the gross earnings less fees and expenses. Economics 101 tells me that if the expected rate of return of an investment is diminished, I would consider moving my investment elsewhere.

Let me be clear: I understand that when two sophisticated investors get together these sophisticated investors enter into complex business and legal negotiations involving multiple economic variables. It may be difficult to discern whether a change in one variable will change the outcome of the negotiations. But a change in one variable will surely have an impact on overall negotiation process. So I'm going to pursue with the panel to describe the negotiations that take place between pension fund and, for example, a private equity fund manager.

I want to emphasize that I do not believe that pension plans should be prohibited from investing in private equity and hedge funds. A strong argument can be made that these investments round out a well- diversified and well-balanced investment portfolio. In addition, the capital that is provided through pension investments could have a positive effect on the economy. I do, however, think that the plan fiduciaries must tread lightly when assessing the risk and return and the cost associated with those types of investments. Plan participants' retirement security obviously depends on it, and this hearing is all about finding about whether that's going to be reduced some way.

I fear the day that a pension plan would go under because a hedge fund or sectors of the private equity industry have trouble. As we examine the taxation of carried interest with these concerns in mind, it's appropriate to ask the question, then, to what will a change in the way carried interest is taxed adversely affect pension plan participants? And that's what this hearing is all about.

Thank you.

BREAK IN TRANSCRIPT

SEN. GRASSLEY: Mr. Read, I want to state four questions to you all at once and they're taking off from Professor Auerbach's testifying that special characteristics of the private equity industry suggest that at least some of the fund managers' higher tax costs would be passed onto pension plans.

Describe negotiations that take place between CalPERS and fund managers generally.

What factors enter into negotiations of the carried interest percentage and fee structure in the various alternative asset funds?

And if Congress were to change the taxation of carried interest, would you expect fund managers to seek changes in their fee structures to make up the extra tax cost?

And then did the fee structures change in any of your alternative asset investments in response to changes that we've had in rate differentials, like in 1986, we had 28 percent for both capital gains and then it went down to 20 percent and now 15 percent?

MR. READ: Taking the last question first, we have taken a look at what the effect has been on changes in taxation on our negotiations and also on fees. In the past, there has not been a discernable relationship.

Now, there is an important caveat which is many of the changes since 1990 -- since we entered into the private equity space -- have been favorable tax changes in terms of more favorable taxation rates for capital gains. As we go the other way towards something which is less favorable, it's hard to state with confidence that there would be no change in our negotiations. In fact, my personal expectation is that this will be a factor. How large of a factor it'll be is a really open question, very difficult to know. My hope -- again, I'd be very pleased if it were a one basis point sort of adjustment in our returns.

What goes into our negotiations, though, is a more complex mix, and I should describe what actually transpires. We look for the very best managers, and there are really three things that we're looking for: great past performance, a great existing team, and a great investment thesis going forward. So all three of those have to be in place.

Once we identify a team that is compelling, that we have confidence that they will deliver terrific investment returns in a particular sector of private equity, we then begin the negotiating process. Again, the factors that are important to us include transparency and liquidity. Fees are part of it, but it's really the after-fee return that we're most interested in, so we have to make an assessment -- we make an assessment of what the after-fee return will be.

One of the important things about the way that this sector is compensated is that most compensation is given in terms of incentive compensation, which is performance-driven. So there have been big fees that have been paid. We ourselves have paid certainly big fees to our private equity partners, but it has been related to real success.

So if they do not perform, if they do not deliver the returns, they don't generally get paid terribly well.

So the fact that the high fees are associated with high performance is a real positive. So it leads to, you know, a very different view of fees than we have in most other areas, namely, you know, we tend to pay the most fees at the time that we get the best returns. So that's a very positive characteristic.

The other thing that is important is that there's a wide dispersion of returns associated with differences private equity managers. This is actually greater in the private equity area than in many other asset classes. So, for instance, having access to the top quartile of managers is very significant. We're actually not as interested in private equity as a general asset class if we simply -- just being exposed to private equity. What we're interested in is having access to the best of the private equity industry. What this means, also, is that they tend to be among the players who command the highest level of fees.

So this is different, again, than I think in some other asset classes. I think in many of the public equity markets and fixed income markets, we are -- you know, having access to those markets is of preeminent importance. Here, having access to the best managers is what is most important. So they do tend to command the best terms.

That's why it's -- I think it gets back to one of Chairman Baucus's points, which is you would think that we would have the upper hand in these negotiations, but because we're seeking to negotiate with the finest private equity managers, it's a fairly even negotiation. We don't find it straightforward to simply dictate terms.

If Congress were to change the taxation of carried interest, I would personally expect that, again, that would come up in the negotiations. How it would manifest itself would be very particular and peculiar on every situation. For instance, for those private equity situations, the managers, that we help to create, we don't believe it would have any effect whatsoever. On others, we think it could be significant. So it's sort of a rich and complex area.

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