By Ed Mendel.

The highest-yielding investment for public pensions like CalPERS and CalSTRS has been partnering with private equity firms, which buy companies, make them more efficient and profitable, and then sell them.

The “leveraged buyout” also has been a windfall for successful private equity firms, creating a number of billionaires. But borrowing to buy and remake a company can have its dark side, even for private equity firms with know-how and honorable intentions.

A presidential candidate, U.S. Sen. Elizabeth Warren, D-Mass., has introduced legislation for what would be the first sweeping regulation of private equity, a growth industry that includes more strategies than the buyout, the most lucrative and frequently criticized.

“For far too long, Washington has looked the other way while private equity firms take over companies, load them with debt, strip them of wealth, and walk away scot-free — leaving workers, consumers, and whole communities to pick up the pieces,” Warren said in a news releaselast month.

Warren, known for a wide range of policy plans, gave the legislation a campaign-style title, the “Stop Wall Street Looting Act”. Support comes from 13 other Democratic congress members, the AFL-CIO, SEIU, and several other unions and nonprofit groups.

Some in the private equity industry expect similar legislation in the House and hearings this fall. A trade group, the Institutional Limited Partners Association, is expected to introduce its own private equity legislation, the “Investment Adviser Alignment Act”.

So, what is a “limited partner”? In the traditional leveraged buyout, the limited partner is a pension fund or other large investor that invests in a fund of the private equity firm or “general partner”, whose financial interests may be at odds with the limited partners.

The traditional “2 and 20” split gives the private equity firm an annual fee of 2 percent of the assets under management and 20 percent of the profits after they exceed a “hurdle” or base rate.

The limited partners, often holding only a small percentage of the buyout fund, are passive investors with little or no control. The private equity firms choose the buyout targets, decide how to reshape the company, and can add more debt and declare dividends.

CalPERS was a limited partner in the leveraged buyout of Toys ‘R’ Us by two private equity firms, KKR and Bain, and a real estrate trust, Vornado. The CalPERS share was $150 million of the $6.6 billion buyout.

Critics said Toys ‘R’ Us, which closed all 800 stores last year and eliminated 33,000 jobs, was crippled by excessive debt and fees. Several former employees made emotional pleas to the CalPERS board for severance, later provided by KKR and Bain with $20 million.

“They bankrupted the company,” CalPERS board member Theresa Taylor said at a May meeting, backing environmental, social and governance (ESG) screens for investments. “The governance of the equity fund was questionable to me, and we lost money on that.”

Under Warren’s legislation, private equity firms have limits on fees and dividends from their companies, are liable for all company debt including pensions and severance, and must publicly disclose fees, debt, expenses, annual returns, and the names of limited partners.

Employees are moved to the front of the payment line in bankruptcies. Interest on excessive company debt is no longer tax deductible. “Carried interest”, the private equity firm profit share based on performance, is taxed as income not at the lower rate for capital gains.

American Investment Council chart

Last week CalPERS and CalSTRS said they are watching, but don’t yet have a position on the Warren legislation that would radically reshape the rules for the investment both want to increase.

Private equity is less than 10 percent of the portfolio of each fund. But its history of above-market returns allows CalPERS, for example, to forecast average earnings of 7 percent, avoiding the need to raise rates paid by the state and local governments.

After a decade of expansion, experts are expecting a weaker economy and stock market this decade. In a long-term trend, the number of U.S. companies with publicly traded stock dropped by half in the last two decades from roughly 7,200 to 3,600.

Now as the demand for private equity from pension funds and others grows, finding high-quality investment opportunities is difficult. Most of the obvious buyout targets have been made efficient, and the money awaiting investment in private equity is piling way up.

The “low-hanging fruit” has been picked is one of the often-heard metaphors. A Wilshire consultant told the CalPERS board earlier this year that the global “dry powder” of money committed to private equity, but not yet tapped, has reached $2.5 trillion.

In search of new opportunities private equity is spreading throughout the economy to pricey health care, stable water and sewer systems, struggling newspapers, and even a growing force in Hollywood, talent agencies.

Canadian public pension funds that bypass private equity firms and make their own deals to purchase companies have been mentioned at CalPERS and CalSTRS board meetings. At this point, neither of the California funds has plans to step out on its own.

What both are pursuing is “co-investment” with private equity funds, making a separate investment alongside a willing general partner that usually results in lower or even no fees. CalSTRS plans to increase its co-investment program that began in 1996.

“We are trying to increase our co-investments, and as we increase our co-investments we see that primarily as buyouts,” Margot Wirth, CalSTRS private equity director, told the board in May while discussing a boost of buyouts from 71 to 74 percent of private equity holdings.

Responding to a CalSTRS board member’s question about buyout criticism, Steven Hartt, a Meketa consultant, said the cycle has moved on from the “arbitrage strip-and-sell approach” to adding value and helping a company grow and develop.

“There had been a time for awhile when one could purchase a company for a price, put a lot of leverage, sell the pieces, and you end up with a lot of money,” Hartt said. “Those investments have largely gone away, and there’s not so much that’s available there.”

A profitable CalPERS co-investment program was halted in 2016 for reasons unavailable at a board meeting in May. But after two board sessions on co-investments, CalPERS is resuming co-investments, now reportedly a trend among large investors.

A ground-breaking change planned by CalPERS would add two new vehicles to its existing private equity program. One would focus on “late-stage investment in technology, life sciences and health care”, the other on “long-term investments in established companies”.

It’s a work in progress. A big step forward came in March when the CalPERS board, on a 10-3 vote, approved the plan “in concept,” allowing staff to begin negotiating with potential partners.

Change is needed because CalPERS has not been able to find enough high-quality private equity funds to meet its current target, 8 percent of the portfolio. Its private equity investments have been “chronically underweight,” about 7 percent of the total investment fund.

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Originally posted at Calpensions.