The big idea: The presidential candidacy of Mitt Romney has brought increased scrutiny of the role of private equity in the U.S. economy. Those concerned about more disclosure have said, “It’s called private equity for a reason.” Yet the growth in the size and influence on the corporate sector raises a key question: How much does the public have a right to know?
The scenario: Public interest in the issue first arose with the 1992 presidential bid of Ross Perot, whose federal election filings disclosed 250 holdings in private equity funds. Attempts to learn more about his holdings were largely thwarted. By October 2002, the San Jose Mercury News sued the California Public Employees Retirement System under the Freedom of Information Act for information on its private-equity investments. CalPERS is the nation’s largest public-employee pension fund, providing at that time retirement and health benefits to more than 1.3 million state workers. Like many pension funds, it had increased its private-equity investments in the 1990s, and as of September 2002, it had invested $20.5 billion (7 percent of its portfolio). The gist of the newspaper’s lawsuit was that because the funds had taken money from CalPERS and ultimately taxpayers would be responsible for any shortfall necessary to pay the benefits of state employees, the public had a right to know how the funds it invested in were performing.
The suit generated tremendous debate among general partners (who manage the funds), limited partners (who provide the funds) and the public. Not surprisingly, general partners were most opposed to more disclosure. They feared that a public familiar with measuring returns on stocks or other liquid assets on a quarter-by-quarter basis would attempt to do the same for illiquid, long-lived private-equity assets. Early returns tend to be negative; it’s as companies grow over time that positive returns are realized. Even for the same investment, assessments of value can differ widely across funds. Furthermore, the insistence on quarter-by-quarter reporting could cause investors to focus more on the short term and therefore defeat the purpose of investing over a longer horizon. Limited partners were more open to greater disclosure and in fact desired greater accountability from general partners, but they, too, feared that the public would misinterpret the returns. Because limited partners get information about investments from general partners, it was mainly the public that was in the dark about performance.
At first blush, the newspaper’s request seems quite reasonable. But let’s consider what disclosure means in the context of investment returns. Taken to its logical extreme, the concept of market efficiency and transparency could significantly reduce the potential to earn the above-market returns that had attracted pension funds to invest in private equity in the first place. In the current low interest rate environment, and with many state pensions underfunded, retirees and taxpayers alike will rely on investments with the potential for higher returns.
The resolution: In November 2002, a court ruled against CalPERS and required it to disclose the returns on its investments in private equity. The court, however, stopped short of requiring that the individual portfolio company holdings and their associated values be made public. Those were deemed “trade secrets” and could remain private.
Lesson: As private equity becomes a larger force in the economy, it is reasonable to expect more information be disclosed about performance. Yet as the CalPERS case illustrates, there are limits to how much disclosure benefits the public. A balance must be struck between the public’s right to know and the industry’s ability to earn high returns.
Chaplinsky is a professor of business administration at the University of Virginia’s Darden School of Business.