Take Your Money and Leave

The growing war between public pension funds and private equity firms.

In August, rather than have its returns disclosed to the public, venture capital titan Sequoia Capital expelled the University of California from its latest fund and asked the university to sell the rest of its holdings.

The move—haughty even for the legendary Silicon Valley firm that backed Google and Yahoo!—came after a court ruled in favor of the San Jose Mercury News and university employees, who had sued to obtain the information. The upshot: The university stands to lose billions in potential future returns as a result of nosy journalists and troublemaking employees.

The episode shines a spotlight on one of the most lucrative corners of the investment world. Private equity firms—the large class of assets that includes buyout funds and venture capital funds—rely to a large extent on public pension funds. These organizations, which invest vast sums on behalf of state or city employees, put the lion’s share of their capital in stocks and bonds but direct a small portion to private equity. And so from Kohlberg Kravis Roberts in the East to Kleiner Perkins in the West, jet-setting deal-makers use taxpayer cash for their private plays.

But as much as they love public funds, private equity firms are passionate about keeping their results, well, private. Their fondness for secrecy is crashing into the post-Enron demand for accountability. Court battles have ensued. So far, the pendulum—and, apparently, the law—is swinging to the side of greater disclosure.

This public-private tension has existed since the beginning. KKR was launched into business largely on the wings of the Oregon Public Employees Retirement System. For more than two decades, fund-raising private equity investors have patiently paid courtesy calls on state bureaucrats, hoping to grab some of their billions. Typically, public pension funds disclose to the public how much money they put into private equity as a class—usually, it’s a small percentage of the total investment—and how much those private funds return in aggregate each year. But, bound by confidentiality agreements, they haven’t released information on how individual funds perform. Until recently.

Last year, under pressure from the Houston Chronicle, the University of Texas Investment Management Co. started releasing performance data. Earlier this year, the California Public Employees Retirement System agreed to post the returns of its holdings—after it was clear that it might lose a court battle to keep such data private. CALPERS, the largest public pension fund in the United States, hasn’t suffered any repercussions from disclosing the data. But the University of Michigan has. Sequoia Capital booted the Wolverines out of its funds after it acceded to requests to make private equity data public. And now University of California is out, too.

Expelling your own investors would seem to be counterproductive. But secrecy is deeply embedded within the industry. Private equity investors are like gamblers who brag loudly about their winnings but never mention losses. Sequoia gladly cops to backing Google and Yahoo! But you won’t find any mention on its Web site that it backed one of the great VC debacles of all time—failed online grocer Webvan. (It’s as if Barry Bonds’ statistics included only his home runs, but not his strikeouts.) Private equity outfits would have the public believe that they’re beating the market every year, and by hefty sums—why else would we allow them to take management fees and 20 percent of the profits?

But the CALPERS data shows that isn’t the case. While some funds have been tremendous winners, returning huge amounts of cash to investors, others appear to be real turkeys—especially the newer ones.

Which points to one of the legitimate reasons private equity firms are reluctant to let it all hang out. Almost by design, private equity funds lag behind stocks or bonds—or even certificates of deposit—in their first couple of years. “These are 10-year funds, and an investment that a fund makes in its first year can still be carried at cost in its third year,” says Michael Granoff, founder of Pomona Capital, a private equity fund that invests in other private equity funds—and one whose results have been disclosed by Texas. A fund could very well show subpar returns for five years and then win big with a public offering in its sixth year. But in the meantime, public disclosure will give critics plenty of ammunition.

The solution is not, as private equity managers say, clamming up. It is opening up, educating the public about the way private equity firms produce returns in hopes of making them tolerate the fluctuations.

Given the precedents established—in and out of court—it seems likely that more information on private equity returns will be made public as a matter of course. And it’s hard to believe it will have a huge chilling effect on the private equity world. Aside from Sequoia, no other private fund has returned the University of California’s money.

Private funds now have the choice of disclosing their performance or sacrificing a large source of cash. In the short term, many private funds might look like chumps in public disclosures. But given the potential rewards, that’s an indignity most private equity investors will gladly live with.