Pension Reform Could Disrupt Investment Funds

Detroit’s financial woes, exacerbated by underfunded pension liabilities, have brought renewed scrutiny to public pension plans. Senator Orrin Hatch, Republican of Utah, and others have suggested overhauling these plans to shift more responsibility to the private sector. Private insurance companies would assume responsibility for these defined benefit plans, offering annuities to beneficiaries in exchange for employer-paid premiums.

Proponents argue that privatization could reduce the risk of municipal bankruptcy and federal bailouts. One downside is the possible increase in fees associated with external management of retirement savings; it creates another way for Wall Street to extract wealth from Main Street.

Merits aside, overhauling the public pension system would cause some interesting and presumably unintended consequences.

First, phasing out public pension funds could cut off an important source of financing for venture capital and private equity. Pension funds like the California Public Employees’ Retirement System, or Calpers, and the Teachers Retirement System of Texas are among the largest and most powerful institutional investors in venture capital and private equity.

Eliminating a chief source of capital could leave a gap in the fund-raising landscape. Venture capital and private equity funds seek investors with longer time horizons who are willing to accept illiquidity for a premium return. Pension funds now contribute as much as a half of all capital to venture capital and private equity funds, although that estimate includes private pension plans.

Private insurance companies also have long investment horizons and would be as well suited, in theory, to serve as limited partners. But insurance companies have not historically participated as actively in venture capital and private equity, and it might take some time for insurance executives to develop the institutional knowledge and capacity to do so well. Only the top quartile of venture capital and private equity funds historically outperform equity markets, and many insurance companies would not have access to top funds.

A second unintended consequence has to do with the tax status of public pension funds: they are tax-exempt. The legal infrastructure of funds would have to continue to accommodate tax-exempt investors, which include other sources of capital like foundations and university endowments.

But a shift toward taxable investors could change some negotiating dynamics around structuring decisions. Currently, most fund investors, because they are tax-exempt, are mostly indifferent to the tax consequences of the fund structure. At the fund level, fees are mostly paid in the form of carried interest, which allows managers to pay tax at low capital gains rates. Taxable investors might prefer to instead pay incentive fees that are economically similar but may generate ordinary tax deductions for investors and ordinary income for the manager.

At the portfolio company level, fund managers might organize more portfolio companies as pass-through entities to allow for the flow through of tax losses to investors. While tax-exempt public pension funds do not care about the flow-through of losses, insurance companies might.

While it is too early to predict the outcome of public pension legislation, it is not too soon for deal lawyers to start planning to accommodate more taxable investors into fund structures.