What does Republican Presidential candidate Mitt Romney have in common with the Seattle City Employees’ Retirement System (SCERS)? Both have money in the Cayman Islands, a British territory in the Caribbean. Romney parked some of his wealth there to avoid paying higher taxes. In 2003, SCERS, which manages Seattle’s pension system, invested $20 million with Epsilon II, a business partnership in the Cayman Islands promising high returns.
And the similarities don’t end there. Romney won’t divulge his Cayman Islands holdings to the public, and the private equity manager holding SCERS’ funds refuses to reveal how much of Seattle’s money is left. The city went to court in 2010, demanding to know where the money was. In dismissing the lawsuit, Judge Richard A. Jones mocked Seattle for investing “$20 million in a foreign investment that by its own terms provided for only minimal transparency.”
Welcome to the world of private equity, which refers to securities that aren’t publicly traded. Romney, who co-founded the private equity giant Bain Capital, has enjoyed the benefits of tax loopholes granted to private equity and certain foreign investments. SCERS hasn’t been so lucky. A 2012 audit of SCERS refers to a $12.85 million “reserve for potential losses on certain investments,” namely Seattle’s unfortunate Cayman Islands investment.
Have SCERS officials learned their lesson? No, they have not. In fact, they’re about to double down on their investment in private equity. At the end of this past June, SCERS had roughly $60 million invested in private equity. The agency’s private financial consultant has recommended doubling this amount. Who will oversee these investments? The same consultant who urged Seattle to invest in private equity and persuaded SCERS to hire the consultant’s own private equity group.
Such conflicts of interest help to explain why SCERS’ investments have performed so poorly since 1984.
Seattle’s retirement system has invested hundreds of millions of dollars with finance managers who insisted they could beat the market. But these bets haven’t paid off: A performance report on SCERS’ website shows that between 1984 and 2011, the retirement system’s investments underperformed their benchmark index by 1 percent each year, amounting to a $500 million cost during this period.
In other words, SCERS has placed bets on investment managers who claim they can outperform market benchmarks even after their managing fees are deducted. And these fees, which aren’t included in SCERS’ $500 million investment loss, can be quite high. Research conducted at Oxford University reveals that the average private equity fund has under-performed the Standard and Poor’s 500 Stock Market Index after deducting fees, which are often hidden from investors.
There’s also an important political issue surrounding private equity, which has come to the public’s attention through Romney’s role in Bain Capital. Private equity income isn’t taxed at the ordinary income rate of 35 percent, but at the capital gains rate of 15 percent. This loophole is so advantageous that billionaire private equity investor Stephen Schwarzman said President Obama’s effort to repeal it was equivalent to Nazi Germany’s invasion of Poland.
Should the city’s retirement system plunge headlong into this financial and moral quagmire? Private equity investments have already caused the city major legal headaches and investment losses. SCERS’ legal budget has tripled since 2008, and its $12.85 million “reserve for potential losses on certain investments” may not cover SCERS’
actual losses on its private equity holdings. Perhaps, worst of all, there’s little doubt some of Seattle’s investment will find its way into organizations now lobbying Congress to protect private equity’s indefensible tax loophole.
The solution to Seattle’s weak investment performance isn’t to “double down” on bets that mainly benefit SCERS’ investment managers, but to eliminate the conflict of interest that produced the problem. In addition to rejecting private equity, Seattle should prohibit SCERS’ private financial consultants from earning fees on investments they recommend. California adopted this rule after a major scandal. Why wait?
Greg Hill is an economist and writer who has published academic articles and a book about Jean-Jacques Rousseau.