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Brett Arends’s ROI: Do ‘ethical’ pension funds have a private equity problem?

The people running public pension plans these days like to boast about their “ethical” investment policies, for example when it comes to the environment or “diversity, equity and inclusion.”

Meanwhile they pour billions of dollars into secretive private-equity funds in pursuit of extra profits.

Now comes yet more evidence that some of those private-equity managers in turn are using that money for the opposite of ethics.

“Private equity ownership leads to an increase of 147% in the percentage of… financial advisers committing misconduct” at the firms they take over, report researchers Albert Sheen, Youchang Wu and Yuwen Yuan at the University of Oregon’s Lundquist College of Business. And the number of misconduct incidents per adviser rises by 200% after a firm is taken over by private equity, they add. “The increase in misconduct is stronger in firms with higher post-buyout growth in assets under management per adviser and is concentrated in firms whose clients include retail customers.”

Repeat: After private equity takes over a financial advisory firm, the number of misconduct incidents per broker typically trebles.

The research is based on a study of 540,000 individual financial advisers at more than 14,000 firms registered with the Securities and Exchange Commission between 2000 and 2020, including 275 firms that were taken over by private-equity funds. The researchers looked at customer complaints and disciplinary actions disclosed by the SEC.

Private equity is the hottest major asset class for big pension funds and other institutional investors, precisely because private-equity managers have been so successful at squeezing extra profits from the companies they buy.

According to the new study, private-equity funds are most likely to buy up financial advice firms with good ethical records — those with few customer complaints or regulatory penalties — and then send in Alec Baldwin’s ruthless character from “Glengarry Glen Ross” to increase the sales.

“While the misconduct rate of the acquired firms is only about 40% of the industry average before the buyout, it becomes on par with the industry average after the buyout,” the researchers found. Private-equity managers “choose targets with untapped ‘misconduct slack’ and exploit the opportunity to make a profit, perhaps at the expense of customers,” they write. “While PE targets advisory firms with a cleaner-than-average record, the misconduct intensity in those firms converges to the industry average after the acquisition.”

In the parlance of the most ruthless investors, any firm that has very few customer complaints and ethical penalties is almost certainly “leaving money on the table.” By “benchmarking” misconduct to the industry average, new owners can “sweat the assets,” “generate alpha,” and “capture untapped economic potential,” while shifting the responsibility for ethics onto government regulators and “the market,” meaning the customers.

But customers are better placed to protect themselves when a product is simple and depends on repeat business. Someone trying to make extra money by, say, selling hammers that fall apart quickly will soon go out of business. By contrast, note the researchers at Lundquist, “financial advice is an opaque, complicated product for many that is purchased infrequently, and thus perhaps there is scope to take advantage of customers… The increase to firm profits by charging extra fees or placing clients in inappropriately expensive financial products may outweigh the costs of occasional violations and their associated penalties.”

The latest study adds to the growing evidence that private-equity managers are driving unethical business practices where they find an opportunity. Studies published last year found the rising private equity ownership of nursing homes is leading to lower standards, higher costs and more deaths. Other research has found that private equity takeovers can be bad for things like employee morale and quality of life, and worse customer outcomes.

Organizations representing the private equity industry did not immediately respond to requests for comment.

The findings need not come as a surprise. The people running private equity partnerships are given enormous, lopsided incentives to squeeze profits ruthlessly at any cost: Most of their pay comes through a share of the extra profits.

Meanwhile they have also been rewarded by Congress — both parties — with lavish tax breaks on that pay, breaks unavailable to the middle class. Thanks to the so-called “carried interest loophole,” a private equity partner can make $10 million or even $100 million in a year, pay almost no federal tax at the time, and years or even decades later pay only discounted “capital gains” tax rates.

Compare and contrast that with other high earners, such as doctors, lawyers, and top business managers, who pay up to 37% federal tax. Not to mention the hospital orderly or busser who pays 15 cents tax on the first dollar they make.

But given the enormous benefits that private-equity managers are showering on the rest of us, who is to say they don’t deserve it?

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