Steven Davidoff Solomon writes for The New York Times, May 12, 2015
Placement agents have been maligned, banned and even imprisoned. And yet, pension funds continue to use them. Despite various scandals, however, a new study finds that the better agents in the business just might provide value.
Placement agents are the multibillion-dollar link between private equity and public pension funds. If you are running an underfunded local or state pension fund these days, you are tasked with earning an outsize return every year. You need to have ever-better returns, but in this low interest-rate environment, where do you invest?
Enter the placement agent. For a commission that is paid by the private equity firm seeking to drum up investors, the placement agent will peddle the firm’s latest fund. The placement agent is best described as a matchmaker, one that finds pension funds looking to invest in high-earning private equity funds and sells those investments.
In 1991, placement agents were nonexistent. But in mid-2014, according to Preqin, they were involved in 41 percent of the fund-raising for North American private equity firms. And they were a mainstay of some pension funds. For example, the California Public Employees’ Retirement System, the large state pension agency better known as Calpers, invested in 784 funds using placement agents from 1991 to 2011, Preqin said. That’s about 27 percent of the funds Calpers invested in during that time, making a full-time business for placement agents.
It is also an idiosyncratic business. Some firms like Blackstone use their in-house placement agent (in Blackstone’s case, it’s Park Hill, which is well known in the industry). Others, like Bain, have never used placement agents.
There is a dark side to the placement agent business. Placement agents are paid amply, around 1 percent of the total investment (which can really add up on multibillion-dollar investments).
And it is a “who you know” business. In the mid-2000s, the business became a place where aging sports stars like Lynn Swann and ne’er-do-well politicians who would otherwise be unemployed could make millions promoting private equity’s wares to their old friends — the new political figures running the state and local municipalities.
With these types of characters and quick money available, is it any surprise that the pay-to-play scandals occurred? Bribery investigations unfolded in Kentucky, New York and California among other states. Fred Buenrostro Jr., the former chief executive of Calpers, pleaded guilty to conspiracy to commit bribery and fraud. .
His crime was steering more than $3 billion in funds to the private equity firm Apollo Global Management after being bribed by a placement agent firm headed by Alfred Villalobos, the former deputy mayor of Los Angeles. Mr. Buenrostro had received $200,000 in cash placed in shoe boxes. As a kicker, he received a round-the-world trip from Mr. Villalobos, who also paid for Mr. Buenrostro’s wedding. Mr. Villalobos, who made more than $50 million in fees from his dealings, committed suicide this year.
In New York, Alan G. Hevesi, the former comptroller of New York State, also went to jail over a pay-to-play scandal involving a web of his friends and family.
The budding political career of Steven Rattner, the founder of the private equity firm Quadrangle Group, was ruined over the firm’s involvement in securing a business deal for the brother of the chief information officer of New York State’s pension fund.
After these and other cases, it looked as if placement agents would be goners. The Securities and Exchange Commission proposed banning them, picking up a call made by the chairman of the agency at the time, Arthur Levitt Jr., in the 1990s.
New York did indeed ban placement agents, as did Illinois and New Mexico. The private equity firm Carlyle Group was caught up in the Hevesi scandal and reached an agreement with New York State to no longer use placement agents.
These moves also raised the question: What did placement agents really do, except take fees that were paid by private equity firms and then passed back to pension funds? Why couldn’t the pension funds simply go to private equity firms themselves? Why was a middleman needed?
But Wall Street lives on, and middlemen and placement agents have survived. Many states adopted disclosure requirements, but the scandals have faded. Even the S.E.C. backed off a total ban.
Instead, the S.E.C. adopted watered-down rules that primarily limited placement agents from doing business with pension funds when the placement agent made political contributions to elected officials with influence at the pension fund.
The reason for the backpedaling was the perception that placement agents could help clients. They could connect lesser-known private equity funds with pension funds. Similar to real estate agents, placement agents could also serve as information sources, guiding pension funds through the private equity process and helping them select better investments.
Placement agents have not only stayed but thrived as private equity eagerly sought investors. In mid-2014, Preqin recorded that 2,188 private equity firms over all were seeking $737 billion in capital. That’s a lot of money, and it is not surprising that placement agents are used at the same level as before the scandals, and rising.
So what gives? Are we just repeating the mistakes of the past, or have placement agents been spoiled by a few bad characters?
A new study — written by myself, Stephen McKeon of the University of Oregon, and Matthew D. Cain, a financial economist at the S.E.C. — finds that the answer is mixed. The study examines placement agent investments from 1991 to 2011. That covered 32,526 investments in 4,335 private equity funds.
For the most part, private equity funds using placement agents underperformed the market by as much as 3.5 percent annually. In other words, most pension funds appear not to get value from placement agents.
We found that even at Calpers, which is big and knows better, funds invested in with placement agents lagged those without by 3.8 percent a year. That’s billions.
On the other hand, we also find that there are advantages to using placement agents. Funds that are new and unknown appear to be of particular use for placement agents. Similarly, the top placement agents (measured by activity) appear to place the better-performing funds.
The bottom line is that placement agents, though they persist, don’t appear to do much other than connect pension funds to mediocre funds. But the top placement agents do stand out, and they can serve to help steer pension funds into better investments.
The study also found that there can be a too close relationship with a pension fund and placement agent. We found that when a pension fund begins to invest with a single placement agent, there is trouble. In the 20-year period of the study, only three such funds had exclusive relationships with a pension fund. All three — Arvco Capital Research, the Wetherly Capital Group and Diamond Edge Capital Partners — had employees convicted in the pay-to-play scandals.
If placement agents only provide middling benefits, why are they thriving? This is really part of a bigger problem. Pension funds are desperate and still have outsize hurdle rates to hit to pay out all of the money they need to.
The stock market is helping, but we are six years into a boom market. With interest rates low, private equity funds are flush and it is a sellers’ market. Blackstone, for example, just raised a new $17 billion fund. A pension fund manager may believe that a placement agent may offer a head start in finding the right fund.
But there are costs. The state employee operating a pension fund is looking for comfort and access. A placement agent can provide both — vetting funds and offering up an easy-to-choose menu board of funds. The alternative is to find the funds yourself and be blamed for your poor performance.
Given what the latest study shows, comfort and access may not be enough. It might be easy to use a placement agent, but the heads of pension funds may do better if they instead do the work themselves.
An earlier version of this column misstated the status of Fred Buenrostro Jr.’s case. Although he has pleaded guilty, he has not yet been sentenced.