US public pension funds may play a role they would prefer to avoid in the 2016 presidential campaign as protagonists in the politically controversial private equity (PE) industry. Indeed, one of the reasons the Republican Mitt Romney lost the race to the White House was his connections to the sector.

At the centre of the dispute are the fees that PE fund managers earn – typically a 1-2% annual management fee on committed capital that is taxed as income, plus 20% of carried interest that is taxed at 23.8% as a capital gain. President Obama wants to raise the latter rate up to 43.4% while the Democrats’ frontrunner Hillary Clinton and Republicans Donald Trump and Jeb Bush have also promised to impose a higher rate.

US public pension funds are involved because they have become the largest investors in PE in the world, with more than $350bn (€332bn) committed globally, according to Preqin. The results of their bets on this kind of alternative assets have been significant – over the past decade, PE investments have beaten all other pension fund asset classes with an annualised 11.9%, compared with 7.7% for real estate and 7.1% for stocks, according to the Wilshire Trust Universe Comparison Service.

But big gains mean also big performance fees, with the aggravating problem that there are no standard rules on how these fees must be disclosed to pension funds. Until recently, pension funds reported the management fees they paid but not total costs including performance fees. 

Things started to change two years ago when the South Carolina Investment Commission in charge of the state’s $29.3bn (€27.4bn) pension fund asked its private equity managers for specific data and began to analyse their reports more thoroughly. It turned out that the real costs of its PE investments were more than double those originally stated. For example, in the last reported fiscal year, management fees paid by the South Carolina State pension funds were $27m, but the performance fees were $35.3 million so the total costs were $62.3m.

Public pension funds in New Mexico, Kentucky and New Jersey have also calculated the total costs of their PE investments and realised they were much higher than they had previously disclosed.

The discussion rose in pitch at the end of last November, when the largest pension fund in America, the $295bn California Public Employees’ Retirement System (CalPERS) released a report on the issue. That report was a game changer, able to unleash a trend according to Reena Aggarwal, a finance professor at Georgetown University in Washington DC. In fact, following CalPERS’ example, other large pension funds may ask their  private equity firms for complete transparency on costs. Aside from that, the high level of CalPERS’ fees could fuel the political campaign in favour of higher taxation of carried interest.

CalPERS previously only reported management fees, but has now implemented a new tool, the Private Equity Accounting and Reporting Solution (PEARS), which sheds new light on the industry. For example, during the fiscal year ended 30 June 2015, CalPERS paid $414m in management fees but the retirement system’s total PE costs were more than $1.1bn thanks to profit-sharing agreements that resulted in $700m in performance payouts. Net profits from those investments were $4.1bn.

CalPERS has $28.7bn, or about 10% of its portfolio, invested in more than 700 PE funds; it is its top-performing asset, producing annual returns of 12% over the past decade. “As a long-term investor, it is an important piece of our investment strategy,” Ted Eliopoulos, CalPERS Chief Investment Officer said in a statement last November.

Regardless of performance, compensation to private equity managers is still excessive according to former CalPERS board member Michael Flaherman, who is now a visiting scholar researching public pension investment at the University of California at Berkeley.