Political Representation and Governance: Evidence from the Investment Decisions of Public Pension Funds

• Date: 01 October 2018
• Author: ALEKSANDAR ANDONOV,YAEL V. HOCHBERG,JOSHUA D. RAUH
• DOI: http://doi.org/10.1111/jofi.12706
• Published date: 01 October 2018

THE JOURNAL OF FINANCE •VOL. LXXIII, NO. 5 •OCTOBER 2018

Political Representation and Governance:

Evidence from the Investment Decisions of

Public Pension Funds

ALEKSANDAR ANDONOV, YAEL V. HOCHBERG, and JOSHUA D. RAUH∗

ABSTRACT

Representation on pension fund boards by state officials—often determined by statute

decades past—is negatively related to the performance of private equity investments

made by the pension fund, despite state officials’ relatively strong financial education

and experience. Their underperformance appears to be partly driven by poor invest-

ment decisions consistent with political expediency, and is also positively related to

political contributions from the finance industry. Boards dominated by elected rank-

and-file plan participants also underperform, but to a smaller extent and due to these

trustees’ lesser financial experience.

HOW DO POLITICIANS AFFECT THE GOVERNANCE of the organizations with which

they are associated as board members or fiduciaries? A large literature suggests

that political connections can be extremely valuable for firms (Fisman (2001),

Johnson and Mitton (2003), Faccio (2006), Cooper, Gulen, and Ovtchinnikov

(2010), Duchin and Sosyura (2012), Amore and Bennedsen (2013), Goldman,

Rocholl, and So (2013), Akey (2015), Acemoglu et al. (2016)). While existing

literature focuses on cost of capital and procurement contracts as channels for

political influence, an unexplored channel through which political influence

may also affect governance is public asset management boards. In this paper,

∗Aleksandar Andonov is with Erasmus University Rotterdam. Yael V. Hochberg is with Rice

University and NBER. Joshua D. Rauh is with Stanford University and NBER. Aleksandar An-

donov, Yael V. Hochberg, and Joshua D. Rauh have read the Journal of Finance’sdisclosure policy

and have no conflicts of interest to disclose. We are grateful to Eddy Hu, Ruomeng Lu, Jo Sun, and

Cindy Wu for research assistance, to Sunil Wahalfor help with the consultants data, and to Itzhak

Ben David, Randolph Cohen, Richard Evans, Victoria Ivashina, Steve Kaplan, Josh Lerner, Ron

Masulis, Ludovic Phalippou, Denis Sosyura, Andrei Shleifer, Joacim Tag,and seminar, workshop,

and conference participants at Erasmus University, Harvard Business School, Oxford University,

Stockholm School of Economics, the joint Berkeley-Stanford finance seminar, Arizona State Uni-

versity, University of California San Diego, Carnegie-Mellon University, University of New South

Wales, Australian National University, University of Hong Kong, Columbia University, Rotman

ICPM, Luxembourg Asset Management Summit, NBER Law and Economics Summer Institute,

NBER Corporate Finance, NBER Entrepreneurship, the UNC Private Equity Conference, the

Finance Down Under Conference, the European Finance Association, and the American Finance

Association for helpful comments and suggestions. The authors are grateful for funding from ICPM

in support of this project. The Internet Appendix for this paper is available in the online version

of this article on the Journal of Finance website.

DOI: 10.1111/jofi.12706

2041

2042 The Journal of Finance R

we demonstrate that political representation on asset management boards has

very different effects from those previously demonstrated, and we shed light

on mechanisms that may lead to these differences.

Our setting is the universe of U.S. public pension funds. Public pension

fund boards of trustees—the composition of which is mostly fixed over time

and set decades in advance—are characterized by both high average levels of

political representation and considerable heterogeneity in the extent of politi-

cal representation across boards. These features provide us with a laboratory

for exploring whether political representation on boards affects decisions and

outcomes, and, if so, whether on average politicians improve or detract from

investment performance. On the one hand, politicians involved in asset man-

agement might be able to use their influence or expertise to gain access to and

direct assets into higher performing investments. On the other hand, conflicts

of interest or a lack of financial expertise might lead politicians to pursue po-

litical goals, at the cost of the financial returns of the investments. The latter

would be similar to the behavior of overtly political investors such as sovereign

wealth funds (Bernstein, Lerner, and Schoar (2013)).

The decisions we examine are the pension fund’s investment allocations and

performance in the private equity (PE) asset class, specifically, buyout, ven-

ture capital (VC), real estate (RE), natural resources, funds of funds, and other

miscellaneous private investment categories. The PE setting is well suited to

examine investment performance for a number of reasons. First, the invest-

ment policies of public pension systems have shifted markedly toward alter-

native investments.1Second, PE exhibits a large interquartile spread in fund

performance, even within relatively narrowly defined fund types, and there-

fore the quality of investment selection is likely to have large consequences for

performance. Third, the relative opacity of the asset class raises the potential

for nonfinancial incentives to affect investment decisions. Finally, each invest-

ment has a clear investment date at which it is entered into, namely, the fund’s

initial closing, which is commonly referred to as the fund’s vintage year.We can

therefore attribute each investment decision to the board members who served

in that specific year.2

There is substantial heterogeneity across public pension funds in the per-

formance of buyout, VC, and RE investments. Prior literature examines dif-

ferences in the PE performance of different types of institutional investors

(Lerner, Schoar, and Wongsunwai (2007), Sensoy, Wang, and Weisbach (2014)).

To the extent that there are differences, these are attributed to differences in

investment objectives, incentives, or investor sophistication. In theory, how-

ever, all public pension funds should share at least one objective: to provide the

benefits promised to participants as efficiently as possible for taxpayers. In our

context, it is the relative representation of politicians on the board of trustees

1For example, in June 2016, the California Public Employee Retirement System (CalPERS)

invested almost 20% of its $295 billion portfolio in buyout, RE, and VC compared to 13% in 2001.

2Were we to focus on investments in public equity or fixed income, making such an attribution

would be difficult.

Political Representation and Governance 2043

that introduces differences in incentives across pension funds. We therefore

focus on the relationship between the fraction of state officials who sit on the

board, and the nature and performance of the PE investments made by the

pension fund.

The performance of public pension funds in PE as measured by net internal

rate of return (IRR) is strongly related to the relative representation of politi-

cians on their boards: each 10 percentage point increase in the fraction of board

members who are state officials reduces net IRR by 0.9 percentage points if the

official is appointed by another state official and by 0.5 percentage points if the

official sits on the board by virtue of her office (ex officio), relative to the omit-

ted category, participant-appointed board members. While other categories of

trustees also exhibit performance differences, they are of smaller magnitude;

for example, a 10 percentage point increase in elected plan participants on the

board reduces net IRR by 0.2 to 0.4 percentage points. Appointed members of

the general public do not perform better than appointed members of the pension

plan itself, and relative to their financial experience may even underperform.3

These results are strongest within VC and RE, and they are not explained by

the pension fund’s choice of investment consultants, risk-taking, or experience

with PE.

Why might pension funds whose boards contain greater representation by

state officials underperform? Shleifer (1996) summarizes three theoretical

channels for poor policy-related decision making on the part of state officials.

First, the Control channel posits that politicians may make suboptimal deci-

sions if a desire to increase political support leads them to pursue legislation,

regulation, or other political actions that advance the interests of particular

industries, unions, or trade groups (see also Stigler (1971)). Second, the Cor-

ruption channel predicts that politicians may make suboptimal decisions if a

desire for personal gains leads them to pursue quid pro quo, bribes, or kick-

backs (see, e.g., Shleifer and Vishny (1994), Fisman, Schulz, and Vig (2014)). In

our setting, this may correspond to outright bribes, future jobs in the private

sector, or political contributions to the extent that such funds are used for per-

sonal gain. Finally, the Confusion channel predicts that politicians may make

suboptimal decisions if a lack of knowledge, expertise, or ability leads them to

use incorrect economic models or parameters when making decisions.

Applied to our setting, these channels first imply that boards with state

officials who face conflicts of interest may not allocate assets to maximize

financial returns. Board members receive limited remuneration. As a result,

incentives to exert effort to select the best performing investments may not

be sufficient to dominate incentives to invest for political gain (the Control

hypothesis) or for personal gain (the Corruption hypothesis).4In addition, if

state officials have less financial knowledge or expertise, boards with more

3These relationships are also obtained using both cash-on-cash multiple and public market

equivalent (for a smaller subsample of PE investments) as performance measures.

4Some examples of such opportunism have come to light as a result of investigations of so-called

“pay-to-play” activity by public officials. For example, former Connecticut state treasurer Paul J.

Silvester who held a CFA, a bachelor’s degree in finance, and an MBA and had worked as an