Delilah Rothenberg has obsessed over inequality since her college years at NYU, where she studied neo-colonialism and neo-imperialism as a triple major in history, politics and African Studies.
While in college, she did some volunteer work in Tanzania. What stuck with her most was not her actual volunteer work but the small and growing businesses she encountered that struggled to access capital. She wanted to help global investors move money to those companies. But knowing nothing about finance, she crashed a career fair at the NYU Stern School of Business during her senior year and landed a job at a research firm that analyzed companies for hedge funds. By 2008 she was working on the trading floor at Bear Stearns, one of the investment banks that famously collapsed during the financial crisis.
Rothenberg landed in the private equity industry, where she started exploring ways for private equity firms to push portfolio companies to do things like pay workers a living wage, create more employee profit-sharing or employee-ownership structures, reduce executive-to-average employee compensation ratios or introduce more environmentally sustainable business practices.
She found these attempts mostly frustrating. One friend she’d made in the industry eventually pointed out that she worked in private equity and the executives at the largest private firms often make way more than corporate executives.
The average CEO compensation among companies that make up the S&P 500 index is reportedly $15 million. Meanwhile, Steven Schwarzman, CEO of Blackstone, the world’s largest private equity firm, reportedly earned $1.1 billion in 2021. As Rothenberg knew intimately from her own employer’s business model, this was due to the standard way investors compensate the Wall Street “fund managers” who manage their investment portfolios.
Rothenberg quit her private equity job in 2018 to co-found The Predistribution Initiative, devoted to reducing inequality by changing the basic business practices of Wall Street.
“It’s complex and it’s not something you can show a picture of in real life like a hungry child or a vulnerable woman,” Rothenberg says. “It’s really technical stuff, but it needs to be addressed if you’re going to help the hungry child or the vulnerable woman or the person on the street or victim of extractive practices of the private equity firm that owned somebody’s home. All these issues come from somewhere.”
Reducing inequality is suddenly a fashionable discussion topic on Wall Street. Just last week, the Wall Street Journal first reported more than 60 banks, pension funds and private equity giants announced the backing of Ownership Works, a new nonprofit promising to create $20 billion in wealth for “lower-level workers” over the next decade through employee-ownership of portfolio companies.
Additional wealth for workers at the lower end of the economic ladder is never entirely meaningless. But as the Wall Street Journal notes, the wealthiest 10% of Americans held $36 trillion in stocks and mutual funds in 2021. According to Federal Reserve data, that’s 21 times the amount those households held in 1989, compared with $260 billion and an increase of just 12 times for the bottom 50%.
An additional $20 billion in wealth over ten years for the bottom 50% wouldn’t make a dent in the wealth ratio even if the wealth of the top 10% stayed at the same dollar amount over the next ten years — which it certainly won’t.
Elsewhere, the White House recently announced a proposal for a “Billionaire Minimum Tax” and local lawmakers in Philly are renewing a push for a redesigned wealth tax that could raise up to $280 million in local funding during a tough fiscal moment for the city.
Rothenberg welcomes the new Ownership Works initiative as “a good step” in the right direction. However, she is convinced more needs to be done. Rothenberg wants to bring more attention to the mechanisms that create inequality by design .
Delilah Rothenberg, the co-founder of The Predistribution Initiative (Photo courtesy of Delilah Rothenberg)
“As long as the wealth of the fund manager executives is growing at an exponentially faster rate than workers or beneficiaries of portfolio companies, the wealth gap is going to grow,” Rothenberg says. “That matters because when wealth pools to very few individuals in the economy, they have the ability to buy up assets like real estate or public equities and that pushes up the valuations or increases the barriers to entry for everyone else. This is happening right now before our very eyes.”
For many decades, the basic fund manager compensation model has been known as the “2 and 20” model. It can be slightly more complicated, but it basically refers to an annual fee of 2% of assets under management plus 20% of profits from sales of stocks, real estate or other investments. The clients who pay these fees include large institutional investors like public and private pension funds, insurance companies, foundation or university endowments, and foreign investor funds as well as wealthy individuals or families.
The thinking behind the “2 and 20” model was that it would align interests — the better the clients did, the better fund managers would do. But since the fees are based on a percentage of assets managed and wealth growth has accelerated over the last decades, fund managers’ revenues have increased automatically in proportion, far exceeding what’s needed to cover the actual salaries and operating costs for fund management firms. The annual bonuses for their executives and employees are tax-deductible for the firms themselves, by the way. This is why financial sector firms accounted for 10% of corporate profits forty years ago, but by 2013 they already accounted for 30%.
The implications for financial hubs are many. In places like New York, Boston and San Francisco, speculative developers have institutionalized the practice of catering to the steady influx of young, highly-paid financial sector workers replacing former working-class tenants. Developers and landlords with commercial space jack up rents on bodegas and discount clothing stores while bistros and boutiques cater to the newer, bigger spenders in the neighborhood. Tech workers get some of the blame but without venture capital and private equity firms, they wouldn’t have startup firms to work for.
To Rothenberg, the speculative developers, landlords, wildly well-compensated financial professionals and tech-bros are just some of the real-world manifestations of the “2 and 20” model. There’s also the shuttering of once-proud retailers like Sears, Payless Shoes and Toys-R-Us, consequences of the leveraged buyout model private equity firms use to meet their financial goals under the “2 and 20” model. If there was a different incentive structure at the heart of each private equity or venture capital firm, Rothenberg believes they would be making different investments, perhaps in a wider set of industries, and using investment structures that might be more favorable to portfolio companies that promise to be better for workers and communities.
“There’s a lot of excitement about supporting campaigns to get fund managers to be more responsible on a deal-by-deal basis, to address human rights abuses, or to address the issues as they manifest on the ground but there’s not a lot of recognition of why these issues are manifesting and where they’re coming from,” Rothenberg says. She’s not entirely opposed to private equity or venture capital — she sees a place for those investment models in a healthy economy, but she says it’s the “2 and 20” incentive structure that needs to change because of how it reproduces inequality and encourages extractive, profits-above-all-else investments.
In industry parlance, private equity or venture capital fund managers are also known as general partners or “GPs” and the clients are known as limited partners or “LPs.” Over the past decade, large institutional LPs have started placing more and more assets under the management of private equity GPs. Earlier this year, the Wall Street Journal reported U.S. pension funds’ private-equity investments swelled to an average 8.9% of holdings in 2021 after three years of straight growth — amounting to roughly $480 billion of state and local pension fund assets tracked by the Federal Reserve, up from about $300 billion invested in private equity back in 2018.
Large institutional LPs like pension funds or insurance companies routinely allocate and re-allocate large sums of money between stocks, bonds, real estate and “alternative” assets like investments in private equity or venture capital funds. They constantly attempt to balance out the need to pay pensioners or insurance claims today against growing their portfolios enough to ensure they can cover payments they need to make tomorrow. Public pension funds are under immense pressure, with record numbers of baby boomers retiring every year. Sponsor governments feel constant budget pressure to reduce or avoid payments into the funds — most public pension funds already know the amount they’ve promised to pay retirees over the foreseeable future exceeds what they currently hold in their investment portfolios.
“LPs are doing their best to get by and cover their liabilities based on the internal way of calculating liabilities and the governance structures that tell them this is the way you need to invest to cover your liabilities,” Rothenberg says. “We’re trying to break through the bureaucracy and say, actually, there’s another way to design their portfolio to get a roughly 7% return they typically need every year.”
Large institutional LPs have sought ways to reduce fund manager fees, but it it’s become difficult because of their reliance on what’s known as a “barbell” type of approach. At one end, super-low fee investments in very low-risk investments like index funds or basic blue-chip stocks and U.S. Treasury bonds don’t generate very much in returns. To make up for the low-return investments, LPs look for private equity funds that are considered much riskier but routinely generate significantly higher returns.
Rothenberg had hoped early on that very large clients of private equity firms would use their status to muscle out alternative compensation structures besides the “2 and 20” model that would lower the absolute amount in fees paid while also incentivizing investments that don’t rely on jacking up the value of real estate to generate sufficient returns or over-burdening portfolio companies with debt as part of a leveraged buyout scheme to generate investor profits. Big LPs, she reasoned, could work out fixed annual amounts to pay GPs based on the staffing and other costs of managing portfolios.
But so far, the large LPs are so dependent on a few large private equity firms that the GPs tend to dictate the terms.
For now, Rothenberg continues to increase the frequency of discussions with LPs and others interested in exploring alternatives to the “2 and 20” model and how those alternatives could incentivize a financial system to be more responsive to workers and communities. She’s also engaging with worker and community organizers to get a sense of how they’d like to see LPs pushing for GPs to change — insights her group recently gathered in a white paper.
Fund manager compensation isn’t the only thing that Rothenberg thinks needs to change, but it’s the one that has captured her imagination. It’s also tied to many other issues — for instance, the lobbying fund manager firms do to sway regulations and laws in favor of ever-higher returns at the expense of workers, communities and the planet.
“It’s not particularly sexy to dig into what policies and procedures of LPs are limiting their ability to invest in other kinds of funds and more regenerative deal terms,” Rothenberg says. “Nobody’s incentivized to address these issues. Instead of engaging companies or private equity firms on a one-by-one basis every time an issue comes up, why not just change the system to begin with?”
This article is part of The Bottom Line, a series exploring scalable solutions for problems related to affordability, inclusive economic growth and access to capital. Click here to subscribe to our Bottom Line newsletter. The Bottom Line is made possible with support from Citi.
Oscar is Next City's senior economics correspondent. He previously served as Next City’s editor from 2018-2019, and was a Next City Equitable Cities Fellow from 2015-2016. Since 2011, Oscar has covered community development finance, community banking, impact investing, economic development, housing and more for media outlets such as Shelterforce, B Magazine, Impact Alpha, and Fast Company.