Tl;drI use a simplified example to illustrate these issues:Opaque Accounting: PE firms use “mark-to-model” pricing to hide losses from pension funds while charging premium fees for middling performance.The Bermuda Loophole: Firms move insurance liabilities offshore to bypass U.S. reserve laws, “unlocking” cash that should be held for safety.Self-Dealing: That unlocked cash is funneled into the PE firms’ own illiquid, high-fee funds (like CLOs), creating a massive conflict of interest.Systemic Fragility: With liquid reserves potentially as low as 5%, a mass claim event could trigger a 2008-style crisis and a taxpayer bailout.The “Exit Liquidity” Trap: Underperforming, illiquid assets are increasingly being pushed into 401Ks and retail platforms to offload risk onto average savers.IntroI’ve been reading Brookfield’s annual reports, listening to their conference calls, investigating their filings, and taking in their investor presentations for around 5 years now. At first I was pretty excited about it and owned the stock because I thought they were great, but the more I learned about finance the more I realized I knew nothing about Brookfield, and couldn’t, because their self-promotion was expert and their most important financials are buried in footnotes and caribbean-domiciled LLCs (so you literally can’t access their filings.)The straw that broke the camel’s back for me was a headline that said something like, “$10B in Distributable Earnings,” but when you looked down a few lines it was actually $9.8B, and I thought, who rounds $200 million? Additionally, when I tried to see what Distributable Earnings really is, I couldn’t really figure it out, and it turns out, neither can actual accountants. So from that moment on I’ve maintained a healthy level of skepticism towards them and other private equity companies, like Apollo, KKR, and Blackstone.These firms are basically fund managers, but instead of investing clients’ cash in stocks and bonds (like index funds or mutual funds) they invest in privately held assets, mostly real estate, credit (loans), equity (businesses), and infrastructure. Another key difference is that they borrow money (leverage), in addition to client capital, to make these investments, similar to getting a mortgage on a house.In theory, these funds perform better than indexes, but after fees, the data says not really. Their fee is usually 1.5-2% of assets plus a performance bonus when they sell the assets at the end of the fund’s life (hopefully for more than they paid). Doesn’t sound like much but when you manage $1T dollars (as they all do), 2% plus a performance bonus is pretty sizable.Who is paying premium fees for middling performance? Our pensions! Their biggest customers are pension funds and other such enormous institutions who like private assets because firstly they see it as diversification, which it is. However, pension fund managers also get paid for performance and the prices of these private assets don’t fluctuate on a daily basis as stocks and bonds do (mark to market), their prices are based on internal models (mark to model).So if real estate stocks drop the pension fund manager might see their performance bonus drop, but if they invest in private real estate funds the price never goes down and they can collect their bonus unscathed. “Illiquidity is a virtue” the CEO of Brookfield often opines.Recently though, illiquidity has not been a virtue. Facing redemptions (withdrawal requests) in the face of market weakness, many of these funds, especially in those that loaned to software companies, has called into question the business model. Why pay premium fees for more risk, middling performance, and limited access to your capital? Makes no sense (unless you’re a pension fund manager).On its own, this is kind of upsetting, but not really a big deal - it’s just another day in finance really. If some big institution chooses a bad money manager and they lose money or don’t make as much or are seemingly doing it for greedy reasons (like their performance bonus), it’s not risk, it’s just people being greedy and dumb - par for the course.But this essay is about SYSTEMIC RISK, how does ordinary greed turn into something to be worried about?We start with the exciting world of INSURANCE. Insurance on its own is a good idea.Intuitive (But Simplified) Example#1 - How insurance is supposed to workJim is a rich guy in town. Someone says, “hey Jim, if my house burns down, will you pay for it?” He says, “Sure. I did the research and there’s a 1% chance that happens in a year, your house is worth $100, so I’ll charge you $1 a year.” Someone says, “Okay, but how do I know you’re good for it?” Jim replies, “Oh, I’ll keep $100 in the bank and send proof to you every now and then.” Someone says, “Sounds good to me, thanks Jim.”Jim puts $100 in a bank account earning a bit of interest and collects $1 a year from Someone. He occasionally sends Someone proof the money is there. It turns out Jim likes this gig and soon has insured the whole town, 100x $100 houses. He charges them all $1 a year for insurance ($100 total), and keeps the total value of those houses in a low-interest savings account, $10,000, so he makes a little but has access to the money in case the whole town burns down in one go.Now, if a house has a 1% chance of burning down and he insures 100 of them, one is statistically probable to burn down. And sure enough, one does. He collects the premiums ($1 from each customer, $100 total) and uses them to rebuild the burnt down house. He still is collecting interest on his $10,000 “capital reserve” in the bank. Not bad Jim, not bad.Now here’s where it gets a little less obvious. Jim gets pitched an amazing restaurant idea and decides he wants to invest, but all his money is being used to let his insurance customers “know he’s good for it” if the whole town burned down. But he desperately needs $5,000 to invest in this restaurant idea. To do this he gets insurance on his insurance, it’s known as RE-INSURANCE.Jim finds the other rich guy, Joe, and says, “Hey Joe wanna be good for 50 houses if they burn down? I’ll pay you 1% of their value each year, so $50.” Joe, after doing his own extensive due diligence says, “Sounds good.” Jim asks, “How do I know you’re good for it?” Joe, the re-insurer, says, “Well I’ll put the $5,000 in a bank account and show you it’s still there from time to time.” Jim exclaims, “Great! For $50 a year, I’ve made sure my $5,000 worth of houses are taken care of in the event of a catastrophe, by someone else.”So with half the town’s houses accounted for, Jim can now retrieve $5,000 from his $10,000 low-interest savings account he was using to show his customers he was “good for the money in case of disaster,” and puts it into something riskier, like a restaurant.This is the totally above board scenario. This is how it’s supposed to play out. Jim and Joe are the ones taking the risks, the home-owners are not.#2 - The current shadowy situationHere’s the scenario that’s happening now.While on holiday in Bermuda with his family, Jim gets pitched the restaurant again, and again, he loves it. But Joe isn’t around, so Jim walks into a local Bermudian bank (yes Bermudian is what they call themselves).The Bermudian, as we’ll call him, hears Jim complaining about having all his money wrapped up in “capital reserves.” He says, “You know, we have different laws here in Bermuda, if you’re insuring $10,000 worth of houses, instead of needing to have the full $10,000 in your account, you only need $5,000.” Jim’s ears obviously widen. He replies, “But I can’t operate the insurance company from here!” Bermudian answers, “No you can’t, but your 5 year old son there, Jim Jr, he might want to RE-INSURE it Jim.”So they set up a company in Jim Jr’s name and, Jim Jr, now devouring a grape popsicle, re-insures the whole $10,000, meaning Jim Jr’s company has now taken on the risk of the houses burning down (as Joe did in the earlier example), freeing up some of Jim Sr’s money.How much? Well, by Bermudian law Jim Jr only needs half the value of the insured houses in a bank account (rather than the full amount), so $5,000 is transferred by Jim Sr to Jim Jr Re-Insurance LLC. Jim Sr keeps $5000 of his original $10,000. Jim uses that $5,000 to invest in the restaurant.#3 - Comparing both scenariosGetting a little thick now, so let’s review:In the first example, Jim Sr basically gave up half his insurance business to Joe in order to invest in the restaurant, but in the second hasn’t actually ceded anything, because Jim Jr is basically representing him. Jim Jr Re-Insurance LLC is now “good for” the 100 houses in town, but requires half the bank account Jim Sr needed before he stepped into that Bermudian bank - Jim Sr just found a way to insure the same 100 houses for the price of 50, freeing up $5,000 to put into riskier ventures, which was previously used to secure his clients’ property. He also doesn’t bother asking if Jim Jr “Is good for it” (as he did for Joe), and Jim Jr doesn’t charge his Dad particularly high premiums either.You might be wondering, but won’t the townspeople just take their business elsewhere once they see that Jim has only half the money needed to rebuild the town if disaster strikes? They absolutely would be wondering that, if they knew or could even find out. You see, Jim Sr can say on paper that the houses have been re-insured – same as he would if it were still Joe doing the re-insuring. This will assure most townspeople and their financial advisers.But Someone is persistent. He asks, “Pray tell, by whom? Joe I hope?” Jim says, “No by a company known as Jim Jr Re-Insurance LLC.” Someone might pipe up, “Well who the hell is that? I’m going to look into them.” What does Someone find? Nothing, because Bermuda doesn’t let outsiders read financial filings of corporations within its dominion. What a great deal for Jim!Back to the real worldJim is Brookfield/Apollo/KKR and this is exactly what private equity giants are doing now, except with life insurance companies. They’re buying up the massive US insurers, who as a whole underwrite $22T in US coverage and $62T in global coverage, move it offshore to “captive re-insurers” (aka Jim Jr LLC), take advantage of the looser laws there, and bring back onshore the extra dollars wringed out.What do they do with the money when it’s onshore? Why they invest it in their own illiquid, expensive private funds of course, then they get to pay themselves fees! For students of the 2008 financial crisis, this is often in the form of their own firm’s “Collateralized Loan Obligations.”Nevermind that they might be worse investors than they thought and lose the insurance company’s capital (datacenter CLOs anyone?) – what happens if there’s a big disaster and the people they’re insuring make tons of claims at once, more than Brookfield has capital in their Bermudian captive re-insurers? Well they have to sell their fund assets… but they can’t because it’s all in half-built apartments in Toronto.So the firm goes bankrupt, but policyholders are still looking to collect. What happens in this case is the other insurance firms are mandated to make the policyholders whole, except these firms also happen to be light on liquid assets… and the only option becomes let them all fail and the people lose billions and trillions in benefits that are rightfully theirs OR bail out the big boys. My bet would be on the latter.In small cases, this has already happened, 777 Partners used this exact scheme to buy Everton FC (yes the soccer team) and it didn’t work out - they’re bankrupt now. They partially got away with it because they had found credit rating agencies willing to rate their re-insurance vehicles A and BBB, Kroll Bond Rating Agency and AM Best, when their Bermudian re-insurers were clearly much less stable.In a market of trillions, a 777 Partners’ $2.5B doesn’t really matter, but it illustrates why people are worried these funds are coming under scrutiny. Because we know what is being risked (people’s benefits, annuities etc), but we don’t and can’t know by how much.ConcludingWe don’t and can’t know because the liabilities (the insurance) are domiciled in offshore captive re-insurance vehicles so the financials cannot be accessed. In the few leaks, 777 Partners for example, it looks like as little as 5% of the liabilities are covered by liquid assets (so 5 of the 100 houses from our example). Scary.Furthermore, the private funds into which the dollars that got wringed out were put, are themselves leveraged - meaning Brookfield (or someone like it) borrowed money in addition to adding the magic Bermudian dollars, often 3-5x more than they contributed. So if the fund sees a 20-33% drawdown in its value, it’s kaput. What a relief they aren’t subject to market pricing!The counterargument here is fairly easy to make: they’re net positive so far and this most recent bump is just market turmoil. And they’re probably right. They’d argue they are good investors and conservative underwriters etc etc, so the capital is better served in their hands than those stodgy old traditional insurance companies ever were.It’s also much easier to get results when interest rates are fairly low - buying a house at 2-4% feels as good to average people as buying a pipeline with 4% debt does to Brookfield. It would feel less good if those rates were to climb.Also, when companies like Brookfield can’t sell their funds’ assets at the end of the fund’s target end date, they just sell the assets to their other funds or those of their colleagues, partially to collect performance bonuses, and partially to hide failure.Increasingly, there’s even been a push to allow private equity into 401Ks (RRSP in the USA). Wealthsimple even offered me a “Private Credit Opportunity” last year. Essentially, these ideas would make the average person Brookfield’s exit liquidity for its underperforming assets.Moreover, it is both optimistic and foreboding that the NAIC (National Association of Insurance Commissioners) has begun implementing a “transparency framework” aimed at Private Equity-Owned insurers specifically targeting “Jim Jr LLC” scenarios.Lastly, the echo boom is firmly underway and economic growth seems likely to persist.All this is to say that there are lots of ways of keeping these juggling balls in the air. But when they start dropping, and people start getting a little fidgety in large enough numbers, pension funds try to withdraw from private funds, people want to cash-in their life insurance policies, their benefits before they can’t etc, will the companies who insure them have the capital? Or will there be a few pennies in a Bermudian bank and some half-finished apartments being sold for 10 cents on the dollar?Hopefully we don’t find out.