Fiscal Commission co-chairs Alan Simpson (L) and Erskine Bowles speak to reporters after their meeting with U.S. President Barack Obama at the White House in Washington April 14, 2011. REUTERS/Kevin Lamarque

From the mission statement on the North Carolina Innovation Fund’s website, a casual reader might assume the publicly funded initiative invests state pension money directly into promising local technology companies. But a recent report by a former Securities and Exchange Commission attorney tells a different story, a story of a fund that generates outsized fees -- paid by taxpayers -- to for-profit financial firms.

Like many states that invest taxpayer resources in similar local innovation funds, North Carolina relies on private financial players to direct the specific investments. This arrangement, which lets financial companies serve as fee-extracting middlemen between taxpayers and local businesses, is increasingly coming under fire as critics argue that it squanders taxpayer dollars on fees while creating the potential for political influence by campaign contributors.

North Carolina, which reported spending a total of $416 million on financial fees last year, illustrates the trend. There, public pension money meant to be invested by the Innovation Fund is filtered through as many as six fee-extracting financial intermediaries before it gets to local entrepreneurs.

One of those intermediaries is Carousel Capital, whose founder and current senior adviser is former White House chief of staff Erskine Bowles. Carousel received a 2011 contract to invest innovation fund money only weeks after a campaign fundraiser was held at Bowles’ home for the government official who oversees the fund, State Treasurer Janet Cowell, a Democrat. Just months earlier, the SEC had enacted a landmark pay-to-play rule designed to restrict campaign contributions from financial firms that manage public pension money.

"Programs geared towards boosting nascent entrepreneurs may instead end up boosting cronies of the nation’s rulers or legislators," Harvard professor Josh Lerner wrote in his book "Boulevard of Broken Dreams: Why Public Efforts to Boost Entrepreneurship and Venture Capital Have Failed — and What to Do about It."

Though lawmakers portray local innovation funds as sending money directly into the community's real economy, many funds -- in Michigan, Indiana, Oregon, New York, for example, as well as North Carolina -- are in fact set up to first deliver cash to financial firms, which are then supposed to invest the money in local companies.

Unlike retirement systems in California and Ontario, which put some public money directly into companies without paying financial management fees, these state governments’ investment initiatives use financial middlemen to direct the investments and extract fees. Some of these states employ so-called "fund of funds," with two or more layers of fee-taking middlemen between public money and local entrepreneurs.

Typically, there is an overall manager like Credit Suisse's Customized Fund Investment Group (which was recently sold to Grosvenor) or The Carlyle Group, which then assigns public money to underlying private equity and venture capital firms. As the Oregon Investment Fund puts it, the structure "commits money to both private equity and venture capital funds that in turn invest in companies located in the state."

The trouble with this structure is highlighted in the report analyzing North Carolina's tech-focused Innovation Fund, which was created by state treasurer Cowell in 2010 and has generated headlines about its investment in (among other things) mobile app developers and early stage life-science firms.

Concerned that North Carolina’s high fees have produced investment returns trailing the median for public pensions over the last four years, the State Employee Association of North Carolina (SEANC) commissioned a report about the Innovation Fund from former SEC investigator Ted Siedle. His analysis explains how each layer of financial intermediaries can extract more management fees, thereby both diminishing the amount of capital getting to local entrepreneurs and potentially reducing taxpayers' overall return on investment.

According to documents from the North Carolina Treasurer's office, taxpayers paid $1.6 million in fees (or 0.7 percent of the $230 million Innovation Fund) to Credit Suisse for managing the fund last year. That, however, may not be the entire outlay on fees. As Siedle’s report notes, the Innovation Fund directs capital through "fund of funds.” Those investments can also extract fees, which can be hidden in the lower returns passed on to investors.

Assuming these underlying funds charge the standard 2 percent management fee and 20 percent fee for investment performance, and taking into account private equity's typical transaction, monitoring and operating fees, Siedle estimates that the fund is paying as much as $15.2 million in management fees each year (and that's without factoring in any additional fees for investment performance). In all, Siedle estimates that since North Carolina's Innovation Fund launched in 2010, as much as $65 million that was billed as going to local entrepreneurs may have gone to financial middlemen in the form of fees.

Those fees are supposed to buy investment returns that significantly outperform the overall market -- the idea being that investors should pay a premium only for returns that cannot be secured through low-fee investments. In 2010, Carolina Journal reported that Cowell said “she expects the fund to outperform a stock index fund, that she hopes it will earn in the ballpark of 10 percent," and that she "wants the Innovation Fund to perform 2.5 percentage points higher than the Russell 3000 index."

While there is no publicly available independently audited evidence of the Innovation Fund’s returns, fund officials said in 2013 that it had generated a 15 percent return so far. By comparison, the Russell 3000 has generated a 16.5 percent return since 2011, and the S&P 500 has shown a 58 percent return since 2011.

Siedle told International Business Times that a significant factor in the Innovation Fund failing to beat the market is undisclosed fees charged by financial management firms.

In response to criticism that the Innovation Fund's structure diverts money from local entrepreneurs to financial middlemen, the North Carolina Treasurer's office issued its own rebuttal defending the fund as "a balanced mix of co-investments made alongside national investment firms and direct commitments to smaller individual private equity funds that have focused on North Carolina." In an emailed statement to IBTimes, a spokesperson for Cowell said that Siedle's fee estimate "is wrong." The spokesperson did not provide any evidence contradicting Siedle's estimate, and the Treasurer has asserted the right to keep detailed fee information secret. Seanc has called on the SEC to investigate.

Siedle's report suggested that investment decisions could be clouded by political considerations, and a timeline of the North Carolina Innovation Fund’s investment in Carousel Capital offers an example of the kind of situation that concerns him.

In March 2010, Cowell announced the creation of the Innovation Fund, in a government press release that quoted Erskine Bowles lauding the idea.

A year later, the SEC enacted its pay-to-play rule. That rule prohibits financial professionals at firms managing state money "from coordinating or soliciting any person [to] make any contribution to an official of a government entity to which the adviser is providing or seeking to provide investment advisory services." The rule includes a "look back" period prohibiting such contributions two years prior to any state investment. It also says financial professionals doing business with a state may "not funnel payments through third parties, including, for example, consultants, attorneys, family members, friends or companies affiliated with the adviser as a means to circumvent the rule."

Three months after the SEC’s March 2011 rule went into effect -- on June 22, according to the ActBlue fundraising website -- a fundraiser for Cowell was held at the home of Erskine and Crandall Bowles. Then, a few weeks after the fundraiser, reported the Triangle Business Journal, Bowles’ firm, Carousel Capital, was selected by Cowell’s Innovation Fund "to help deploy" an undisclosed amount of $230 million of taxpayer money. Carousel already collects fees from other investments it manages for the North Carolina pension system, and its separate deal to manage Innovation Fund investments adds to those fees.

In response to questions about the timing of the fundraiser, Cowell's spokesperson told WRAL that "the fundraiser was held at the house that Mr. and Mrs. Bowles share” but that "Erskine Bowles was not a host for the event." The spokesperson said it was a fundraiser hosted only by Crandall Bowles -- who is a board member of JP Morgan, another firm with which North Carolina invests taxpayer money. At the time of the fundraiser, Bowles was a board member of JP Morgan, and North Carolina invested money with JP Morgan, according corporate and government documents.

IBTimes received no responses after contacting JPMorgan Chase & Co. (NYSE:JPM) with a request for comment from Crandall Bowles, and after contacting Carousel Capital with a request for comment about Bowles’ status at the firm.

Cowell's spokesperson said in an emailed statement that "by policy and practice, political issues have no role in investment decision-making." The spokesperson declared that "the political contributions of Crandall Bowles do not create an issue under the SEC Rule on political contributions by investment advisers" because, he asserted, "Erskine Bowles, in his capacity as Senior Advisor to Carousel Capital, is not a 'covered associate' as defined under the rule."

In his own emailed statement responding to questions about the relationship between Carousel, Cowell and the Innovation Fund, Bowles said that he and his wife periodically host fundraisers for public officials, but that he was not involved in the Cowell event. He also distanced himself from Carousel Capital, despite being listed on its website.

“I have had no active role [in Carousel] since 2005,” wrote Bowles, who was the co-chair of the Obama administration's Simpson-Bowles Commission that proposed major changes to Social Security. “I am not involved in the management of the firm nor do I [have an] office there. Should they want my advice I would gladly give it. However I have had no role in any fund raising in the last 10 years and have not spoken to North Carolina or for that matter anyone else about investing in Carousel during that time.”

The SEC recently prosecuted its first case under the 2011 pay-to-play rule, and Public Citizen’s Craig Holman told IBTimes that he believes North Carolina warrants SEC scrutiny.

"It stretches credulity to believe that Erskine Bowles, as founder and senior advisor to Carousel Capital, does not play a significant role in influencing the company’s investment decisions,” Holman, who leads Public Citizen’s efforts to pass pay-to-play laws, said. “Bowles should be assumed to be a covered associate under the SEC pay-to-play law, and an investigation should be conducted by the SEC to make a final determination. The role of the Bowles family in hosting extensive campaign fundraisers for state officials that oversee the management of state funds, and their investment firms receive state funds and contracts in return, is precisely the type of suspicious activity the pay-to-play rules are designed to prevent."

In response to Bowles’ comments, Seanc executive director Dana Cope told IBTimes: "This is exactly the type of thing that made Seanc file a complaint with the SEC. When an investment manager hosts a fundraiser for the Treasurer at his home, and the Treasurer follows that fundraiser by handing him a contract which the public is not even allowed to see, it is time to stop the madness and demand accountability."