When I went to my inbox at the start of my day, one of the noteworthy e-mails in my inbox had the subject line: “NYT Column about You.” Its content:
Though your fight is never mentioned, this column is clearly motivated by your dispute with CalPERS. This is an “Empire Strikes Back” piece:
Now I tend not to personalize things, particularly since the idea that New York Times Dealbook column would be a channel for taking issue with my lawsuit against the giant public pension fund CalPERS seems a bit grandiose. But several other observers read this column the same way, and on reflection, they are probably right.
By way of background, last September, we filed a Public Records Act request (California’s version of FOIA) for private equity return data that CalPERS had not previously published. While CalPERS has published quarterly data on a fund-by-fund basis since settling an earlier Public Records Act case in 2002, three researchers at Oxford published a paper in 2013 which discussed specifically and in detail how they were the first to obtain the entire history of CalPERS’ investing in private equity, back to its first participation in the strategy in 1990, including previously non-public data. For more detail, see this post. This battle escalated when CalPERS issued a remarkable press release last week attacking us and our suit.
There are two reasons to believe that this article by Jonathan Axelrad, a partner in the Silicon Valley office of Goodwin Proctor and co-head of its venture capital practice, was indeed spurred by our lawsuit (keep in mind that venture capital is a subset of private equity; the other main type of strategy is “buyouts” which is the acquisition of mature companies). The first is that the nominal news hook for this piece is a much older struggle by reporters, in this case Reuters, with the University of California to obtain venture capital returns information. The fact set differs in big ways from our lawsuit, and even this article simply mentions it rather than going into details. The critical part is that Reuters won in lower court in October 2012 but lost on appeal in December 2013.
December 2013….December 2013. Let’s see, this is April 2014. Someone felt motivated to write about an old news decision now? You can see why discerning readers thought the real driver might be something a tad more current.
The second reason is that our case is getting more attention than we thought in the pension fund world, no doubt due to the reporting of Chris Witowsky at the Reuters publication peHUB, which has published two stories about our lawsuit. For instance, we got this message earlier this week from Michael Hudson who said he had gotten e-mails from two different correspondents in the pension fund business about our suit against CalPERS and concluded, “At any rate, they are now under scrutiny for this by what looks like the entire pension fund community, wondering just what’s up.”
Another correspondent wrote:
We were talking about the CALPERS thing, and my friend says, “Well, you know CALPERS has shut down and lawyered up since receiving requests from Yves Smith.” I started laughing – how strange. These organizations used to fear Congress, or a litigation firm, or, I dunno, the Irish Mafia – but now, one single intelligent person who refuses to buy their story is enough to freak everybody out. Now, I know that you have numerous talented collaborators and are seriously informed – but you know what I mean. This internetwebs thing sure is powerful.
Now even though there apparently is some interest in our case, that does not mean this article is part of an orchestrated pushback. It’s more likely that Axelrad heard some grumbling in his circle and thought he could play a quasi-statesman role by articulating the industry party line.
So what does the article say? It’s a well-packaged recycling of already-disproven arguments for lowering the disclosure of performance data. But of course, it positions itself as trying to strike a balance between the needs of fund managers like venture capitalist and the public, when the conclusion it reaches are clearly favors the fund managers.
The article gets disingenuous quickly. This is the third paragraph:
First, a little background. The venture capital business is actually a fairly confidential one. A venture capital fund typically raises money by privately offering limited partnership interests. The fund then invests in young companies that are privately offering preferred stock.
Folks, the industry is not natively or inherently confidential. Real estate syndications, oil exploration deals, and all sorts of investments structured as limited partnerships and sold as “private” placements, which means they are not registered with the SEC and offered to the public at large. So while there are important restrictions on marketing these investments, that is not tantamount to an inherent need for pre-Snowden-NSA levels of secrecy, which is what the industry seeks to impose.
But what Axelrad then does is try to conflate confidentiality at the company level (that is, the so-called portfolio companies that the funds invest in) with confidentiality at the fund level:
Until a company goes public in an initial public offering, both the fund and the company have many reasons to maintain confidentiality. Young companies are fragile. Their most valuable assets may be intangible, like business plans and technical insights. Struggling to attract customers, business partners and additional employees, they can be destroyed by premature publicity or even rumor.
First, no one, and that includes Reuters in their suit, was seeking to get information about companies. And the claim that anyone was ever seeking disclosure of “business plans and technical insights” is a straw man. Public companies, which are subject to extensive disclosure requirements, don’t reveal sensitive competitive information. To be blunt, what the VCs are sensitive about is the publication of how bad the losses are at startups, and what competitors might be able to infer about staffing levels and other cost drivers. Even if they weren’t that bad, it’s not hard to see that other companies could spin the results to pick off staff or scare prospective customers. But this isn’t a contested issue and so bringing it up is diversionary.
And the next section contains a point that investors should find very troubling:
Venture funds have their own reasons to crave confidentiality. It is notoriously difficult, for example, to establish the value of private company stock in their portfolios. Different venture funds that have invested in the same private company may attribute wildly different values to their holdings. Publication of those valuations could wreak havoc on young companies.
Translation: VCs don’t want to be caught out valuing the same company differently. But you can see the barmy claim about how the secrecy is necessary to protect the company, and not to save the VCs from embarrassment or worse. Well, take it back, Axelrad does ‘fess up to that issue:
Prematurely publishing information about the investment performance of a specific venture fund can damage the reputation of its parent venture capital firm, making it more difficult for the firm to conduct business.
Ahem, if you publish inflated valuations, pray tell why shouldn’t investors punish you? And why is this a bad thing? Axelrad comes close to defending a Gresham’s dynamic where bad actors (those who exaggerate returns) suffer no consequences, and that puts them at an advantage relative to the firms that are more realistic. Remember, VC fund have seven to as long as 15 year lives, and most raise money 4-5 years after their last fund was launched. That means those squishy interim valuations are what investors rely on when deciding whether to invest in a new fund.
The Oxford study that led us to seek data from CalPERS found widespread exaggeration of valuations at the time private equity funds are raising new funds (both VC funds, where the companies are legitimately more difficult to value, and the “buyout” funds that focus on established businesses). In other words, this concern about cheating has been confirmed in a large-scale study using the data we’d like to get our hands on. You can see why the industry is so keen to keep everything under wraps.
We then get the next sleight of hand:
If both portfolio companies and their venture capital backers are motivated by similar desires for confidentiality, what’s the rub? It’s this: A large portion of the money invested in venture capital funds comes from public agencies, and these agencies are governed by myriad laws intended to protect the public’s right to know.
In other words, the problem is the damned government. In reality, more disclosure is good for the investors, since they can make better decisions about which funds to invest in over time. This is true regardless of whether they are public pension funds or private investors like wealthy individuals or endowments. But as we’ve seen with CalPERS and its Los Angeles cousin LACERA, the public pension funds have a bad case of Stockholm syndrome and too often cater to the needs of the private equity industry when they’d do much better to show more spine.*
The article goes through the more-than-decade-old legislative battle that assured portfolio-company-level confidentiality but required disclosure of overall fund returns. The article gets squirrelly again:
Nevertheless, almost no one in the venture industry is happy about the law’s requirement that each fund’s performance data be disclosed each year. Indeed, the websites of California public agencies that disclose this data are replete with warnings that the information is unreliable and misleading.
Um, aren’t customers’ desires, in this case those of the pension funds, the ones that count? In just about every industry, dealing with customer requirements is often a pain but vendors must nevertheless respond to their pet needs. It’s revealing how Alexrad gives such prominent play to the venture capitalists’ unhappiness with completely reasonable customer desires.
Moreover this paragraph parrots the scare tactics used ten years ago to try to block disclosure of overall fund returns, that it would scare the children, um, the broad public who was too unsophisticated to understand the information. It was established pretty quickly that the broad public doesn’t like reading financial statements, and only people with an interest (which means pre-existing finance knowledge) look at these documents.
To the extent the article talks about the Reuters-Univesity of California case, it’s again disingenuous. In very simple terms, Reuters won a case years back about obtaining returns data from public pension funds. Two venture capital firms, Sequoia and Kleiner Perkins, had a hissy fit and refused to let funds that would disclose their return data invest in them. Now this is of course terribly dramatic and has given some grist to the public pension funds’ paranoia that they’s be shut out of investments if they get too uppity. But the fact is that public pension funds overall aren’t big venture capital investors. And people in the industry argue that there was a obvious self-serving motive for Sequoia to hide its returns. Sequoia has launched a number of foreign funds, and many are believed not to have performed well. Why would you invest in Sequoia’s, say, third India fund if you could see that funds one and two were dogs?
In any event, the University of California still wanted to invest, and so they worked out a procedure where the data on their fund returns was kept at Sequoia and University of California staffers could only get at it by going to Sequoia’s offices and inspecting it (and I believe even how often they could visit was restricted). Reuters decided to challenge this arrangement, since it was clearly intended to evade the Public Records Act. As we noted earlier, they won at the trial court but lost on appeal on the question of whether this data was considered a record under the Public Records Act and thus disclosable.
If you go to the article, you see the real issues in this case are glossed over. And then we get faux concern for the poor investors, when it’s VCs behaving as if they have something to hide that are the source of the problem:
For starters, the current situation is genuinely perverse. Public agencies, seeking to invest in the best venture capital funds, are forfeiting the right to receive data that will help them understand and manage their investments. It’s easy to see how the next lawsuit may assert that public agencies breached their fiduciary duties by making investment decisions based on inadequate information.
In reality, that sort of suit would be a great outcome for investors. It would solve the public pension funds’ collective action problem of not being very good at working together, and put them on a unified footing of having to have sufficient information available on their premises, not kept under lock and key at the fund managers’ premises. But of course, Alexrad uses this phony threat to call for even less disclosure:
A more attractive middle ground would be to allow public agencies to combine the performance data of multiple private investments and disclose only the aggregated result. This would allow the public to hold agency officials accountable for overall performance, while protecting individual venture capital funds from premature and misleading disclosure of their investment data.
And this is the tie-in to our case. We are seeking fund-by-fund information. This piece tries to make a plausible-sounding argument as to why more disclosure would be harmful to investors, when the long history of securities laws in the US shows that sunlight really is the best disinfectant. But Axelrad’s article shows how eager the industry is to prevent just that, which suggests they must have a reason to fear exposure. Stay tuned.
* This isn’t just our conclusion. The Kauffman Foundation, which has a long track record as an investor in venture capital, issued a stinging indictment in the form of its 2012 report, “We Have Met the Enemy and He is Us.” Kauffman also found widespread misvaluation around fundraising time. The study was also critical of the conventional valuation methods used in the industry and the inability of investors, known as limited partners, to get information about the internal operations of the venture capital firms themselves that would enable them to make better picks. They set forth some not-earthshaking recommendations on issues that limited partners should unite on. My impression is that the Kauffman proposals have not gotten any traction.