CalPERS, an Anatomy of Capture by Private Equity

If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:

Executive Summary
Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity Fees Work
CalPERS Chief Investment Officer Defends Tax Abuse as Investor Benefit

* * *

One of the strongest, most consistent reactions of experts who watched the video of the last meeting of CalPERS’ Investment Committee was that the staff and the Investment Committee members, save JJ Jelincic, were completely captured by the private equity industry. For instance:

Ludovic Phalippou, professor at Oxford’s Said Business School:

I do not see any difference between that presentation and that of any general partner. The language, perspective, line of defence are the same. We should expect a limited partner not to use the exact same marketing document as those of fund managers.

Eileen Appelbaum, co-author of the landmark book Private Equity at Work:

The answers provided show just how much top staff members are in thrall to private equity. GPs, they told the Board, have a large number of investors to choose from. CalPERS, they said, can’t control things. CalPERS has limited ability to influence the actions of GPs. The Limited Partners Advisory Committee doesn’t have a say over investments – it only looks out for conflicts of interest between GPs and LPs.

I find these responses, which I am sure are sincere, simply incredible.

Andrew Silton, the former Chief Investment Advisor to the State Treasurer of North Carolina:

What’s the best defense against capture? A strong staff and informed trustees. The CalPERS video strongly suggests that CalPERS is lacking on both fronts.

If you doubted that the video is representative of CalPERS’ or typical limited partner (LP) conduct, a former private equity partner cited other examples of how limited partners fail to act in their best interest:

¶ The investors are fiduciaries themselves but are delegating their fiduciary duty to parties (the PE firms) that demand the right to give priority to their own interests over those of their investors

¶ The LPs claim that they are powerless in the relationship with PE managers, even though they collectively provide all the capital

¶ The LPs actively resist public disclosure of PE bad practices contained in the LPs’ own records, even though disclosure would greatly promote the curbing of such bad practices

¶ LPs actively defend the PE managers in the claim that their limited partnership agreements are “trade secrets,” even though almost all of the details are now in their SEC Form ADV filings, except for various shenanigans that are used to trick the LPs

We have been writing about private equity abuses for over two years. We have also highlighted how little investors have done even after the SEC made clear that misconduct was both widespread and serious and included stealing. Other long-standing issues have similarly have been allowed to fester, like the widespread use of misleading measures of investment returns. When readers have grasped the extent and severity of these problems, they immediately want to know how the staff and trustees have been bought off. They find it inconceivable that such vendor-favorable results have occurred in the absence of payoffs. Yet that is precisely what has taken place.

The ugly secret of the investment management business is that the so-called buy side (investors) is far more successfully played by the sell side (Wall Street) than outsiders recognize. Private equity is an extreme version of this syndrome. The general partners have achieved the impressive feat of inducing investors, the overwhelming majority of which are fiduciaries, to behave as if they are more concerned about maintaining friction-free relationships with the general partners than with serving the interests of their beneficiaries. This is “working towards the Führer” on a grand scale.

But how did this pathology develop? Andrew Silton, who as the former Chief Investment Advisor to the State Treasurer of North Carolina was responsible for the management and oversight of billions of dollars of retirement assets, explained how investors come to identify their interests with those of the private equity industry:

In my view, capture is a more subtle process that occurs in two simple steps. First, most money managers are adept at stroking the egos of public pension officials. As I’ve mentioned on a couple of occasions in this blog, I was the smartest, funniest, most good-looking CIO until the day I resigned from the North Carolina pension plan. Money managers are adept at making pension officials believe that they’ve asked brilliant questions or extracted huge concessions, when in fact the question was lame and the concession was minor from the money manager’s standpoint. In the CalPERS video, you’ll hear Mr. Desrochers tout the fee concessions extracted by CalPERS under his leadership. In reality, the private equity managers have made small concessions on a product that is still grossly overpriced and riddled with hidden fees. Nonetheless, by granting these small concessions, the private equity industry has turned Mr. Desrochers and many other public pension officials into industry advocates.

Second, the success of the money manager and the pension professional are inextricably tied together. While public pension officials talk about due diligence and oversight, once a money manager is hired, a pension official’s objectivity begins to erode. Moreover, the impartiality may begin to erode during the due diligence process if a fund is oversubscribed. The public pension professional will feel pressure to woo the money manager in order to get an allocation to the hot fund. Over time, the pension professional becomes an advocate and defender of his decisions, including his roster of managers. This is especially true in private equity and real estate where there’s no easy way to fire a manager. Once the contract is signed, the pension official has committed the pension to a ten to fifteen year relationship, and his objectivity has been compromised.

Former banker, now private equity independent researcher Peter Morris describes other incentives that promote capture in a 2015 paper, Time to Rethink the “Sophisticated Investor”:

The people who work for a “sophisticated investor” do not have the same interests as the people whose money it is looking after. After all, it is not their money….

The head of “alternative” investments at a large pension fund will likely benefit if it allocates more capital to his area. So will the consultants who advise the fund to do so (more complexity is always more profitable for them). That does not mean the decision is always in the interests of the fund’s beneficiaries.

He also warns:

There is only one way truly to align the interests of a principal and an agent, and that is by literally merging their identities. Anything short of that can only be imperfect. It might be more or less imperfect, but that is all. And, paradoxically, imperfect alignment of interests is more dangerous than none at all. That is because it gives a principal false confidence that she can afford to stop worrying about her agent’s conflict.

Yet as the video of the last Investment Committee meeting shows, CalPERS staff and its board members, save JJ Jelincic, and perhaps also Priya Mathur, see private equity general partners and CalPERS as having far more in the way of common interests than they really do.

The private equity professionals and Investment Committee members at CalPERS no doubt see themselves laboring diligently and effectively on behalf of CalPERS’ beneficiaries, as opposed to the private equity general partners who have succeeded in creating a “heads I win, tails you lose” economic arrangement. It is therefore critical to understand how these supposed experts rationalize their subservience to the general partners, when the investors provide the private equity funds with virtually all the money invested and thus should be in a strong position to dictate terms.

CalPERS’ staff gave some of the foundational limited partner excuses for their failure to stand up to the general partners in the Investment Committee meeting. We’ll review them over the upcoming days. Seeing how CalPERS’ officials and board members operate is important in understanding CalPERS’ failure to put its beneficiaries’ interests first. It also shows how supposedly independent and savvy organizations have become mouthpieces for private equity industry talking points.

The embedded letter from CalPERS’ Investment Committee member JJ Jelincic, the focus of a Financial Times article over the weekend, underscores how the issue of capture and competence are connected. Jelnicic describes (as we have) how the inability of CalPERS’ private equity staff to field basic questions “raises fundamental questions of their competency.” He also described how CalPERS employees “propagate GP propaganda.” This is precisely the sort of behavior one would expect to see from individuals who have decided that they can’t afford to ask serious questions. Like an athlete who has stopped training, over time, they don’t simply lose their competitive edge; they become incapable of playing the game at a professional level.

Only when the press and policymakers understand that limited partners see themselves as joined at the hip with the general partners will they be able to recognize that the limited partners’ defenses of private equity need to be taken with a fistful of salt.

[spiderpowa-pdf src=”http://www.nakedcapitalism.com/wp-content/uploads/2017/09/Letter-to-Anne-Stausboll-re-Aug-IC.pdf”]Letter to Anne Stausboll re Aug IC

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20 comments

  1. Eric Patton

    When readers have grasped the extent and severity of these problems, they immediately want to know how the staff and trustees have been bought off. They find it inconceivable that such vendor-favorable results have occurred in the absence of payoffs. Yet that is precisely what has taken place.

    Because markets, baby. Oh yeah. Party *down*.

  2. Jim Haygood

    Had to look up the acronym ‘ESG’ used in Jelincic’s letter. According to CalPERS, it means ‘environmental, social and corporate governance.’ CalPERs’ report on the subject, written by the financial consultant Mercer, says everything is just peachy (p.23):

    General Partners (GPs) can maintain their large stakes in companies for periods of 5 years or more while occupying a seat on the board or having a direct line of communication to management.

    This type of relationship, plus the relatively small number of Limited Partners (LPs) in a private equity fund, lends itself to opportunities for robust engagement on ESG issues.

    https://www.calpers.ca.gov/docs/forms-publications/mercer-report-second-decade.pdf

    Rich! The authors must have laughed themselves sick while typing that.

  3. flora

    “The investors are fiduciaries themselves but are delegating their fiduciary duty to parties (the PE firms)….

    How does a fiduciary delegate their fiduciary duty to an interested 3rd party without violating that duty? Every one of these posts on CalPERS and PE has left me staring at the screen in disbelief.

    Thanks for your PE and CalPERS reporting. This problem affects more pensions than just CalPERS.

  4. RUKidding

    The ugly secret of the investment management business is that the so-called buy side (investors) is far more successfully played by the sell side (Wall Street) than outsiders recognize. Private equity is an extreme version of this syndrome. The general partners have achieved the impressive feat of inducing investors, the overwhelming majority of which are fiduciaries, to behave as if they are more concerned about maintaining friction-free relationships with the general partners than with serving the interests of their beneficiaries.

    Well many investors actually DO know that the buy-side is “played” by Wall St. The issue is: other than burying my money somewhere, what can investors actually “DO” to stop the grift/scam/rip off/whatever by Wall St?? Therein lies the problem.

    But thanks for your efforts here at NC bc that is ONE way to go: shine a light on it, keep pushing and hope that some changes for the better can actually happen.

  5. anonymous

    As a former bond fund manager I can relate to the experience of the North Carolina pension officer who was “the smartest, funniest, most good looking CIO” until he resigned. The sell side are nothing if not consummate courtiers.

    Old joke: What’s the difference between the buy side and the sell side? When you get to the buy side, you can say “a$$hole” BEFORE you hang up the phone.

  6. washunate

    When readers have grasped the extent and severity of these problems, they immediately want to know how the staff and trustees have been bought off. They find it inconceivable that such vendor-favorable results have occurred in the absence of payoffs. Yet that is precisely what has taken place.

    I’m a little confused by that particular framework? The payoffs are clear as day. They’re called wages. And job titles. And rubbing elbows with important people. And having control over your little fiefdom. The top management at CalPERS personifies everything that is wrong with public policy entrenched wage inequality at our nation’s public pensions, tax-free universities, hospital franchises, injustice system, and elsewhere.

    http://transparentcalifornia.com/salaries/2014/state-of-california/
    http://transparentcalifornia.com/salaries/2013/university-of-california/
    http://transparentcalifornia.com/salaries/2013/orange-county/

  7. SWF auditor

    I dont know why everyone is so surprised, I mean when you fill your investment office with your unqualified law school buddies and other Angelides cronies what do you expect?

    Mexi mafia Villalobos/Valdez/Buenrostro, Landsource, Stuyvesant, “superior PE performance” seem about right to me and are the legacy of this “CEO” and “CIO”

  8. cnchal

    Poor Real. Don’t you just like how he tacked on the 50 million dollars from out of nowhere?

    September meeting looks like a doozy!

  9. Senator-Elect

    Thank you for this series. While the fact that Wall Street continues to fool its customers is not surprising, it is somewhat stunning that a massive institutional investor such as CalPERS appears to be a sucker like everyone else. If CalPERS can’t get Wall Street to play fair, who can?
    This should be enough to put to rest the idea in economics that parties “freely” enter into contracts and that the outcomes of these contracts should therefore be respected. Nothing takes place in a vacuum. Power and social pressures matter. Competence and governance matter. Human beings are the ones signing these deals, not robots. Time to recall the economists and send in the sociologists and psychologists.

  10. Sluggeaux

    As someone who has walked the halls of the state capitol in Sacramento and attended the CalPERS annual meeting, I think that the corruption angle is being understated in Yves’ reporting. CalPERS staff do appear to be dunces, but they are serving the elected officials in the Governor’s office and the Legislature, all of whom benefit from the generosity of political donations from the PE industry, where many of the players are former officials and lobbyists. Staff are touting PE because the electeds want them to. Follow the money.

    It also troubles me that much of the reporting here could be twisted by the touts of pension privatization. In fact, there are ways to enforce fiduciary duties other than a strict market-driven alignment of interests. Many of us in the legal profession (a minority, perhaps, but many) still respect our fiduciary duties. We do so because we are subject to constant scrutiny by the Bench and the State Bar. The electeds in California have control over the CalPERS board and CalPERS staff — and the electeds see the monies invested as the property of the state until such time as an employee becomes an annuitant. Current employees need to have more say over the makeup of the CalPERS board, so that the board has greater incentive to hold staff to their duties as fiduciaries for future beneficiaries. It’s no coincidence that the only outspoken member of the CalPERS board, JJ Jelincic, was elected by current employees over management opposition (and a smear campaign) to be their representative.

    1. RUKidding

      Thanks for that insight, which is unsurprising. Sadly it is the way of the world.

      I see/hear CA citizens (a segment of the citizenry, at any rate) beefing, per usual, about public employee pensions as the alleged bane of their very existence… how unfair, taxes!1!, blah blah blah. It doesn’t help if the pension fund is being deliberately mis-managed to benefit the few in power at the top, which can have the consequence of CA citizens’ taxes having to bail out the fund. That’s hardly the fault of the CalPers annuitants, but of course, the PTB will point fingers of blame at the dreaded public retiree, rather than the real pillaging villains at CalPers and in power in the State.

      But… what else is new these days?

    2. Yves Smith Post author

      The reason I don’t agree is that Anne Stausboll has systematically limited the influence of the board, as in your “electeds”. The board used to have four members of staff as direct reports. They have AGREED to have their power limited, and now only the CEO reports to the board. As someone who knows CalPERS well put it, “The board has been turned into a bunch of potted plants.”

      And guess what? Jelincic, because he is on staff, is barred from voting on CEO matters.

      1. Sluggeaux

        I think that we agree on the board being “potted plants” and that this has been a move in the wrong direction. The 7 Ex Officio and Appointed board members (who represent the Executive and Legislative branch “electeds”) have veto power over the 6 Member representatives (one more vote, two more on CEO matters). They have conspired with the CEO and staff to marginalize the other board members. The use of bullying tactics via “disciplinary” actions against Jelincic and Mathur appears to be part of a campaign to cow the board into acquiescence.

        However, I do have a certain amount of sympathy for all the players — they are trying to put a happy face on trying to manage investments in a “market” that Ronald Reagan, Bill Clinton, and Phil Gramm turned into a rigged casino. They are trying to smooth out the roller-coaster ride of bubble-driven looting that is the new normal.

  11. FedUpPleb

    It is therefore critical to understand how these supposed experts rationalize their subservience to the general partners,

    With apologies to the net-decorum of the blog, I feel compelled to mention that the internet meme “cuck” was tailor-made to perfectly describe and skewer this kind of behavior.

  12. Chris Tobe

    I think the underlying fuel to this fire is dark money political donations from Wall Street to state officials.
    Since Citizens United superpacs, foundations etc. are providing more and more of the funding for state offices. In the last year or so 3 private equity GP’s have been elected Governor, in IL, MA,RI, this is not a coincidence.

  13. Bob Richard

    Two days ago, CalPERS issued a press release titled “The Facts on CalPERS Private Equity Program”. It begins:

    Since our private equity program began in 1990, our investment returns have averaged:

    – 1-year: 8.9 percent
    – 3-year: 14.1 percent
    – 5-year: 14.5 percent
    – 10-year: 12.2 percent
    – 20-year: 12.3 percent

    During these time periods, the returns have outperformed our peers in public pensions, according to an August report to the CalPERS Board of Administration.

    Doe anybody know how to deconstruct these numbers in line with idea that PE firms don’t tell the truth about returns? Also, if the average return over roughly 24 annual periods is 8.9 percent, how can the average over approximately four 20-year periods be 12.3 percent per year? Or do they actually mean the 12.3 percent is for the period as a whole and not annualized? What is going on in these numbers?

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