As we’ve mentioned, many of the fees and costs that private equity investors bear are hidden from them by virtue of being shifted to the portfolio companies. For instance, private equity firms charge what Oxford professor Ludovic Phalippou has called “money for nothing” or “monitoring fees.” Many also charge “transaction fees” on top of the large fees they pay to investment bankers for buying and selling companies. The reason that those charges are opaque to private equity limited partners is that they have no right to see the books and records of the investee companies.
But surely limited partners like private equity investor heavyweight CalPERS know what they are paying in contractually specified fees, namely the annual management fee and the so-called carried interest fee, which is a profit share (usually 20%) which usually kicks in after a hurdle rate (historically, 8%) has been met, right?
Think again. Private equity firms simply remit whatever they realize upon the sale of a company, net all those lovely fees and expenses (which include hefty legal fees) and any carry fee they think they think they are entitled to take.
Put it this way: If you were selling your house, would you hire a firm to provide a turnkey service (spruce up the house, negotiate the sale with a buyer, and take care of all the closing costs) and not demand an accounting of the gross price and what was deducted to arrive at your net proceeds? Yet it’s standard practice all across the industry for private equity investors simply to receive distributions with no explanation at all.
See the discussion from the investment committee section of the CalPERS board meeting. The presentation on cost management starts at 1 hour 55 minutes, and the section on carried interest begins at 2 hours 6 minutes, and the CalPERS staff member making the presentation is Wylie Tollette, Chief Operating Investment Officer.
Amusingly, Tollette starts his talk by referring to one of CalPERS’ investment principles, “Costs matter and need to be effectively managed.” You’ll see shortly how CalPERS is in flagrant violation of its own lofty beliefs.
Tollette discusses how CalPERS implemented a cost reduction effort in 2007 and the recent results on metrics the staff has defined as important. Board member JJ Jelincic leads off the questions at 2:06 (emphasis ours):
Jelincic: The external management fee, profit sharing line, second one down, that does not include private equity.
Tollette: That’s correct. That does not include private equity. That includes real estate and ARS for the Absolute Return Strategy, which was fully in effect through the fiscal years in question, and a few that exist in the Global Equity Program.
Profit sharing in the private equity market, in fact the whole private equity industry, it’s embedded in the return. It’s not explicitly disclosed or accounted for. We can’t track it today. That’s — as you know, that’s part of the effort around the PEARS project, which I’m going to touch on in a few slides, as well as requiring additional disclosure by the private equity managers in order to track incentive fees in the same way that we can across the other asset classes.
Jelincic: But if you can’t track them, they’re kind of hard to manage, and that kind of goes to costs matter and goes to the fact that we’re current on the fees.
Tollette: They — it’s an industry challenge in the private equity space, where the fees that — the carried interest or the profit sharing fees that are accrued and retained by the management firm, that’s not just a CalPERS issue, that’s an industry issue. And we’re trying to put in place the tools, so that we can have better disclosure and understanding of what they are.
Understand what is going on here. Tollette is trying to blunt Jelincic’s questions by saying that CalPERS is getting a new computer system in place that will have the data fields that will enable staff to capture these fees. That’s an admission that the information service that CalPERS used and much of the industry still uses, Private Edge, didn’t even attempt to capture this information. Why have empty fields for information you don’t get? So Tollette is acting as if having the ability to record the data someday, down the road, is tantamount to actually getting it. There’s no reason to think that the general partners will provide this information unless CalPERS starts demanding it in negotiations when it invests in funds. We’ve seen nothing in the private equity industry press reports or CalPERS board presentations to suggest that CalPERS has even tried to negotiate these changes, much the less had any success.
And these omissions are material. Jelincic again, at 2:20:30:
Jelincic: It’s not even disclosure. It’s not knowing. It’s really hard to figure out what we are paying in carry. My guess for that year, based on tidbits here and there, is a rather narrow range of somewhere between 600 and 900 million dollars, which is at least twelve times what we are paying staff for the total fund. It’s a big number, and we don’t really know what we are paying, and I find that frustrating.
We’ve found it hard to convey how badly captured limited partners are, and this example hopefully provides a sufficiently vivid illustration. Here, CalPERS, supposedly the most seasoned and savvy investor in private equity, is flying blind on how much it pays in carry, while going through the empty exercise of meticulously tracking its woefully incomplete tally of visible charges. This is a garbage in, garbage out exercise as far as private equity is concerned. Moreover PE real (as opposed to visible) fees and costs are so high that CalPERS’ claims about its fees and costs across its entire portfolio are rubbish.
Let us put it another way: If you found an aged parent had given money to a fund manager who had the same degree of latitude that private equity firms have to charge fees and expenses and not account for them, you’d not only seek to get the money back from that manager as quickly as possible, you’d seek to take that parent’s checkbook away because they were obviously incapable of managing their investments responsibly. Yet the same sort of recklessly trusting conduct is accepted as perfectly normal by major fiduciaries. Time for state legislatures to wake up, smell the coffee, and start asking some tough questions.