Top Private Equity Reporter: CalPERS is Either Lying or Has “a Massive Breakdown in Financial Controls”

CalPERS is suffering a richly deserved hit to its reputation by virtue being too chummy with private equity general partners and thus neglecting its duties as a fiduciary.

As we pointed out at the beginning of June, CalPERS board member JJ Jelincic elicited this stunning admission from Chief Operating Investment Officer Wylie Tollette:

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

“Profit sharing” is another way to describe the private equity carry fee. That’s the “20” in the prototypical “2 and 20” for the private equity general partner’s 2% annual management and 20% share of profits, typically after a hurdle rate of 8% has been met*. Needless to say, these are really large fees if a fund is doing well. As we observed:

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 it means that CalPERS’ claims about its fees and costs across its entire portfolio are rubbish.

This example of the dereliction of duty of private equity limited partners like CalPERS is so striking that it caught the attention of the finance-friendly New York Times Dealbook. Ironically, the Dealbook piece effectively contradicted a New York Times editorial less than ten days earlier that praised CalPERS for its efforts at fee reduction, and erroneously tied those to its plans to reduce the number of private equity managers drastically.** As Jelincic pointed out in the board meeting, you can’t manage what you don’t track.

But the Dealbook story was timid compared to the reaction of the top private equity journalist, Dan Primack at Fortune. The reason that Primack’s assessment is important that it is virtually unheard of for a beat reporter to go after prominent institutions or criticize widespread practices in the industry he covers. From Primack’s daily newsletter last Friday:

…..the reality is that CalPERS is once again showing signs of dysfunction….

During an investment committee meeting in April, the system’s chief operating investment officer, Wylie Tollette, was asked about how much the system had been paying out in carried interest to its private equity managers. His reply:

“Profit-sharing in private equity is embedded in the return. It’s not explicitly disclosed or accounted for. We can’t track it today.”

Tollette’s claim is absurd. Either he’s not telling the truth, or he’s overseeing a massive breakdown in financial controls. Whichever way you slice it, the result should be pissed off pensioners.

CalPERS receives annual audited financial statements from all of its private equity fund managers. These documents do indeed include information on carried interest.

Yes, you may need a calculator to break out your pro rata piece of the fund, or to work out the amount of carry paid since a fund’s inception, but it most certainly can be done. I’ve spoken to a variety of senior LPs at other institutions (including public pensions) over the past day, and each of them is dumbfounded by the CalPERS claim.

Another CalPERS excuse for being unable to calculate its carry is that there is no standardized reporting of private equity returns. This is true. But it doesn’t prevent CalPERS from regularly publishing data such as internal rates or return (IRRs) and total fees paid. How come lack of standardization prevents CalPERS from calculating carried interest, but not numbers that come from the same primary sources?…

LPs tell me that if CalPERS feels it is not receiving adequate information on carried interest, there is a simple solution: Call the PE firm and ask for it. “There is no way a general partner would refuse to send such basic information to one of its largest LPs,” says a longtime private equity portfolio manager.

A CalPERS spokesman says that, in the system’s opinion, this is a “private equity industry issue.” No. This is a CalPERS issue. Once again, America’s largest public pension has its house out of order.

Now in fact, private equity limited partners not bothering to obtain basic information they need to oversee fees and costs properly is a pervasive problem. A private equity standard-setter, CEM Benchmarking, singled out one investor, the South Carolina Retirement System Investment Commission, as setting the standard for identifying fees and costs. Its report stressed how far short other private equity limited partners fell when compared to the most diligent investors. The gap was massive, a full 2% per annum. Other experts have suggested the missed fees and costs are much higher. Even worse, CEM opined that the overwhelming majority of public pension funds like CalPERS were out of compliance with government accounting standards.

CalPERS is hoist on its petard of being so craven as to not ask private equity general partners some basic questions necessary to do an adequate job as a fiduciary. Dan Primack saying CalPERS’ house is not in order is as damaging as not standing up to the general partners. The general partners have managed to convince even powerful investors like CalPERS that they must play nicely with the general partners or they’ll be late on the list to be solicited for investment, which in theory could mean they’d miss being in a hot fund (in practice, this theory is absurd since private equity fund outperformance does not persist).

But private equity insiders tell me that investors, particularly public pension funds, also get relegated to “low on the list” if they are perceived to be involved in a controversy. Staff will be distracted and slow to make decisions, so it’s better to target organizations that are well run and not in the spotlight in a bad way.

CalPERS needs to wake up and smell the coffee. Its PR about its skill and acumen does not stand up to scrutiny. And it is learning far later than it should that being too slavish to the general partners is at least as bad as being too aggressive.

* Note that the 2% drops to a lower rate after an initial period of years when the managers are supposedly doing the heavy lifting of finding companies to buy and vetting and closing on purchases. Another huge can of worms in the industry is that investors haggle over the headline fees and miss the fact that the artwork lies in the dense print of the contracts. As Oxford professor Ludovic Phalippou pointed out in a 2009 paper, based on a review of 6000 private equity agreements:

As another example of the importance of details, consider incentive fees. The broad outline of the incentive fees almost never varies from 20 percent of profits and an 8 percent hurdle rate, but much variation arises in the details of their calculation. Some funds start receiving carried interest when they have returned 8 percent per annum on capital committed; for others, it is when they have returned 8 percent per annum on exited capital (like the example above). In the past, some funds would receive carried interest separately for each investment made, which is an expensive detail for investors. Some funds have a “claw-back provision” as described above for returning what turns out to be excess carried interest payments to investors; some do not. Some buyout funds pay accrued interest when refunding the carry; some do not. Another related “detail” is the hurdle rate. It is almost always 8 percent, but it can be soft or hard. The soft version is the one described above and led to a payment of 0.20 x (229 – 110 – 20.35) = $19 million. The hard version takes as a basis the amount invested compounded at 8 percent per year. The carried interest is then paid on a sort of excess return instead of the plain return. The hard version would lead to less than half that payment: 0.20 x (229 – (110 + 20.35) x (1.08)5) = $7.5 million. These details clearly make a large difference for the incentive fees paid.

** If you look at the documents in the latest board update on the manager reduction initiative (Agenda Item 8a), you’ll see they mention cost reduction, not fee reduction. The distinction matters. CalPERS is seeking to reduce administrative complexity. That will allow for the reduction of costs at CalPERS proper. However, it’s a mistake to think this translates into more bargaining power with managers. CalPERS is already the big fish with more negotiating leverage than any other private equity investor. Reducing the number of funds means it will be making much larger investments, and hence concentrating on the bigger funds and managers. These funds tend to be more powerful players and they’ll know that CalPERS is more limited in where it can invest than in the past. So it’s unlikely that CalPERS will have more clout than it has now, and accordingly, the staff documents to the board make no such claims.

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  1. Tom Stone

    These are not mutually exclusive categories, dishonesty and incompetence are frequent companions.

  2. Rhondda

    “The general partners have managed to convince even powerful investors like CalPERS that they must play nicely with the general partners or they’ll be late on the list to be solicited for investment, which in theory could mean they’d miss being in a hot fund (in practice, this theory is absurd since private equity fund outperformance does not persist).”

    To my eyes it seems that “play nicely” really just means looks the other way while we skim off your participants’ money.

  3. diptherio

    Can’t you be sued for dereliction of fiduciary duty? Can’t someone be held personally accountable for being so willfully stupid? Most of the CalPERS board, for instance, seems liable…

    1. flora

      If Yves earlier case is any indication, the CA courts seem CalPERS friendly. So a suit by pensioners would have an extra hill to climb. my opinion. But, yes, this situation does call for remedial action.

      1. Sluggeaux

        The California Judicial Retirement System, JRS, is wholly administered by CalPERS. The state judiciary has a powerful incentive to keep CalPERS solvent, and I can assure you that the scores of California judges with whom I am personally acquainted are very aware of where their retirement contributions are going.

  4. TheCatSaid

    Yves, the quote from Phalippou in the endnote seems very important. I don’t have enough familiarity to understand what the impact would be of the various scenarios he mentions.

    Please consider posting a table with worked out simple examples for the sample scenarios, showing how the different fine-print calculation methods impact fees and/or the billed cost & return paid out to investors such as CalPERS. (And also a table showing how the various calculation methods might impact the financials of the PE firm. So we can understand what terms are in their best interest.)

    Without understanding the implications of the various fee methods, it’s hard to ask questions or read a contract with sharp enough eyes to spot crucial terminology and understand what is or isn’t in a pensioner’s or investor’s best interest.

    Such a table could be of immeasurable value to NC readers, allowing people to ask smarter questions and apply pressure more effectively on PE firms, pension fund board members, etc.

  5. Sluggeaux

    I just love the phrase so often used here at NC: “It’s a feature, not a bug.

    I’ve been a CalPERS contributor for over 30 years, and hope to become an annuitant in a couple of years hence. I also have colleagues who have left government employment to work with firms that place or invest CalPERS money. A dozen years ago I came to the realization that campaign contributions from placement agents and PE firms to the various Governors, Senators, and Assembly-members is the grease that lubricates the wheels at CalPERS. Staff have no intention of answering JJ Jelincic’s questions — obscuring the over-paying of fees is how the graft works here in California. Investments always just happen to go to the “friends” of those in political power in Sacramento.

    Unfortunately, in the Age of ZIRP there is no more “slop” left in the system like there was during the various bubbles blown by Wall Street’s looting of the economy over the past 40 years. Historic rates of return can no longer be realized. I just hope that I can draw my pension for a while before graft gets turned off and those politicians who have been living off of the corruption turn into looters themselves.

  6. Kokuanani

    But we can all confidently predict that once CALpers comes up “short” on any pension payments, it will be the fault of “greedy unions” and “lax officials who agreed to too generous contributions.”

  7. RUKidding

    Thanks for the info re the dubiousness of CalPers & PE investments, tracking fees, etc. Keep these informational posts coming!

    Someone above indicated the corruption is just another day in California. I won’t argue with that, but I posit that this *type* of corruption is commonplace just about anywhere in the USA. Where is it NOT happening is what I’d like to know.

    Yes, the pols are all “in” on the fix, so we won’t see a lot happening to make improvements, although – correct me if I’m wrong – I believe CalPers did lead something of a charge in stopping investments in equally dubious Hedge Funds (which had equally opaque fees, etc). So there is that.

    Of course, if there are any issues with paying out annuitants, it’ll be blamed, as indicated in a prior comment, on the horrid terrible public service unions who are simply ruining everything, plus also the insane greed of the CA public sector workers. We are just so greedy and out of control and lazy and so forth, doncha know?

    I am a CalPers contributer and hope to be an annuitant some day.

    1. John Zelnicker

      I hope you get the pension you have earned. Unfortunately, you are correct about placing blame when the fund comes up short of its obligations.

      I made this comment on another NC post:

      IMNSHO everyone needs to stop blaming labor and/or the labor unions. It’s not the front line workers, teachers, retail clerks, adjunct instructors, all those people who do the actual work rather than managing other people. Those workers have no bargaining power, and the unions have lost most of theirs, in part due to the horrible labor market, as well as other important reasons.

      We have demonized virtually all of the government workers who actually do the work that enables us to even have a government (all levels) and to provide the services we demand, such as public safety, education, and infrastructure. These people are our neighbors, relatives and friends; we owe them better than this.

      /end of rant

  8. alex morfesis

    how do the rating agencies deal with this “selective incompetence”…

    not having systems in place would seem to open questions for the accounting firms…how can they sign off on financials if the client admits the information is incomplete, not reliable or inadequate

  9. washunate

    Great read, continuing to enjoy this series. It appears that CalPERs possesses both truth challenged management and internal control challenged management.

    That’s what tends to happen when public sector management is overpaid.

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