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.