Memo to CalSTRS: When you are in a hole, stop digging.
When the larger of the giant Sacramento-based public pension funds, CalPERS, was caught out for failing to track the biggest fee that private equity investors pay, carry fees, CalPERS rapidly reversed course once media criticism started snowballing. CalPERS scrambled to gather information across its entire program, contacting all its private equity general partners and demanding responses by July 13.
The Financial Times broke the story that CalSTRS, the second largest public pension fund investor in private equity, was not capturing carry fee data either. But while CalPERS was sheepish when caught out, CalSTRS has tried to depict the desire to have that information compiled as an unreasonable request. From the Financial Times story:
The second-largest US public pension fund has admitted it has failed to record total payments made to its private equity managers over a period of 27 years….
A spokesman for Calstrs, which helps finance the retirement plans of teachers, said the fund does not record carried interest. “What matters is the overall performance of the portfolio.”…
Ms [Margot] Wirth [director of private equity at Calstrs] argued it was “wrong to conflate the fees paid to private equity managers with carried interest”.
She said: “Carried interest is a profit split between the investor and the private equity manager. The higher that carried interest is, then the better both the investor and private equity manager have performed.”
This line of argument is prima facie evidence of an advanced case of private equity intellectual capture at CalSTRS.
One of elements of the due diligence that fiduciaries are supposed to do, but is not done in by private equity investors, is asses the reasonableness of fees and costs when deciding whether to commit funds to an investment strategy. To the extent it is done at all, private equity limited partners perform this task in a garbage in, garbage out manner, by looking at fees in isolation.* The one fee they sort of sanity check is the management fee, the prototypical 2% annul fee out of the classic “2 and 20” formula. For larger funds, the fee is often smaller, precisely because the investors look at the size and composition of the team that will be allegedly working on behalf of fund investors, and make a quick and dirty computation as to how much it ought to cost, and compare that to the overall management fee.
Separately, that approach has been shown to be bankrupt, as stories in the New York Times and Wall Street Journal have exposed the fact that individuals that were presented to investors during the marketing period as part of the “team” and by implication part of the general partner’s overhead, are in fact charged as consultants, meaning they are billed separately to investors at the portfolio company level (as in through the companies that the private equity fund has acquired on behalf of the limited partners).
So how does the carry fee fit into this picture? The only way to assess the reasonableness of private equity fees and costs if you can see all of them. If private equity funds are making a handsome, or indeed overly handsome living on carry fees and management fees alone, private equity limited partners should refuse to invest in any fund that charges other fees, such as transaction fees, which are simply an abuse (they are set at the level of investment banking fees or even higher, when the funds hire investment banks to provide those services, and those costs are charged to fund investors). It isn’t simply that those fees are excessive; they also create bad incentives. For instance, transaction fees reward private equity firms for churn rather than making good investments. They are why, as has been documented at length in numerous studies on private equity, like Eileen Appelbaum’s and Rosemary Batt’s Private Equity at Work, or Josh Kosman’s The Buyout of America, that private equity firms earn juicy returns irrespective of whether they make money for their investors.
And there is every reason to assume that the total charges are outrageous. Again from the Financial Times:
Professor Ludovic Phalippou, a finance professor at the University of Oxford Saïd Business School, who specialises in private equity, told FTfm last week: “Calpers’ total bill is likely to be astronomical. People will choke when they see the true number.”
Prof Phalippou said the same would be true of Calstrs.
California Treasurer and CalSTRS board member John Chiang has said he wants to get to the bottom of this matter:
Mr Chiang said he would demand clear answers from Calpers over why it does not know how much has been paid in “carried interest”…
Yet CalSTRS is refusing to get with the program, and it’s also making conflicting statements about its practices. From Private Equity International on July 22:
In mid-July CalSTRS admitted it had not been recording and disclosing payments it made to fund managers since 1988, when it first invested in private equity.
“I think it’s a mischaracterisation of what we’re doing,” Duran said. “Claiming we failed to record payments made to private equity managers is untrue. We track every dollar that goes into and out of the funds.”
Let’s stop right there. Duran’s remark is a bald-faced lie.
Carry fees are deducted from the distributions made when fund investments are sold. Funds like CalSTRS receive only net payments. They do not receive any accounting when they receive those distributions as to what charges were deducted from them to arrive at those net amounts. CalSTRS is thus bizarrely and inaccurately trying to insinuate that a fee taken via withholding a share of profits is not a fee at all. That’s tantamount to saying that a class action lawyers who receive a percentage of their clients’ awards are not getting fees either because they are getting a profit participation.
Duran can’t even keep his own dodge straight. Again from the story:
Duran said he is aware of larger funds that track and disclose carried interest and that CalSTRS is looking for a software system to help the pension fund record fees “more explicitly”, and for tools to track fees more precisely.
Carry fees are a number. Pray tell, how does one “record “them in some sort of Schrodinger’s cat indeterminate state so that they are not fully explicit?
CalSTRS now uses the private equity information service from State Street called Private Edge (see footnotes on page 4 of the PCA report for confirmation). As we discussed at some length in an earlier post, CalPERS is developing an in-house system, PEARS, for Private Equity Accounting and Reporting Solution, to replace Private Edge. CalPERS’ Chief Operating Investment Officer Wylie Tollette stated in a CalPERS board meeting that it would not have the ability to capture the private equity carry fee information until it had PEARS in place. (As an aside, that’s a “dog ate my homework” level excuse; there’s no reason for CalPERS not to track this information in a separate database or spreadsheet). But CalSTRS is making a variant of the lame excuse that CalPERS was trying to fob off on its board.
Now as Dan Primack of Fortune pointed out earlier, it is possible to derive total carried interest payments made in a reporting period from fund financial statements:
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.
Even so, CalPERS is being conservative and vetting its numbers. Again from Primack, emphasis ours:
Fortune has learned that the pension system yesterday sent out emails to all of its private equity fund managers, asking for the amount of carried interest paid — and, separately, the amount of carried interest accrued — by CalPERS since the inception of each private equity fund. The information is due by July 13, with CalPERS asking for detailed supporting documentation that will allow it to “independently recalculate and tie out the amount of carry and management fee.”
Moreover, Duran tells another howler in his Private Equity International remarks:
Carried interest is not as meaningful as other payments to GPs such as monitoring fees, Duran said, noting that he believed the pension fund reported those figures as part of fees to managers.
This is another remarkable misrepresentation. As readers who have been following private equity know, monitoring fees are charged to portfolio companies. Limited partners have absolutely no idea what the portfolio companies are paying in the way of fees and expenses to the general partners, its affiliates, and employees that might be baby-sitting the company, say by playing interim CEO. They have no right to see portfolio company financial information, nor are general partners inclined to give it to them out of the goodness of their hearts.
Finally, Duran tries to depict the carry fee contretemps as a matter that CalSTRS can ignore because it might blow over:
The California State Teachers’ Retirement System sees the recent firestorm around its nondisclosure of carried interest payments as part of cyclical pressure in the private equity industry, the pension fund’s spokesman Ricardo Duran told Private Equity International.
“Private equity disclosure comes up from time to time and this just happens to be one more aspect of it,” Duran said in a telephone interview….
“We”ll have to see how the conversation moves,” Duran said of the ongoing debate around pension fund private equity fee reporting.
So Duran is saying that CalSTRS will do squat until it feels more heat, defying its board member John Chiang. However, given our reading that Chiang is merely jumping on a bandwagon, CalSTRS’ staff seems to read him the same way, as a mere opportunist rather than a real player.
But what about Duran’s insinuation that these periodic rows about disclosure are just noise that he can ignore? History show his claim to be off base.
One major wave of pressure for more private equity disclosure came in the dot-bomb eras, when beneficiaries was concerned about how much public pension funds had lost when the value of their venture capital investments had obviously plunged. The critical event was when the San Jose Mercury sued CalPERS for its refusal to disclose information about its investment returns in response to a Public Records Act request (California-speak for a FOIA).
In its settlement, CalPERS agreed to provide returns each quarter, along with other financial information, for every fund in which it has invested. The idea that general partners would shun CalPERS as a result of its disclosures proved to be bogus. Return disclosures of the type that CalPERS made is now bog standard among public pension funds.
Another major battle over disclosure came as a result of CalPERS’ pay-to-play scandal. CalPERS started disclosing placement agent data. The numbers revealed were so large as to raise eyebrows and spur media investigations, leading eventually to staff and board member resignations, as well as the indictment and successful prosecution of CalPERS’ former CEO Frank Buenrostro and the indictment and suicide of board member Fred Villalobos.
In part due to CalPERS’ unwittingly keeping the scandal in play by hiring Steptoe & Johnson to provide a surprisingly thin report on the affair, the problem of pay-to-play continued to get media coverage. That in turn made it well nigh impossible for other public pension funds to maintain that it was defensible not to demand that general partners disclose any such payments. Again, public pension funds that were early to fall in line with the new information demands weren’t redlined by general partners. Those standards became the new normal.
So when the public wakes up to the importance of prying more information out of the hermetic private equity industry, it has not surprisingly been forced to fall into line. And each time, CalPERS has played a decisive role in the move towards greater disclosure. The fact that CalPERS has quickly conceded the case on carry fees means CalSTRS has no leg on which to stand. But it will be amusing to see how long its staff continues to embarrass themselves by fighting a losing battle.
* As we’ve noted previously, if you look at the reports prepared by industry consultants, they are embarrassingly superficial in how they review fees. Oxford professor Ludovic Phalippou explained in a 2009 paper that this sort of simple-minded comparison is misleading. For instance, supposedly standard terms like a 20% upside fee subject to an 8% hurdle rate, using a representative set of fund cash flows, could lead to success fees being as low as $7.5 million or as high as $19 million depending on the definition of key terms.