CalPERS’ Private Equity, Exposed: Executive Summary

Over the course of this week and next week, we will examine a recording from the most recent meeting of the Investment Committee of CalPERS’ Board of Administration. This session was part of the regular process of the review and oversight of CalPERS’ portfolio. We will focus on the agenda items related to private equity.

This video demonstrates that:

¶ Senior private equity professionals at CalPERS do not understand the economics of private equity funds, raising questions about the staff’s competence

¶ CalPERS’ staff made significant misrepresentations to the board about the private equity practices and current legal/regulatory issues, either overtly or via omission of important information

¶ CalPERS’ staff appears to be largely captured by the private equity industry. It has internalized the viewpoint of the private equity general partners who manage the funds and recites their talking points when challenged

¶ When CalPERS’ staff faces questions that have the potential to expose either the limits of their expertise or questionable private equity industry practices, staff members become highly evasive at best and, at worst, insubordinate and overtly defiant

¶ Most CalPERS board members lack sufficient knowledge of private equity to compensate for the failings of staff. That means they are not able to adequately supervise CalPERS’ substantial private equity investments or judge whether staff members have succeeded at, or are even capable of fulfilling that duty. It also means that the overwhelming majority of the board members are also effectively captured by virtue of having to rely on staff members that are themselves captured.

It is hard to overstate how damning these findings are. CalPERS is widely recognized as one of the largest, most disciplined, and most experienced investors in private equity. CalPERS goes to considerable lengths to identify what it believes to be the best advisors to assist with program design, manager selection, negotiation of agreements, and ongoing oversight. It also has a far larger staff than the overwhelming majority of private equity investors (“limited partners” or “LPs”), including a team that specializes solely in private equity. And CalPERS does in fact hew to what are widely considered to be high standards for oversight procedures: well-established policies and processes, extensive data gathering and reporting, and a strong focus on cost minimization. Even in my limited dealings with CalPERS, over a series of Public Records Act requests, CalPERS, in striking contrast to other governmental bodies I have dealt with, has been meticulous about the formalities of handling the requests, even when we have disagreed strongly about the substance of the response.*

But CalPERS, like many other private equity limited partners, has blinded itself to the fact that adherence to formal procedures offers no protection from being swindled in private equity. The SEC expressed what came close to shock, when you translated former examination chief Andrew Bowden’s famous May 2014 speech, “Spreading Sunshine in Private Equity” out of bureaucrat-speak, over how one-sided private equity contracts are and how little private equity investors do in the way of oversight after they hand over their money.

The reality is that private equity is an extraordinarily one-sided arrangement that no sane person, let alone a fiduciary, should enter into. One economic researcher, when first told how strong the rights the general partners are to get their funds (capital calls with five- to at most ten-day notices, with draconian consequences if the money is not delivered on time), that the general partners have very broad latitude within their mandate, that they provide very little information about the investee companies, and that they control of when the limited partners get their money back, said, “It’s like being married to a drug addict.”

To help obscure this power imbalance, the private equity firms tout the limited partner-flattering line that the contracts with them are heavily negotiated. In reality, as Oxford professor Ludovic Phalippou, who has read over 300 private equity agreements, has said, “Contracts in PE are basically take it or leave it.” Private equity insiders say the same thing, that the negotiations focus on a few “headline” figures and terms, when the real artwork typically lies in other technical, legally dense parts of the contracts, such as the definitions of terms or convoluted tax language. To conclude the deal, the general partners make some minor tactical concessions so that the limited partners can tell themselves and their constituencies that they’ve gotten their interests protected, when in fact virtually nothing of substance has changed.

As former banker Peter Morris, who now provides independent research on private equity, said :

The video helps to explain a longstanding so-called “puzzle.” Academics and policy makers alike make it an article of faith that big investors like CalPERS are “sophisticated.” This is a code word meaning that on average, big investors know what they are doing and can safely be left alone to make good investment decisions.

The so-called “puzzle” arises because it is hard to square the actual results in private equity over time with the belief that big investors are “sophisticated.” Stubbornly excessive fees have meant that investors on average have received mediocre net returns. The “puzzle” has been why “sophisticated” investors would allow this to go on happening.

In reality, it was never much of a puzzle. It has long been an open secret among anyone who knows about private equity that the prevailing article of faith is simply wrong. Many big investors just do not behave in the way academics and policy makers assume they do. In other words, they cannot be relied on to make good investment decisions. In private, other people involved in the market (both investors and managers) will readily admit this. The CalPERS video is a piece of direct evidence.

Or as a former private equity partner stated:

The essential, unspeakable truth of private equity is simply that the investors generally have no idea what they are doing.

For example, the problematic tax behavior of private equity managers is clearly able to flourish, to a large degree, because the limited partner investors don’t at all understand the tax stuff. Similarly, the egregious related party transactions with the portfolio companies have gone unchallenged because, again, the LPs don’t really understand them. Ultimately, because the LPs don’t understand how private equity managers make money, the LPs are unable to recognize the complete inconsistency between professing to be dependent on the long-term health of the overall economy and allocating capital to strategies that undermine that health.

What is striking about this board meeting is how much of the damage was self-inflicted. You will see that the presentations and exchanges that are the most damning focus on private equity fees. This topic is so prominent at this August board meeting in large measure because CalPERS’ staff failed to deal openly and honestly with a major embarrassment at a board meeting earlier this year. Then, Chief Operating Investment Officer Wylie Tollette not only admitted that the giant public pension fund did not track the very sizable private equity profit-share generally called “carry fees,” but also made the remarkable claim that no one in the industry could obtain the information. After we broke this story in June, a firestorm of expert and media consternation ensued. CalPERS backtracked rapidly, and asked all of its fund managers to provide the data for the entire history of all of their funds.

As you’ll see over this series of posts, rather than simply ‘fess up to a long-standing error and say it was well on its way to rectifying the matter, CalPERS’ staff instead engaged in the bizarre diversionary tactic of serving up what ought to have been an insultingly basic tutorial to the board on how carried interest works, which as we’ll show was so oversimplified as to be misleading. The fact that the board seemed unaware of how badly this reflected on what the staff appears to have correctly judged to be their level of expertise was also damning. As Professor Phalippou said of the presentation: “So simple it is incorrect, but if they have to show something that simple this indeed shows that Investment Committee has zero knowledge. All my MBA students after the first session of my private equity course would know more.”

More generally, the fact that pulling on such a thin thread would produce such defensive responses shows how brittle is the pretense of limited partner expertise. It is well nigh certain that CalPERS, as an institution, will go into intense denial about the implications of this board meeting. The staff would have to admit to themselves, and the board would have to acknowledge about the staff, that:

¶ CalPERS is not a leader in this area; they know vastly less about private equity than they think they do

¶ CalPERS’ staff regularly provide the board with materially incomplete or false information

¶ As it is currently practiced, private equity is so full of now-well-understood contradictions that CalPERS can no longer discuss the topic in public, on camera, without opening themselves up to embarrassment and serious criticism

¶ Unbeknownst to themselves, the board and staff have become so badly captured that some of their actions serve the interests of private equity managers more than CalPERS’ beneficiaries

¶ They have lost control of a situation that has become volatile and somewhat dangerous to them

Obviously, no one wants to admit such negative things about themselves. It is also very difficult for the board to think so poorly of the people to whom they have entrusted their fate. That means that this site and the media will need to keep putting the mirror in front of CalPERS’ face until it can see itself accurately and take remedial action.

Moreover, CalPERS must be made to recognize what is at stake, which goes far beyond the success or failure of the organization’s private equity investment program. For the last quarter century, CalPERS has wielded significant and generally very positive influence in the world of finance. It has been a global leader in corporate governance and also in encouraging investors to think about the economic impact of long-term issues like global warming.

CalPERS acquired this influence for two main reasons: first, because other investors and opinion leaders generally viewed the organization as sophisticated and knowledgeable; second, because CalPERS’ views were widely viewed as righteous — the organization was seen as essentially “the good guy of finance.”

If CalPERS continues to be unwilling to grapple with what the public can now see is both a huge expertise gap in private equity and a propensity to side with private equity general partners over its own beneficiaries’ interests, the organization will lose its power in the wider world. Indeed, one can sense that is already starting to occur. Needless to say, we at Naked Capitalism do not want that to happen.


* To CalPERS’ credit, even though I lost a suit against them over private equity data with prejudice, meaning CalPERS could then have ignored me, they had told the judge they intended to fulfill the request. And CalPERS did live up to their word in the end, although it took a further six months of often heated exchanges with CalPERS’ counsel to wrest all the information from them.

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  1. diptherio

    Was there supposed to be a video with this? Since you say “this video demonstrates that…” I was looking for one…

  2. Larry

    The video and following is going to be something to behold this week. It’s clear from Yves writing on the topic that many managers of public retirement funds are completely beholden to the interests of outside financial product managers. I always wonder if this is the standard public-private relationship that we see in America, where the pension fund managers eventually go on to lucrative careers fleecing the next generation of managers, of if the public pension fund managers are simply incompetent and not capable of keeping retirees best interest in mind. From this post, it sounds like the managers at large and supposedly sophisticated firms are incompetent. It makes me wonder education and experience are required to be one of these fund managers.

    1. Tiger

      It should be very entertaining when it comes out. Yves has been amazing with her research on this but I disagree with the conclusion. Put money in the pocket of workers and let them manage their own portfolios. These large institutions ARE the problem.

      1. washunate

        I agree the scale of management failure calls into question the very concept of regionalized yet centralized public investing. The top public officials are so obviously corrupt it’s funny.

        But perhaps there is another angle to consider as well. Maybe rather than making individuals secure retirement through investment returns, the problem is two-fold:

        1) We lack one universal retirement promise covering all workers equally, and
        2) We pay for the hodge podge of retirement promises today with investment returns rather than taxation.

      2. John Zelnicker

        Put money in the pocket of workers and let them manage their own portfolios.

        Umm, I don’t think that’s going to work. Very few people know enough about investing to handle their own portfolio.

        washunate, I think, has the right idea; a universal retirement income guarantee for all workers, including those doing what is now uncompensated labor, such as personal care of relatives or children, provided by the federal government, which doesn’t need tax revenue (or investment returns) to pay for the benefits.

    2. tegnost

      yes, similar to lamberts link yesterday on offshoring to avoid regulation. It’s like “the mole”, or putting a fox in the henhouse as a guard…from yesterdays link
      “Many of the CFTC employees who were lobbied in these meetings went on to work for banks. Between 2010 and 2013, there were 50 CFTC staffers who met with the top five U.S. banks 10 or more times. Of those 50 staffers, at least 25 now work for the big five or other top swaps-dealing banks, or for law firms and lobbyists representing these banks.”

  3. JTMcPhee

    Amazing how us ordinary people who staff and operate the Real Economy are stripped and fleeced and hornswoggled at all points in the process, and still buy into the wholesale idiocies puked out by the parasites that eat us, that unions are evil, particularly public employees like teachers, that people with pensions including Social Security ought to be strippied back into the gray poverty that no one really needs to suffer. And the thieves continue to prosper off our sweat and blood, “cuz that’s how it works and always has ..”

    “Catch me if you can, ” laugh the thieves. “By the time you catch up to where I was, I’ll be gone on to something else. Stupid muppets…”

    Too bad there’s no decent and sensible organizing principle for anything better or even just different to coalesce around.

  4. tegnost

    Thanks, I’m beginning to have a more comprehensive understanding of PE thanks to these posts and look forward to the coming weeks content

  5. craazyman

    The Pile

    oh man, this is what happens when brains get rotted from too many business dinners, wine and cheese and cocktail chatter.

    you lose the ability to think for yourself. your brain rots. Your brain gets holes in it like cheese.

    It comes from too many meetings, wine and cheese talking about money. the first thing is, you can’t think for yourself. People panic when they have to think for themselves. What are they supposed to think? there’s so much confusion. Then they get together and talk about it. Just to stop the pain. The pain of thinking alone. Even their degrees from the university. Even there they never had to think alone. They always had somebody tell them how to think. There was always money around too. And wine and cheese.

    They get together and decide to follow what some dude says, or some lady dude, whatever that word is. What’s the word for “lady dude”. I can’t think of a good one. The reason they decide to follow dude or lady dude is the pile of money the dude or lady dude sits on top of. A huge pile.

    They get some wine and cheese then they sit down and have dinner and say “You know, so and so has a fund that invests in private equity. They’ve got great operations people and they do turnarounds and the finance various stages of the business. They made 100% last month. The month before they made 89%. In 10 years, they should own the entire world and we can have a piece of the action.”

    That sounds good! the funny thing is the person in question — the dude or lady dude — they may have the ability to think for themselves by themselves. They may be able to take the pain. Then they think “If I blow enough smoke, I can convince people it’s air. They’ll be breathing the blue air. And I’ll say, Don’t worry, your getting rich. the air is blue isn’t it. Just look at the sky. Just take deep breaths. Slowly.”

    That’s a person who can think for themselves. it weird.

    1. John Zelnicker

      What’s the word for “lady dude”.

      For women dudes I have used “dudette”, although I’m not sure if that would be considered offensive or belittling. It’s a term I rarely use (as is dude), but, so far, no one has told me that they have a problem with it.

    2. tegnost

      That is weird…so do you think it’s the wine, the cheese, or the money pile? … i commonly refer to lady friends as dude and am not sure if lady dude will be seen as an improvement or get me a snarly look, i’ll get back to you…

      1. craazyman

        if your lady friends are hot, don’t call them ‘dude” unless you’ve given up on sleeping with them.

        if you have, you must be gay. haahahahahhaha

        just kiddmg..

        you can call a lady friend dude if the circumstances are appropriate, as long as it’s in a “‘ironic and inclusive humorous context”, for example, if they’re married or in a relationship and they’re just a friend and your talking about what will happen if they double park for half an hour on 3rd avenue in new Yawk while they get a coffee at Starbucks. you cay ‘dude, dom’t even think about it.”

        1. tegnost

          Right, but in your subset of dudes who are ladies will there be an objection to lady dude?
          Enquiring minds want to know…

          1. craazyman

            are you talking about girly men guys who wear raincoats and overcoats that stop above their knees? that’s all the stores sell these days it seems.

            those guys, they like to be called “dude”. They don’t even know they’re girly men!

            can you believe it?

            Some of them might even invest in private equity deals. They’re the ones who pay the 2 and 20. The guys who collect the 2 and 20, if you look at what they wear in the rain, I bet you’ll see a proper raincoat made in England that comes down to the knees. Even the women! i bet they don’t have petticoats either unless they’re indoors or it’s not raining except when they make it themselves

            1. tegnost

              I mean the chicks who are dudes who you just hang with you know, the “ironic and inclusive” thing. I just wonder if chicks I know who don’t want to be called chicks but somehow don’t mind dude would feel the same about lady dude that they feel about chicks but as I go on here I think the thing about dude is it’s syntactic finality and sublime ability to convey exasperation

              1. craazyman

                it’s hard to explore this question from a theoretical perspective. Let’s get them all together in one place, have a few beers, and see what happens. we can try out a few salutations, like “Miss Hotness Herself”. or maybe “What God Had in Mind when He Created The Idea of Beauty”. however, those salutations might be both clumsy upon repetition and perceived as gratuitously over the top and we might discredit (no pun intended) ourselves.. “Dude” might work, as long as it’s not conveyed with a tone of exasperation.

            2. tegnost

              Oh and I prefer hats and umbrellas and agree those waist length raincoats are lame and will leave your knickers drenched

  6. Edward Downie

    Still another example of how failing to enforce KISS standards allows
    criminals to rob with impunity.

    1. TheCatSaid

      sounds like lots of the “non-simple” bits are hidden in fine print with conditions in obtuse language, giving the impression this is normal boiler-plate (i.e. don’t bother reading or questioning what this means, it’s just standard. . . .)

      1. TheCatSaid

        IOW, when the video is up I bet it’ll show their explanations were perfectly “simple”==inaccurate, incomplete, misleading

  7. TheCatSaid

    When a fund quotes 2% & 20%, what are the specific questions we should ask to allow us to determine how accurate/inaccurate those numbers are?

    1. cnchal

      We demand to see the pirate’s books and bank statements! Never trust Pirate Equity.

      I am reminded of the bullshit jobs post. Could there be a better bullshit job than to chow down on six or seven figure, and be a Calpers “executive”? Other than being a pirate yourself and chowing down on tens of millions.

  8. alex morfesis

    welcome to fiduciary theater…maybe elvira and count floyd can buy some time on bloomberg saturday nites and comment between the babble…

    boo…very scary kids…
    scary scary boo

    sadly all too often, when one thinks the stake has been driven thru the heart of the vampire, what really happens is the vampire ends up getting a nice vacation and a juicy wagyu ribeye at gallaghers when they are done with their penance and time in pergatory…

    but pushing forward is the right course of action…

    they are out to get you…each and every one of you…but…they are not as invincible as they would want you to believe…

    remember that toto with the curtain thing…follow the yellow brick road

    and let them eat gold

    great work…

    never give in…never give up…fight all evil on all fronts

      1. Jim Haygood

        Add dancing girls, and an emcee in a top hat, and you get ‘fiduciary cabaret.’

        Our next assignment is to create a new adaptation of the widely-parodied clip from Downfall: “Hitler Learns His PE Fund Overcharged Him.”

  9. griffen

    Thank you for the excellent research. These posts and updates are a prime reason I visit the site.

    While damning for CalPers, just how difficult would it have been, or do so in the near future, to hire a few low level analysts with an affinity for deep arithmetic to run the calculations and produce the exhibits?

    The “2 and 20” structure always strikes me as an excessive arrangement. But, when it works really well no one asks these questions.

  10. fresno dan

    “The reality is that private equity is an extraordinarily one-sided arrangement that no sane person, let alone a fiduciary, should enter into.”

    The market provides a plethora of frauds, cheats, scoundrels, rascals, reprobates, scalawags, and, in proof contrary to the laws of economics, the supply of swindlers is unlimited and unbounded by ANY constraint.
    And the only law of finance that even approaches the certainty of a physical law is: anyone who tells you that they are giving you a special deal is really giving you a special scr*wing.

    1. Fool

      I’m inclined to think that outside of Chernyshevsky’s Crystal Palace and economics textbooks written in Chicago, a lot of people enjoy getting screwed provided that it makes them feel special.

  11. Fool

    Yves, I’ve probably read everything you’ve written about PE in the past 3 years, and there’s something that I’ve never understood about why the LP’s acquiesce so willingly: why don’t they say no? I’ve seen you use the term “intellectually captured” a lot, but that doesn’t explain why the place is run by idiots in the first place! I would be curious to know the systemic incentives of hiring idiots at Calpers. I hope that’s in the video!

    1. wolflikeme

      One thing not mentioned that often is the tenure of investment staff at Calpers and other public pensions is usually only a few years, and this timeframe does not align closely most PE fund commitments. Would it be in your interest to trash all the work of your former colleagues when you will move on to another job in a couple of years? Better from a professional standpoint to just pretend you are ok with things.

      1. Fool

        “…the tenure of investment staff at Calpers and other public pensions is usually only a few years,”

        Where do they work after?

    2. Chris

      The pension Boards and Commission don’t matter. They do as staff instructs them (ever so gently).

      Staff wants to be in the “big game” and will spend billions of other peoples money to get there.

      Retirement funds are the perfect place for wanna be investment hacks. All reward, no risk.

      “Fiduciary theater” is the most perfect phrase I have heard in decades. It sums it all up!

  12. flora

    This intro to the coming articles makes some stunning charges. Look forward to reading them.

    “Where large sums of money are concerned, it is advisable to trust nobody.”

    -Agatha Christie

  13. Oregoncharles

    Makes me glad I’m not on a public pension – and says a lot for the Social Security model, as opposed to investment models. (No, the SS trust fund isn’t invested – it is just a claim against the Treasury, as needed. Where else would the money to repay those “bonds” come from?)

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