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.