If you have not done so already, please read the preceding posts in our CalPERS’ Private Equity, Exposed series:
The oversimplifications, mistakes, and refusals to answer basic questions by CalPERS staff members at the last Investment Committee meeting of its board suggest that CalPERS has so little understanding of private equity that it cannot responsibly invest in that strategy at all. These errors related to concepts that are fundamental to understanding the economics of a private equity investments and hence to negotiating them.
In a must-read post, CalPERS Can’t Explain Private Equity, Andrew Silton, former Chief Investment Advisor to the State Treasurer of North Carolina, wrote:
As I watched the staff for the better part of two hours, I could only think that CalPERS shouldn’t have $30 billion in exposure to private equity and probably upwards of $45 billion in future commitments. The senior staff of the world’s largest public fund cannot readily explain the basics of private equity investing and doesn’t demonstrate mastery over its investment portfolio. As I listened to Mssrs. Eliopoulos, and Desrochers I heard lots of platitudes about transparency, due diligence, and alignment of interest, but very few specifics. Although CalPERS has been investing in private equity for decades, I heard comments and questions from the trustees (and these are the trustees on the Investment Committee) that I would have expected from a public pension plan that had never invested in private equity before. Moreover, when one or two trustees asked pointed questions, it seemed as if the senior staff was doing a fine impression of evasive private equity executives instead of acting as a staunch stewards of a public pension.
Recall that earlier this year, Wylie Tollette, the Chief Operating Investment officer at CalPERS, tried excusing the giant public pension fund’s failure to keep tabs on the private equity profit-sharing payments widely called “carry fees” by claiming that no one in the industry could obtain the information. CalPERS had to reverse itself quickly in the face of a firestorm of industry and media criticism.
We’ll continue our discussion of a presentation by Réal Desrochers, who has the day-to-day responsibility for the private equity portfolio.
CalPERS Managing Investment Director of Private Equity Does Not Understand How Management Fees Work
Desrochers presented the last item on the agenda for the Investment Committee meeting, a very simplified presentation to the board of how “carry fees” work. We’ll turn to the presentation proper in later posts. Suffice it to say for now that private equity experts who have read it concur with our view that Desrochers’s presentation has been oversimplified to the point of being misleading. For instance, Eileen Appelbaum, co-author of the highly-regarded book Private Equity at Work, called it a “ludicrous example.”
Board Member JJ Jelincic: The presentation is good as far as it goes. It’s very high level. But one of the things that it did is that it assumed away the things like offsets and fee waivers and clawbacks and fund costs and preferred returns, which are all the areas that are creating the controversy.
These are the areas where the SEC has said limited partners are getting ripped off, where the IRS has said it looks like taxpayers are getting ripped off. So I want to dig a little deeper, if I may….
Jelincic then describes a 2005 vintage fund he’s picked out as being representative and tries working through the fund economics.
Jelincic: But when I looked at the CAFR [CalPERS’ Comprehensive Annual Financial Report] on this particular fund, one of the things that I see is the fees and costs we report. And I would assume that the fees are the management fee and the costs are all those costs that go into the fund, the auditing fees, the advisory firm, all that kind of stuff. Is that a reasonable assumption?
Managing Director Desrochers: There’s — I don’t know. There’s three types of — there’s in a fund, a co-mingled fund, you have the management fees that are paid, you have sharing of the profit, and you have all sorts of…
Jelincic: Sharing of what?
Desrochers: Sharing of the profit, the carried interest.
Jelincic: Oh, OK.
Desrochers: Then you have fees that are charged to portfolio companies that are to be shared with the limited partners. And then these are market, market driven. Some, if you go to the cycle, you say 2005 vintage year, I don’t know what the name of the fund, but a fee of seven….
If you know a smidge about private equity, this interaction is stunning. Jelincic asks a complete softball question: Do the fees that CalPERS reports in its annual report as fees and costs include the management fees plus the costs of running the fund, like the auditing firm?
If you listen to Jelincic’s question and watch his body language, he expects to get agreement. He looks to be going through what he thinks is obvious background, presumably for the benefit of the other members of the board, to set the stage for his real question. But Desrochers goes on tilt and shunts the conversation to fees charged to portfolio companies, which are not fees paid directly by CalPERS, and he flounders there too.
No interpretation of what happened is pretty. Either Desrochers does not know what the normal operating expenses of a private equity fund are, or he is so unwilling to answer any questions about private equity that he’ll put as much noise as he can in his signal so as to grind any inquiry to a dead halt.
And immediately after that (starting at 1:21:20 on the video), the chairman of the Investment Committee, Henry Jones, intercedes on behalf of Desrochers, in what is clearly an effort to shut Jelincic down by arguing that Jelincic should not be asking questions that require specific figures for a response, that Jelincic instead should give the questions to staff and allow them to provide a detailed response. (It’s almost certain that any such response would not take place in an open board meeting and hence in view of the public). Jelincic replies that Desrochers does not need to know the details to answer his questions.
In a remarkable sequence, Jones indicates that he is still opposed to the questioning. Jelincic asks if he is being ruled out of order. Jones first says no. Then as Jelincic continues, Jones reverses himself and rules Jelincic to be out of order. Jelincic appeals the ruling and asks for a roll call vote. Jones loses control of the meeting. Committee member John Chiang suggests that Jelincic restate his question to be more general. Jelincic asks if Jones is reversing his ruling. Jones gives an equivocal answer, but says a general question is acceptable.
If you doubt that Desrochers is either being obfuscatory in the extreme or is in over his head, what happens as Jelincic presses on provides incontrovertible proof otherwise.
Regular readers of our private equity posts will recall that the SEC and the media have exposed a great deal of misconduct as far as so-called management fee offsets are concerned. Recall that the prototypical private equity fee structures is “2 and 20”, for a 2% annual management fee based on the amount of capital committed, and a 20% share of the profits after a certain level of return (the “hurdle” or “preferred return”) has been met, usually 8%. But private equity firms are also allowed to charge the portfolio companies directly with fees that are paid to the general partner or related parties. Rather than tell the general partners to cut it out, the limited partners have instead agreed to the device of the “management fee offset,” in which a portion of these portfolio company fees (now averaging 85% across the industry) are charged against the management fee. The net effect is to shift a part, and in some cases, all, of the management fees from being paid directly by the limited partners to being indirect charges, pulled out of the portfolio companies.*
Jelincic returns to his 2005 vintage fund example. The facts he pulls from it are simple: 1.5% management fee, so that with CalPERS’ commitment amount, the annual management fee should be $180 thousand. But the CAFR shows CalPERS paid only $30 thousand.** He asks Desrochers for what could account for the disparity. If you look at the video, you will see Desrochers responding like a hostile witness in a trial.*** He fails to mention the most obvious reason, the management fee offset. When Jelincic brings that up, Desrochers then tries the tactic of saying at considerable length that the offsets vary by fund as a way of again dodging the issue. Jelincic continues:
Jelincic: Let me repeat the question. If the manager charges fees to the portfolio company and shares that with the LPs, would the LPs’ management fee be reduced?
Jelincic: Okay. And the — because the GP got the same amount of fees, but they got part of it from the portfolio company, and part of it from the LPs, correct?
Desrochers: I’m sorry. No, repeat that. No, because — no, it doesn’t get the same amount of money.
Now, in fairness, a bit later Desrochers says that in Jelincic’s example, Jelincic is correct, but then continues to refuse to make a general statement. Jelincic continues to try to pin him down. One private equity expert who watched this sequence remarked, “We need a Nobel prize for patience. JJ should get it!”
Jelincic uses an example where a private equity fund has an annual management fee of 100 and a 100% fee offset, so for every dollar charged to the portfolio company, the management fee is reduced by the same amount:
Jelincic: To the extent that the GP collected money from the portfolio company and shared it with the LP as an offset, then the total that the GP would have collected would have been the same. Because otherwise he could have collected 100 from the LPs. Instead he collected 50 from the LPs, gave the, the portfolio companies gave the GP the LPs’ credit for that 50, and still wound up with his 100.
Investment Director Christine Gogan: Just if you could, Mr. Jelencic, just boil down the essence of the question again and Réal and I will do our best to try to answer it from the theoretical perspective.
Jelincic: If the GP collects from the portfolio company and uses that money to offset the LPs’ management fee, so it takes it from one pocket and credits it to the other pocket, the total fees that the GP collects will be the same, assuming it’s a 100 percent offset. When you go back…you don’t agree? I mean if the assumption’s wrong…
Desrochers: No. I don’t agree.
Jelincic: If — let me give a specific. Management fee is 100. The fees to the portfolio company is 50. There is a 100 percent offset to the LPs. So what then happens is that the GP has collected 50 from the portfolio companies, and he will collect the other 50 from the LPs, because that part has not been offset. So he will have collected the 100. Correct?
Desrochers: No. He will collect 50.
Jelincic: So if he, if the management fee is 100, he collects 50 from the portfolio companies…
Desrochers: No, he offsets the management fee of 100 by the 50 million dollars that he collected from the portfolio companies.
Jelincic: OK, so he offsets 50 of the management fee. What happens to the other 50 of the management fee?
Gogan: It’s paid by the limited partners.
Jelincic: OK, so the GP ultimately gets 100. He gets 50 from the portfolio companies, 50 from the LPs. Right?
This is just scary. Where does Desrochers think that the $50 million charged to portfolio companies in this example goes? To the tooth fairy? Or is he arguing that 50 + 50 does not equal 100? Either interpretation says he has no business having any role investing funds in private equity, much less being the person in charge.
In the words of Leon Shahinian, Desrochers’ immediate predecessor at CalPERS (emphasis his):
JJ [Jelincic] is correct in making the point that a private equity manager collects the full, contractual management fee amount via some combination of charges to portfolio companies and direct charges to the LPs through management fees. This is true regardless of what the management fee offset percentage is and regardless of how much the PE manager collects from the portfolio companies. I don’t see this as a minor point. It is a central economic feature of private equity funds that, remarkably, some LP investors do not understand, though clearly JJ does.
And from Gregg Polsky, a law professor at the University of North Carolina:
JJ Jelincic was obviously correct about the basic economics of fee offsets. The incompetence or stonewalling (take your pick) was incredible. Thank goodness there’s video.
It is not plausible that Desrochers could possibly be confused about what Jelincic was asking. Desrochers was doing everything in his power not to answer the question and to try to persuade the rest of the board that Jelincic was being unfair. There are only three possible justifications for Desrochers’ stance (and note that they are not mutually exclusive):
¶ Desrochers really does not understand how fee offsets work. If true, that would be stunning incompetence for someone at his level
¶ Desrochers does not want to admit to the board that CalPERS ultimately bears the full cost of the management fee. Desrochers has been regularly providing the board with reports on the cost efficiency of CalPERS’ investment in private equity. They are grossly misleading by virtue of omitting the portion of the management fee that is shifted to portfolio companies. An industry standard-setter, CEM Benchmarking, which has CalPERS has a client, has included this matter as one of the issues that limited partners like CalPERS need to rectify in order to report costs properly. So not only is Desrochers trying to defend the continued use of a bad metric, he is doing so in defiance of the advice of CalPERS’ own expert on this matter
¶ Desrochers does not believe that staff is accountable to the board, but that the board should have only the information that staff deems necessary and should follow the staff’s guidance. In other words, his attitude is fundamentally insubordinate. Under this theory, his efforts to stymie Jelincic weren’t as much about management fee offsets as much as a power struggle over the board’s right, indeed duty, to know
Desrochers Has Given Diversionary at Best Responses About Management Fee Offsets in the Past
The sort of response that Desrochers made at the August Investment Committee meeting is not an isolated event. See this clip from CalPERS’ December 2014 Investment Committee session:
Jelincic: One of the things that I was able to tease out is that these fees [as reported in the slide show that Desrochers just presented to the board] don’t actually represent all the money that the partners are getting. Um, for example, if the partners are getting management fees, that reduces what we pay them, that management fee issue doesn’t disappear, although it really is a cost to the program.
Desrochers: It doesn’t, it doesn’t…. The manager, the manager can collect all sort of fees. They have all kinds of fees, and it goes in cycles. There is monitoring fee, there is investment banking fee, there’s all kinds of fees they can charge. And these fees typically are shared with the limited partners. And this was today, I was, I am looking at Scott, most of them are 100% back to the LP. If you go when everybody wanted to be in private equity, the fee sharing was 50/50, 60/40. It depends, I would say it depends on the manager and it depends on where you are in the cycle. To my knowledge, we have not done any deal, and I’m looking at Scott, where the LPs don’t get 100% of the fee today, over the last two and one half years.
Jelincic: In one of the Blackstone fees, I like to pick on Blackstone because it’s one of the agreements out there on the Internet, we paid $4.3 million to them in the first year of their fund. The second year, presumably the fund was bigger because they’d put out some more commitments, but we paid only $544,000 in fees.
Desrochers: I don’t know. Because they, the fee… I will not challenge you on the numbers, and I’m happy to visit, but typically these fees are applied to reimbursement of whatever CalPERS has to pay. With Blackstone, I go back I don’t know how many years where the LP didn’t have to pay any fee because they were charging to their company and they were reimbursing the management fee.
Jelincic: So it’s likely that the reduction in what we report as fees reflects a reduction in what we paid out because they were collecting it from portfolio companies..
Desrochers: It’s possible.
Jelincic: … which ultimately we’re paying for because we own it.
Desrochers: I don’t disagree with you.
Step back to understand what happened. Jelincic raised the same issue in December with Desrochers that he did in the last Investment Committee meeting, namely that CalPERS’ staff obscures that limited partners like CalPERS ultimately pay the full amount of the management fee, as in the contractual amount, regardless of whether they make a hard dollar payment by wire or indirectly, by having some or all of the payments shifted to the portfolio companies that the investors (among them, CalPERS) own.
As you can see in a post earlier this year, in December, Jelincic’s line of questioning served to undermine a slide that Desrochers had just presented, one that sought to imply that CalPERS’ staff was doing a good job because the hard dollar management fee payments had fallen in the last year versus the previous year. Jelincic was exposing that metric as bogus. It was thus possible to see Desrochers’ hemming and hawing, and eventual nolo contendere conclusion, as a way to keep Jelincic from taking the next step of saying the slide was obviously irrelevant and staff needed to find better performance measurements.
But Jelincic posing the same question mere months later has exposed an even uglier truth: Desrochers is completely out of his league in serving as the head of CalPERS’ private equity program. He didn’t just try to evade the issue, he reversed his earlier position that Jelincic had a point and doubled down by making repeated, erroneous statements which can only confuse and misinform the board. Whether it was because Desrochers can’t grasp a simple, pervasively-used private equity technique, or that he is determined to preserve the misleading view he presents of private equity’s true cost to CalPERS, Desrochers has no business being responsible for billions of dollars of beneficiary funds.
* The SEC and media scrutiny has focused on the fact that the limited partners assumed that all portfolio company fees were being shared, as in offset against the management fees. It turns out that only specifically enumerated fees are shared. Investors have learned, much to their embarrassment and consternation, that large fees such as termination of monitoring fees have been charged to portfolio companies and not shared as the limited partners had naively assumed.
** Jelincic actually said $180 million and $30 million, proof that Desrochers’ and Jones’ efforts to derail him had an impact.
*** If you are a glutton for punishment, you can look at this CalPERS Investment Committee meeting video starting at 1:24:20 to see what I’ve spared you.