If you have not done so already, please read the first post in our CalPERS’ Private Equity, Exposed series, the Executive Summary.
Over the course of the last Investment Committee meeting of the CalPERS Board of Directors, many of the statements made by senior members of CalPERS’ investment staff showed a lack of understanding of basic issues, such as the private equity industry’s economics and how widely-used contract terms operate. The fact that a single meeting in which private equity was only one of several topics exposed so much in the way of ignorance and misunderstanding is deeply troubling.
As we will demonstrate, these failings are obvious in the case of Réal Desrochers, the Managing Investment Director responsible for private equity. But the lack of sufficient expertise is evident among all the senior staff members responsible for private equity: Desrochers, Ted Eliopoulos, the Chief Investment Officer, and Wylie Tollette. Other than Desrochers, no senior CalPERS officers have meaningful previous experience in private equity; Eliopoulos come out of real estate investing; Tollette spent 18 years before CalPERS at Franklin Templeton Investments, where he worked only with liquid investments. Anne Stausboll by background is a lawyer and political operative.
Now in theory, it would be possible for any of these professionals to study up and become sufficiently skilled in private equity. Thus, the failure rests with CalPERS’ Chief Executive Officer Anne Stausboll. It is her job to recognize that the risk and complexity in private equity are greatly disproportionate to that of CalPERS’ other investments and to make sure that her staff is up to the task, particularly its senior leaders. Instead, her team amounts a group of actors performing a private equity play. It is not hard to understand why they are easily led by the private equity general partners since as we’ll see, they feed these performers their lines.
Let us turn first to Réal Desrochers.
Réal Desrochers Does Not Understand that Private Equity Has Created a “Heads I Win, Tails You Lose” Fee Scheme
The final item on the agenda for the Investment Committee of the CalPERS Board of Directors was a slide presentation about carry fees. We’ll discuss this thin presentation itself in due course.
One of the first lines of questions came from board member Priya Mathur. Recall that the “management fee” is “2” in prototypical “2 and 20” fee structure for private equity. The “2” stands for a 2% annual management fee and the 20% is the profit share widely called “carried interest” or “carry.” It’s typically 20% of the profits after a so-called “hurdle rate” or “referred return,” usually 8%, has been met. The slide presentation assumed the management fee was 2% and omitted any hurdle rate.
Board Member Priya Mathur: Thank you, Mr. Chair. Thank you, Mr. Desrochers, for that presentation. I recognize that you’ve just used round numbers for illustrative purposes, but if we could go back to page five In this example, the management fee is actually greater than the carried interest.
Managing Director Réal Desrochers: Correct.
Mathur: Is that typical? De we typically see the management fee [over the life of a fund] being, exceeding the carried interest?
Desrochers: You don’t want that. No, it’s not typical. This is why I say it’s very rich. You don’t want that, because in a case like that, it means that the people, I mean, they’re going to get rich no matter what. I mean, not rich, but, I mean, they don’t have the incentive to really work the asset.
Desrochers: No, that’s not good.
Mathur: I mean, in this example, they’re getting [as the management fee] 36% of the total proceeds of the investment of $100 million in this case.
Mathur: And is that typical that they that the…
Mathur: the GP would end up with third or more?
Desrochers: No. The typical, you want the general partner to have, we say, skin in the game. They have to have money at stake.
Desrochers: We verify — the short answer is no. They should not get rich on the…
Mathur: On the management fee.
Desrochers: …on the management fee. They have to have the incentive to work and to earn through the profit sharing really. And to do that — yeah, that’s my comment.
Mathur: And have we looked at our own portfolio to see how that is, actually shakes out?
Desrochers: We do that all the time. We do that. We do that all the time before we underwrite a new commitment.
You’ll notice that Desrochers seems relaxed answering what he appears to regard as a not-very-demanding question. His confidence is wildly out of line with how inaccurate and dishonest his answers are.
Let’s start with the dishonesty. Desrochers says, definitively, at the end of his exchange, that CalPERS checks “all the time” how much fund managers have earned with past CalPERS investments on management fees versus “carry fees” before making a new investment.
That’s obviously untrue, since as we and numerous other media outlets reported, Wylie Tollette stated earlier this year that CalPERS did not collect carry fee data and further tried claiming that no one in the industry could get that information. In the face of widespread press criticism, CalPERS never reversed itself and said, “Oops, Tollette was wrong, we really have been getting that information.” Instead, CalPERS scrambled to obtain it, afresh, from all of its private equity fund managers.
It is thus utterly impossible for CalPERS to have made the tests that Desrochers blithely tells the board it makes “all the time before we underwrite a new commitment.”
Not only has he misrepresented the extent and rigor of CalPERS’ private equity due diligence, which in and of itself should be a firing offense for someone so senior, but he is also completely wrong about how private equity firms make money. Once you get past the smallest firms, they do get rich on management fees alone. And CalPERS, by virtue of its size, invests almost entirely in mid-sized and larger funds.
One former private equity partner laughed at the notion that industry members were only getting by from management fees and needed to work hard to get rich: “The LPs [limited partners] lost that battle long ago.” He said that the heads of some firms make close to $100 million annually before “carry fees,” including firms that manage funds in which CalPERS holds investments.
Eileen Appelbaum and Rosemary Batt, in their landmark study Private Equity at Work, similarly found that the overwhelming majority of private equity income came from fees not at risk, as in the management fees and the other fees and expenses that they extract from the portfolio companies that they own. From p. 52 of the original print edition:
Despite changes in fee structure, management fees are still a major source of income for PE general partners. The pay packets of GPs, not including their share of carried interest, are quite high. Average senior GP pay in 2011 was nearly $1.4 million and ranged as high as $5 million. For a less experienced junior GP, average salary in 2011 was $270,268 and ranged up to $750,000.
Andrew Mettnick and Ayako Yasuda found that “close to two-thirds of total revenues [of the PE firm] derive from fixed-revenue components, and about one-third from the variable-revenue components.” That is, in their study, management and other fees provided two-thirds of the income earned by a fund’s general partner. Carried interest accounts for about one-third.
Desrochers Understates How Large Management Fees Really Are
The fact Desrochers does not understand that general partners do extremely well even if they don’t earn a dime in carry fees is bad enough. There is yet another misrepresentation, albeit a much less obvious one, in what Desrochers said, that the management fee he used in his example of 2% is “rich.” Desrochers’ depiction, which is common among private equity limited partners, reflects how badly they have been captured intellectually by the general partners.
In other types of investment management, such as stocks and bonds, and even in other alternative investments like hedge funds, the fees are set by convention based on a stipulated measure of assets under management. For instance, CalPERS runs its own equity index fund in house for well under 15 basis points (0.15%). While CalPERS does take a stab at calculating its management fee on a similar basis to that of its other investment strategies, the result is understated by virtue of the failure to include the portion of management fees that are shifted on to portfolio companies.*
Private equity general partners have managed to brainwash limited partners into conflating the formula for setting their fees with the actual costs. The 2% private equity fees are based on the committed amount, not the amount that CalPERS has invested. Limited partners have their capital called to make investments over the first three to five years of the fund. Thus that 2% of the committed amount is a much higher percentage of the funds actually deployed. Thus, as Oxford Professof Ludovic Phalippou pointed out via e-mail:
If they assume 2% over 10 years of amount invested, they won’t be far from the truth because the 2% is too low but the 10 years is too long, so they make two mistakes that cancel one another by chance.
Desrochers Not Only Ignores That He Makes General Partners Rich Regardless, But It Matters Who in Particular Gets Rich
In the exchange above, Desrochers speaks of the general partner as if it were a person, that the general partner needs to have “skin in the game.” But general partners are not single individuals; they are firms manned by teams with a range of experience and expertise.
As members of general partners themselves will tell you, the most important document that limited partners should insist on reviewing as part of their investment process, after the limited partnership agreement, is the so-called “GP Agreement” or agreement among the members of a firm who participate in the carry pool (that is, will receive a cut of the profit share if the fund does well).
The Kauffman Foundation, a premier venture capital investor, published We Have Met the Enemy … and He is Us, a landmark critique of limited partner abdication of investment duties. Keep in mind that “venture capital” is a specialized strategy within private equity, so virtually all the concerns that Kauffman Foundation raised for venture capital apply to private equity. One of its five big areas of concern was what it called “the black box” of “firm economics”:
“Do as I say, not as I do” is the maxim in force when it comes to VC firm economics. When VCs conduct due diligence on potential portfolio companies, they carry out a comprehensive assessment of the company’s financials (cash flow, burn rate, key expenses, and stock option plans, etc.) and require complete detail on senior management team salaries, bonus amounts, ‘skin in the game,’ and equity ownership. GPs know this information is crucial to understanding company financial health as well as management team incentives, stability, and succession. Every GP we interviewed acknowledged the essential importance of senior management team compensation in their portfolio company investments. One GP emphasized its significance, saying that not only does his firm “know everything about the compensation… a lot of times we structure it.”
LPs have the exact same interest in understanding the firm economics of the partnerships in which we invest, and the compensation structure of the GPs investing our capital. LPs also have the same fiduciary obligation as GPs to understand the economics and incentives that underlie investments, and to evaluate how fees, carry, and ownership align investor and investee interests. What LPs seem to lack is the conviction to require the information from GPs in the same way the GPs themselves require it. Even more disconcerting, investment committees and trustees fail to require a disciplined approach to understanding and evaluating firm economics of VC partnerships to which they allocate, approve, and oversee large capital investments.
Kauffman put this issue on its short list because they’d found it made a difference: “It’s our experience that bad firm economics cause VC firms to lose top-performing partners.”
Yet in Desrochers’ discussion of all of the careful “skin in the game” and other supposedly exhaustive due diligence that CalPERS performs on general partners prior to investing, you’ll see nary a mention of the issues of how the firm itself operates. Given his cluelessness about utter basics like the importance that management fees in overall industry pay packages, plus his silence on due diligence of the general partners’ organizations, it seems highly unlikely that Dersrochers has ever pushed on the issues that Kaufman flags as being of top-order importance.
As former banker and independent private equity researcher Peter Morris said: “Making good investment decisions includes understanding clearly both in what ways and how much you are paying your investment managers.” Despite its pretenses otherwise, CalPERS fails to meet this standard.
* While the fact that the fees are based on the committed amount, as opposed to the funds being put to work, increases the effective fees paid when stated on a percentage basis, that prototypical “2% of the commitment” fee schedule usually applies only in the so-called “investment period” which is generally the first five years of the fund. The fee level commonly steps down to 50% of that level after the investment period, and is also then applied only to the amount of remaining commitment, i.e., as companies are sold, the amount subject to fees also goes down. The fact that the committed amount is paid in over time, via capital calls, and paid out gradually, as companies are sold and distributions are made to the limited partners, means that average life of the majority of private equity funds is shorter than the ten years used in the example with CalPERS’ board.