If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:
Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity Fees Work
CalPERS Chief Investment Officer Defends Tax Abuse as Investor Benefit
One of the strongest, most consistent reactions of experts who watched the video of the last meeting of CalPERS’ Investment Committee was that the staff and the Investment Committee members, save JJ Jelincic, were completely captured by the private equity industry. For instance:
Ludovic Phalippou, professor at Oxford’s Said Business School:
I do not see any difference between that presentation and that of any general partner. The language, perspective, line of defence are the same. We should expect a limited partner not to use the exact same marketing document as those of fund managers.
Eileen Appelbaum, co-author of the landmark book Private Equity at Work:
The answers provided show just how much top staff members are in thrall to private equity. GPs, they told the Board, have a large number of investors to choose from. CalPERS, they said, can’t control things. CalPERS has limited ability to influence the actions of GPs. The Limited Partners Advisory Committee doesn’t have a say over investments – it only looks out for conflicts of interest between GPs and LPs.
I find these responses, which I am sure are sincere, simply incredible.
What’s the best defense against capture? A strong staff and informed trustees. The CalPERS video strongly suggests that CalPERS is lacking on both fronts.
If you doubted that the video is representative of CalPERS’ or typical limited partner (LP) conduct, a former private equity partner cited other examples of how limited partners fail to act in their best interest:
¶ The investors are fiduciaries themselves but are delegating their fiduciary duty to parties (the PE firms) that demand the right to give priority to their own interests over those of their investors
¶ The LPs claim that they are powerless in the relationship with PE managers, even though they collectively provide all the capital
¶ The LPs actively resist public disclosure of PE bad practices contained in the LPs’ own records, even though disclosure would greatly promote the curbing of such bad practices
¶ LPs actively defend the PE managers in the claim that their limited partnership agreements are “trade secrets,” even though almost all of the details are now in their SEC Form ADV filings, except for various shenanigans that are used to trick the LPs
We have been writing about private equity abuses for over two years. We have also highlighted how little investors have done even after the SEC made clear that misconduct was both widespread and serious and included stealing. Other long-standing issues have similarly have been allowed to fester, like the widespread use of misleading measures of investment returns. When readers have grasped the extent and severity of these problems, they immediately want to know how the staff and trustees have been bought off. They find it inconceivable that such vendor-favorable results have occurred in the absence of payoffs. Yet that is precisely what has taken place.
The ugly secret of the investment management business is that the so-called buy side (investors) is far more successfully played by the sell side (Wall Street) than outsiders recognize. Private equity is an extreme version of this syndrome. The general partners have achieved the impressive feat of inducing investors, the overwhelming majority of which are fiduciaries, to behave as if they are more concerned about maintaining friction-free relationships with the general partners than with serving the interests of their beneficiaries. This is “working towards the Führer” on a grand scale.
But how did this pathology develop? Andrew Silton, who as the former Chief Investment Advisor to the State Treasurer of North Carolina was responsible for the management and oversight of billions of dollars of retirement assets, explained how investors come to identify their interests with those of the private equity industry:
In my view, capture is a more subtle process that occurs in two simple steps. First, most money managers are adept at stroking the egos of public pension officials. As I’ve mentioned on a couple of occasions in this blog, I was the smartest, funniest, most good-looking CIO until the day I resigned from the North Carolina pension plan. Money managers are adept at making pension officials believe that they’ve asked brilliant questions or extracted huge concessions, when in fact the question was lame and the concession was minor from the money manager’s standpoint. In the CalPERS video, you’ll hear Mr. Desrochers tout the fee concessions extracted by CalPERS under his leadership. In reality, the private equity managers have made small concessions on a product that is still grossly overpriced and riddled with hidden fees. Nonetheless, by granting these small concessions, the private equity industry has turned Mr. Desrochers and many other public pension officials into industry advocates.
Second, the success of the money manager and the pension professional are inextricably tied together. While public pension officials talk about due diligence and oversight, once a money manager is hired, a pension official’s objectivity begins to erode. Moreover, the impartiality may begin to erode during the due diligence process if a fund is oversubscribed. The public pension professional will feel pressure to woo the money manager in order to get an allocation to the hot fund. Over time, the pension professional becomes an advocate and defender of his decisions, including his roster of managers. This is especially true in private equity and real estate where there’s no easy way to fire a manager. Once the contract is signed, the pension official has committed the pension to a ten to fifteen year relationship, and his objectivity has been compromised.
Former banker, now private equity independent researcher Peter Morris describes other incentives that promote capture in a 2015 paper, Time to Rethink the “Sophisticated Investor”:
The people who work for a “sophisticated investor” do not have the same interests as the people whose money it is looking after. After all, it is not their money….
The head of “alternative” investments at a large pension fund will likely benefit if it allocates more capital to his area. So will the consultants who advise the fund to do so (more complexity is always more profitable for them). That does not mean the decision is always in the interests of the fund’s beneficiaries.
He also warns:
There is only one way truly to align the interests of a principal and an agent, and that is by literally merging their identities. Anything short of that can only be imperfect. It might be more or less imperfect, but that is all. And, paradoxically, imperfect alignment of interests is more dangerous than none at all. That is because it gives a principal false confidence that she can afford to stop worrying about her agent’s conflict.
Yet as the video of the last Investment Committee meeting shows, CalPERS staff and its board members, save JJ Jelincic, and perhaps also Priya Mathur, see private equity general partners and CalPERS as having far more in the way of common interests than they really do.
The private equity professionals and Investment Committee members at CalPERS no doubt see themselves laboring diligently and effectively on behalf of CalPERS’ beneficiaries, as opposed to the private equity general partners who have succeeded in creating a “heads I win, tails you lose” economic arrangement. It is therefore critical to understand how these supposed experts rationalize their subservience to the general partners, when the investors provide the private equity funds with virtually all the money invested and thus should be in a strong position to dictate terms.
CalPERS’ staff gave some of the foundational limited partner excuses for their failure to stand up to the general partners in the Investment Committee meeting. We’ll review them over the upcoming days. Seeing how CalPERS’ officials and board members operate is important in understanding CalPERS’ failure to put its beneficiaries’ interests first. It also shows how supposedly independent and savvy organizations have become mouthpieces for private equity industry talking points.
The embedded letter from CalPERS’ Investment Committee member JJ Jelincic, the focus of a Financial Times article over the weekend, underscores how the issue of capture and competence are connected. Jelnicic describes (as we have) how the inability of CalPERS’ private equity staff to field basic questions “raises fundamental questions of their competency.” He also described how CalPERS employees “propagate GP propaganda.” This is precisely the sort of behavior one would expect to see from individuals who have decided that they can’t afford to ask serious questions. Like an athlete who has stopped training, over time, they don’t simply lose their competitive edge; they become incapable of playing the game at a professional level.
Only when the press and policymakers understand that limited partners see themselves as joined at the hip with the general partners will they be able to recognize that the limited partners’ defenses of private equity need to be taken with a fistful of salt.