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
CalPERS, an Anatomy of Capture by Private Equity
CalPERS’ Chief Investment Officer Invokes False “Superior Returns” Excuse to Justify Fealty to Private Equity
In the last CalPERS Investment Committee meeting, one of the most revealing incidents took place when Investment Director Christine Gogan repeatedly refused to answer a simple, direct question about a widely-used private equity tax abuse, management fee waivers,* from board member JJ Jelincic. This was pure and simple insubordination and reveals serious governance problems at CalPERS. This is also not the first time we’ve seen staff show disrespect for a board member, but it is one of the most flagrant incidents.
Moreover, Gogan’s evasiveness suggests that she was not able to field a response, raising doubts about her ability to do her job. Finally, her misdirection served not simply to keep the board in the dark, but also conveyed inaccurate information to them.
Board Member JJ Jelincic: Okay. I won’t ask about offsets. Fee waivers. Can you explain to me what fee waivers are, how they’re used, and how the GP gets their money back?
Investment Director Christine Gogan: So by management fee waivers, just to make sure that we’re on the same page, what you’re talking about is the ability for a general partner to use a management fee waiver in place of a deemed contribution for their one to three percent…
Gogan: …correct? And so your question is, to start with, you’re trying to get a sense of throughout our portfolio how common that arrangement is?
Jelincic: That’s a question that I had asked earlier. There’s some research apparently being done on it. But this question is just how does it work? What’s the process? What’s the economics of it? You know, quite frankly, I’m sure that the Wall Street hearts of private equity don’t say, you know, I overcharged you, I’m just not going to take the money.
Gogan: Well, I think, if I could, one thing that I would like to back up and offer up is that with respect to our entire portfolio, it’s important to note that the entire portfolio is audited. Everything is audited. Ninety-seven and a half percent of the portfolio is audited under standards that conform with U.S. GAAP. And so one of the questions without going into a lot of detail on how the management fee waiver mechanics work from partnership to partnership, and it depends to Réal’s earlier point on the waterfall computation, one thing that does give us comfort with respect to having assurance that the bottom line numbers that we’re relying upon are fairly stated, is that the majority of the portfolio, as I mentioned, the overwhelming majority is prepared in accordance with U.S. GAAP. And there are independent auditors typically, one of the top three, that provide a statement to us that provide information that we, as investors, are reasonable in relying on the fact that the financial presentation of the income statement, the balance sheet, and the capital accounts are materially accurate and fairly represent the financial position of the company.
Jelincic: And so how does the fee waiver function work?
Gogan: And so with respect to the fee waivers, to some degree, it’s going to depend on whether it is a European waterfall or whether it is a deal-by-deal waterfall. But my point in trying to go back to the audited financial statements is that in accordance with presenting the financial condition of the individual partnership, there are independent auditors that look every year to evaluate and assure that the computation of net income is consistent with the particular limited partnership agreement, and take into account each of the idiosyncratic conditions of the various waterfalls that exist for that particular partnership.
Jelincic: And the SEC would say they didn’t do a very good job of it.
As South Carolina Treasurer Curt Loftis wrote:
The staff responses are absurd.
Ms. Gogan failed a basic test of her fiduciary responsibilities. She is required to provide information in a timely and practical manner and she did neither. The Committee’s questions were direct and clearly stated and her replies were evasive, perhaps even obtuse.
Gogan’s repeated reliance on the audits for detail specificity is misplaced and is a “dodge.” GAAP audits are helpful but are not, as she implies, appropriate as the primary due diligence tool for PE fees, expenses and income. A sophisticated fund such as CalPERS has the ability and right to demand more stringent initial and on-going due diligence and the staff should be willing participants in that effort. Committee members should not be forced to “dance” with staff for information due them as a fiduciary.
As ugly as this picture is, it’s actually worse than Loftis indicates. If you watch the committee meeting in full, you’ll see again and again that if a staff member looks to be having difficulty answering a question, someone rides in quickly to their rescue. Here, no one more senior spoke up.
By contrast, recall our post last week where the CalPERS Chief Investment Officer, Ted Eliopoulos, described management fee waivers as beneficial to CalPERS when they are a tax dodge that does not benefit limited partners like CalPERS.** Eliopoulos had spoken up because the Managing Investment Director responsible for private equity, Réal Desrochers, was struggling to come up with the proper term of art, management fee waiver, in response to a question from board member Priya Mathur (and yes, the fact that Eliopoulos had to intervene was not a good sign). Similarly, when Jelincic was trying to get answers from Desrochers about another common provision in private equity limited partnership agreements, management fee offsets, Desrochers kept saying he’d be happy to answer the questions later, which almost certainly also meant out of the public eye. When Jelincic pressed onward, the chairman of the Investment Committee called Jelincic out of order, then reversed himself when Jelincic appealed the ruling and asked for a roll call vote.
Thus, as Gogan engaged in a heavy-handed form of obstructionism, no one intervened. By implication, her stonewalling of Jelincic had the full support of her boss, Réal Desrochers, and his superiors who were also present at the meeting, Eliopoulos and the Chief Operating Investment Officer, Wylie Tollette, as well as Mike Moy, CalPERS’ private equity consultant. In other words, staff and CalPERS’ outside advisors are apparently united in its position that the board is not entitled to honest and complete answers. As we discussed at length earlier this year, Tollette clearly and knowingly misdirected the board in trying tell them that it couldn’t get carried interest fees.
And most of the members of the Investment Committee seem to back staff’s apparently successful effort to tell board members as little as possible. You’ll notice that the chairman of the Investment Committee, Henry Jones, never once supported Jelincic’s efforts to pry information loose from the private equity team. Instead, he consistently weighed in on behalf of staff to uphold their apparent right to be less than forthcoming.
Gregg Polsky, former Professor in Residence in the IRS Office of Chief Counsel and now a professor of law at the University of North Carolina, surmised that the reason for Gogan’s slipperiness was that she could not answer Jelnicic’s question. That would be consistent with the performance of the rest of the senior staff. From Polsky via e-mail:
Gogan completely dodges the question, talking about financial statement audits and European versus deal-by-deal waterfalls. I can’t see any relevance at all of this to Jelincic’s questions.
There are two potential explanations for the dodging: she doesn’t actually know at all how fee waivers work or she’s defensive about where Jelincic is going with his questioning. I’d vote for the ignorance explanation for two reasons: (1) someone who knows the basics of fee waivers could have dodged whatever questions were coming without coming off as clueless (she could have fended off any criticism simply by noting that fee waivers can’t hurt CalPERS and she could have pointed out that, in any event, fee waivers are pervasive in the industry and the CalPERS lawyers thought fee waivers were fine at least until the recent guidance which requires them to take a fresh look); and (2) relatedly, there is no reason for someone well-versed in the basics of fee waivers to be all that defensive about them (at least from the LPs perspective). It’s a tax game between the GPs and the IRS; the LPs are really just bystanders.
Bottom line is that I think the exchange suggests that Gogan doesn’t know much about fee waivers. It’s like when I ask a law student in my class about something that he or she knows very little about even though they should know it. They change the topic to something they know about, even if it has little relevant to the topic at hand.
Actually, there could be a reason for Gogan to refer to waterfalls, but that would simply confirm that she indeed does not understand how management fee waivers work. The “distribution waterfall” determines how to divvy up the proceeds of the sale of a company between the general partner and the limited partners. By focusing on the distribution of funds in the event of a sale, Gogan is cementing the misinformation that Eliopoulos also conveyed to board members in the same meeting, namely, that the management fees that the general partners forego are put at risk on the same footing as the monies provided by the investors. Earth to board members: They aren’t. As we discussed at length in a post last week, the general partners have the ability to gin up profits for purposes of recovering their waived management fees, including creating them even when there have been no sales of assets in the fund at all.
So take your pick. Gogan is either trying to cover for the fact that she is out of her depth or is choosing to mislead the board by doubling down on the false story that management fee waivers are a plus for CalPERS because they aligning the interests of the general partners with those of the limited partners.
At another point in the Investment Committee meeting, Gogan fails to answers a simple, direct question and shades the truth so heavily as to be engaging in distortion:
Board Member Dana Hollinger: In the past have we seen the financials of those underlying companies or no?
Chief Investment Officer Ted Eliopoulos: Well, I’ll turn that question over to Christine.
Gogan: With respect to what’s been occurring in the industry is there’s definitely been an evolution that’s occurred over time. And I would say we are moving towards an environment where we are receiving the much more detailed information with respect to the underlying. But to make a broad statement that we have always had access to the underlying detailed information in the portfolio companies is a stretch. It’s definitely improving.
The truthful answer to Hollinger’s question is “No, and we don’t typically get them now either.” Yet Gogan tries to give Hollinger the misleading impression that the limited partners get a considerable amount of disclosure, although she throws in some baffle-speak (“we are moving towards an environment”) to try to make her claim sound like less of a stretch than it is. Curt Loftis concurs:
Ms. Gogan’s response was bureaucratic gobbledegook. She chose to ramble incoherently for several minutes rather that submit a truthful and straightforward “no.”
Public pension plans should not accept as gospel the paltry representations from the GP as to the condition of the underlying investments, valuations and their attendant risk. The failure to perform the required due diligence and adequate ongoing oversight are unforgivable errors that will cost the fund substantial sums of money.
And that’s before you get to the fact, as we discussed in depth in a 2013 post, Why You Should Not Trust the Financials of Private Equity Owned Companies, that many general partners use a portfolio company software package called iLevel Solutions that gives private equity general partners an unprecedented ability to cook the books of their portfolio companies while maintaining a facade of compliance. In other words, the portfolio company data that CalPERS does get is of questionable integrity.
Gogan’s stonewalling shows the true face of CalPERS’ private equity staff: They deem it to be acceptable to defy and mislead the board to protect private equity general partners. This warped sense of loyalties is proof of serious governance problems at CalPERS. But the sorry fact is that the board itself, save JJ Jelincic, has made clear by its failure to press for better answers that it fully supports this abject failure of governance and neglect of fiduciary duty.
* A management fee waiver is a provision in the limited partnership agreement that allows the fund manager to forego management fees that it was going to receive for overseeing the fund, substituting a separate profits interest (often mislabeled “carried interest”).
As Lee Sheppard wrote in Tax Notes:
Fund governing documents usually allow the general partner to find profits to cover the waived fee wherever it can. The general partner often has a lot of discretion in accounting for profits. Some fund documents refer to undefined “available profits.” The general partner takes its profits to cover the waived fee out of the first profits in any future accounting period, regardless of losses in other periods.
So a fund could lose money over its lifetime yet have enough isolated successful quarterly or annual periods that the waived fee can be recouped. The point is that there are lots of machinations that the general partner can use to ensure that its waived management fee gets paid.*
As Sheppard concluded in a more recent Tax Notes article (emphasis ours):
There is no real intention to subject the management fee to the risks associated with the general partner’s profits interest.
** Former Professor in Residence in the IRS Office of Chief Counsel and now a professor of law at the University of North Carolina Gregg Polsky stresses that management fee waivers are designed to leave the economics of a private equity fund unchanged.