If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:
• Executive Summary
• 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
• CalPERS’ Senior Investment Officer Flouts Fiduciary Duty by Refusing to Answer Private Equity Questions
• How CalPERS’ Consultant, Pension Consulting Alliance, Promotes Intellectual Capture by Private Equity
• CalPERS Board Members Defend Poor Performance by Staff, Capture by Private Equity
Over a series of posts, we dissected a video of the August meeting of CalPERS’ Investment Committee, in which the head of CalPERS’ private equity effort, Réal Desrochers, gave evasive and incorrect answers to simple questions about private equity fees, and the Chief Investment Officer, Ted Eliopoulos, and another senior private equity specialist, Christine Gogan, also made inaccurate and misleading statements. Board members, save JJ Jelincic, similarly showed a lack of understanding of basics about private equity and acted to defend staff, rather to obtain accurate information. As we wrote in our initial post:
¶ 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 who are themselves captured
Private equity experts, if anything, characterized the failures of CalPERS’ staff and board in more damning terms than we did. For instance, the former chief investment officer of North Carolina, Andrew Silton, wrote:
CalPERS doesn’t have the management wherewithal to oversee the allocation, performance, or risk of the private equity portfolio and should stop investing until they have the required leadership.
The Treasurer of South Carolina, Curt Loftis, came to the same conclusion:
Public plans ought not make investments they don’t understand. The senior staff at CalPERS, as well as staff at many other plans, do not understand private equity and therefore should look to other asset classes to satisfy their investment needs.
This board session should worry not only CalPERS’ beneficiaries but also California voters, since CalPERS, like virtually all public pension funds, is underfunded, and taxpayers are liable for shortfalls. Thus the concerns we have raised about CalPERS’ program, that private equity has over the last decade persistently not generated enough in the way of performance to justify the risks, that private equity firms charge indefensibly high fees (and worse, CalPERS and other investors are ignorant of the full amount they are paying), and that SEC officials have determined many private equity general partners are stealing from investors, are all hazards to taxpayers’ health.
CalPERS’ staff and board (save Jelincic), in responding to these issues, show a warped sense of priorities. Both staff and the board have made it clear that they regard protecting the image of the private equity program and general partner interests as more important than those of CalPERS’ beneficiaries and California citizens.
There was a brief discussion of private equity again at the Investment Committee meeting just yesterday. It showed that CalPERS’ board is doubling down by backing staff. The board is clearly following Investment Committee Henry Jones’ directive to regard the staff as the only “accurate” source of information. That’s a dereliction of duty, particularly given that numerous independent experts and other industry publications called out the private equity staff for giving clearly incorrect answers, and looking badly out of its depth. Yet in keeping with board’s head-in-the-sand attitude, board member Richard Costigan, at yesterday’s meeting, chose to characterize staff’s credible imitation of hostile witnesses in a deposition as “The back-and-forth last month was extremely difficult,” and praised staff for their loyalty and dedication.
How CalPERS Works Against Itself by Investing in Private Equity
CalPERS’ professionals and board have chosen to blind themselves to four central contradictions of private equity. First is that what is good for private equity is destructive to society, including to state and local government budgets and to the political viability of public pension funds. Eileen Appelbaum and Rosemary Batt, the authors of the landmark book Private Equity at Work, in a careful reading of the work underlying a widely-publicized, large-scale study by Steven Davis and his colleagues, concluded that private equity owned companies cut jobs more aggressively than comparable businesses. Fewer jobs means lower growth, lower incomes, lower real estate values, all of which translate into lower tax receipts for state and local governments. This sort of rent extraction thus puts state and local governments on a downward spiral, making it more tempting for them to cut staffing and pay levels, which only adds to the underlying economic stress.
A second contradiction is that CalPERS, which likes to see itself as the “good guy” of finance, has actively enabled tax abuses by private equity general partners in the form of management fee waivers, a topic raised by board member Jelnicic, that the Chief Investment Officer Ted Eliopoulos, head of private equity Réal Desrochers, and private equity senior staff member Christine Gogan all failed to address squarely and accurately. As Appelbaum said in an e-mail:
The winners are the PE funds’ general partners who get to pay taxes on half of their management fee income at the lower capital gains tax rate. The real losers are the taxpayers — the other 99% of us who have to shoulder a larger tax burden because private equity partners don’t want to pay their fair share.
And mind you, the private equity fee waivers are only a particularly extreme example of the extent to which the profits of the general partners depend on aggressive tax strategies. Recall that tax expert Lee Sheppard wrote in Tax Notes, “Private equity often seems like a tax reduction plan with an acquisition attached.” Limited partners like CalPERS benefit from the heavy use of borrowed funds in acquisitions, another strategy that lowers corporate tax revenues, and has the effect of shifting the tax burden from the capital-owning classes onto laborers, and lowering tax receipts at the Federal and state level.
A third contradiction is that private equity firms routinely seek to terminate pension plans at the companies they buy, which represents a long-term threat to public pension plans like CalPERS. Political conservatives have increasingly been targeting public sector workers as overpaid relative to private sector employees. Private equity firms have been at the forefront of corporate efforts to end pension plans. As private sector pension plans become more and more scarce, it will become harder for state governments to repel attacks on public pension funds. In other words, in funding private equity, CalPERS might as well be signing the death warrant for public pension funds.
A fourth contradiction is that CalPERS denies that private equity general partners are not good partners. Private equity is at its core a mergers and acquisition business. Being good at it requires a Milken-level of financial and tax engineering, legal, and negotiating skills, and above all, ruthlessness well disguised beneath a veneer of charm.
Limited partners like CalPERS have fooled themselves into thinking that the general partners see their interests as aligned with those of their investors, the limited partners. In fact, what has happened instead is that the general partners have persuaded the limited partners that the general partners are on the limited partners’ side even as, to paraphrase the former SEC enforcement chief Andrew Bowden, the general partners are picking the investors’ pockets. In any other business, if someone found that a vendor had cheated them, they’d terminate the relationship as soon as possible. Yet CalPERS’ staff and board staunchly defend private equity investing and simply deny the growing body of evidence of how private equity firms fleece their investors.
CalPERS Lies to Itself About the Necessity of Investing in Private Equity
Private equity’s One Excuse That Rules Them All is that it is essential because it provides a level of returns that cannot be achieved elsewhere. But as we’ve pointed out repeatedly, that is simply false.
CalPERS’ own results show that private equity has consistently and considerably underperformed CalPERS’ private equity benchmarks, and by a large margin, over the last ten, seven, three, and one years. That means that CalPERS is not being paid enough for the risks it is taking for investing in private equity.
Moreover, CalPERS is persistently underperforming its private equity benchmarks despite using an overly flattering measurement of returns, internal rate of return, which is widely acknowledged as making private equity performance look better than it really is.
Even worse, CalPERS staff and board seem to have convinced themselves that they can do better (despite falling short by such a large margin over such a long period of time) via better fund selection. Yet CalPERS apparently already outperforms a peer-group index its consultant, Pension Consulting Alliance, recommended. But Oxford professor Ludovic Phalippou noted that CalPERS’ private equity returns are typically “12% per annum. That is the same as the average PE fund return documented in all academic studies I know of.” In other words, while CalPERS may comfort itself with the idea that it has managed to modestly outdo other public pension funds, it’s ignoring the elephant in the room of substantially sub-par returns relative to the needed risk-adjusted returns.
And as we’ve stressed, it is a fool’s errand for CalPERS to expect that it can out-compete other private equity investors in fund selection. As Andrew Silton pointed out:
Moreover at CalPERS’s immense scale, the best CalPERS can hope for is to build a portfolio of private equity funds that delivers market performance. In order to build a $30 billion private equity portfolio, CalPERS has to select so many managers and funds that it is virtually impossible to generate anything more than the market’s overall return for the asset class.
Perversely, CalPERS is doggedly loyal to private equity and does not appear to have considered other investment strategies that have delivered similar levels of return. Contrary to the assertion of CalPERS’ Chief Investment Officer Ted Eliopoulos that private equity was the only strategy that could beat CalPERS’ overall return targets, Phalippou identified several that had historically achieved similar or higher levels than private equity. So why isn’t CalPERS pursuing them?
Andrew Silton pointed out that private equity allows pension funds like CalPERS to mask the fact that they are making wagers with borrowed money. And debt has a nasty way of amplifying losses as well as gains:
If a public fund believes that private equity is one of the only ways to exceed its investment hurdle, it should borrow money in the municipal market and invest in public equities. Why? The fate of private equity investments is inextricably tied to the public markets (accounting and the dynamics of fund management make it appear that they aren’t closely linked. They are taking a bullish longterm view on equities.
In addition, public pensions can borrow far more cheaply than their private equity managers (CalPERS is a better credit [and enjoys tax exemption] than a PE portfolio company). Finally, the 2 and 20 fee structure would disappear. However, public funds prefer to hire PE managers and pay huge fees, because it hides their accountability for making a leveraged bet on equities.
CalPERS’ Failings are a Bad Sign for Other Investors in Private Equity
One of the most disheartening elements of the abjectly poor performance of CalPERS’ staff and board is that CalPERS is widely perceived as being more sophisticated than the overwhelming majority of public pension funds. At a bare minimum, CalPERS has a large team of dedicated private equity professionals, which is more than many limited partners can boast.
Moreover, many investors follow CalPERS’ lead in private equity. As Andrew Silton wrote:
Over the years, many institutional investors have looked up to CalPERS as a leading authority on investment policy, due diligence, and transparency. If CalPERS signed on to a particular private equity fund, many investors assumed that the legal documents and economic terms had been aggressively and competently negotiated. For small institutions and public funds with limited resources, CalPERS’s involvement in private equity was a source of comfort.
In other words, when CalPERS fails, many smaller investors will have naively gone along for the ride, and will end up in the same ditch.
What Should CalPERS Do?
CalPERS needs to stop digging its hole deeper. As Andrew Silton and Curt Loftis recommended, it should stop making any new private equity commitments until it has upgraded its private equity team in a major way. That at a minimum means firing Réal Desrochers.
Second, CalPERS needs to fundamentally rethink its approach to achieving its return targets. Investing in a strategy that is vastly underperforming relative to the actual risks is as prescription for future shortfalls. CalPERS needs to either get better results from private equity or turn to other strategies. One way to improve returns from private equity is to squeeze the general partners on fees and terms related to who assumes risks. The current CalPERS staff is clearly too cowed by private equity general partners to even take halting steps in that direction. Another approach, which would take some time to implement, would be for CalPERS to abandon its rapacious middlemen and invest in private equity directly. As we indicated, CalPERS also needs to examine other strategies more seriously than it apparently has.
Third, to the extent that CalPERS continues to invest through private equity general partners, it needs to recognize that it does not have the same interests as the general partners and it needs to do a much better job of protecting its own interests. The fact that the South Carolina pension system has been able to shake up private equity fee reporting is a testament to what a vigilant institution, acting on its own, can achieve. CalPERS, with its vastly greater profile and investment spending, should be able to do a much better job in effecting change than it has. Instead, it hides behind the largely toothless Institutional Limited Partners Association, an organization we will examine in the future.
CalPERS’ decision to double down on its loyalty to private equity means it will need to face much more external pressure in order to change course. Readers, if you are based in California, I hope you will will support this effort, since you have a stake in CalPERS’ performance. And if you are not, I still hope you’ll help by circulating this post widely, particularly to friends and colleagues in California, as well as posting in on Facebook and tweeting it.
Please call or write the CalPERS board members that are elected officials, Treasurer John Chiang and Controller Betty Yee, both of whom sit on the Investment Committee. Tell them that you are appalled by the incompetence and insubordination of CalPERS staff, in particular Réal Desrochers and Christine Gogan, and are also worried about the fact that the board is clearly unwilling and incapable of providing adequate oversight. Please also tell Chiang and Yee that you expect them to support the proposed IRS rule change to end the management fee waiver abuse. As Eileen Applebaum said via e-mail:
The retirement savings managed by CalPERS are the deferred earnings of public sector workers that are paid by California taxpayers for public services. California Controller Betty Yee and Treasurer John Chiang serve on the CalPERS board precisely to look out for the interests of these taxpayers. Yee joined the CalPERS board this year; as former Controller and now as Treasurer, Chiang has served on the CalPERS board since 2007. They should never have allowed CalPERS to enter into agreements with PE firms that sanctioned this behavior. If Yee and Chiang are serious about representing taxpayers, they should call on IRS to investigate the management fee waivers claimed by GPs in funds that include CalPERS. Taking the lead in demanding IRS enforcement of existing tax rules will be far more effective in reining in this practice than the recent call by state treasurers for the SEC to create more regulation.
Here are their contact details:
Mr. John Chiang
California State Treasurer
Post Office Box 942809
Sacramento, CA 94209-0001
Ms. Betty Yee
California State Controller
P.O. Box 942850
Sacramento, California 94250-5872
Please also contact your local newspaper and television station, as well as the Sacramento Bee. Tell them you think this story is important for all California taxpayers and you wonder why they haven’t taken it up. You can find the form for sending a letter to the editor here.
In 2006, CalPERS was resorting to strained rationalizations for continuing to invest in hedge funds despite years of underwhelming returns. Yet it took another eight years before CalPERS finally decided to renounce hedge fund investing altogether.
While hedge funds were merely an investment that CalPERS deemed to be not worth the trouble, private equity has done CalPERS serious damage as an institution. Its 2009 pay-to-play scandal, involving Apollo and four other private equity funds, led to the successful criminal prosecution of its CEO, Frank Buenrostro, the indictment and suicide of the placement agent former board member Alfred Villalobos, the ouster (and likely scapegoating) of its head of private equity, and the resignation of board members. Although the current slow-motion private equity fee mess is not as serious a threat, CalPERS is nevertheless again suffering damage to its reputation as a result of investing in private equity.
CalPERS is a much more important force in private equity than it ever was in hedge funds, and has the stature to force long-overdue reforms, if it would only abandon its undue deference to general partners. But CalPERS appears to be a long way away from admitting to, much the less correcting, its bad private equity habits.