Please see the preceding posts in our CalPERS Debunks Private Equity series:
• Executive Summary
• Investors Like CalPERS Rely on ILPA to Advance Their Cause, When It is Owned by Private Equity General Partners
• Harvard Professor Josh Lerner Gave Weak and Internally Contradictory Plug for Private Equity at CalPERS Workshop
• CalPERS Used Sleight of Hand, Accounting Tricks, to Make False “There is No Alternative” Claim for Private Equity
• How CalPERS Lies to Itself and Others to Justify Investing in Private Equity
• More on How CalPERS Lies to Itself and Others to Justify Investing in Private Equity
• How CalPERS Violated California Open Meeting Laws to Stifle Private Equity Skeptics and Keep the Board in the Dark
A major undercurrent of the private equity workshop that CalPERS held in November was how little ability it had to change the rules of the game in private equity. We’ll discuss today how CalPERS’ learned helplessness has more to do with intellectual capture than with the reality of the power relationships.
We’ve taken issue in past posts with many of the assumptions that CalPERS and other investors have made, the most important being that they have to invest in private equity due to its allegedly superior returns. We’ve debunked that notion.
First, returns are “superior” on a risk-adjusted basis only if an investor can manage to invest in top-quartile funds. Yet it is fallacious to base an investment strategy on the assumption that one can be the Warren Buffet of private equity. Most institutional investors accept that they can’t beat the market in stocks; the most the savvy ones do is “tilt” their exposure, say more to sectors they deem promising, like foreign or small cap stocks, to try to pick up additional return. CalPERS has actually done somewhat better than its peers in its private equity results, at least according to its consultant PCA, yet it has still underperformed its benchmarks for private equity by a large margin over the last ten years and for every subperiod in that range.
Second, as we’ve also discussed at length, there are strategies in more liquid assets that provide returns similar to those of private equity at comparable levels of risk (at least when you measure risk properly). Yet CalPERS does not appear to have given any of these option serious consideration.
But the misguided belief that limited partners like CalPERS must play nicely in order to be allowed to invest in “hot” funds, when past top quartile performers are now less likely to be top quartile on their next fund than by mere chance, says the very velvet rope assumption, that the “hot fund” will be strong performer, is all wet. That means there is much less to be lost by standing up to private equity than the presenters at the November session would lead you to believe.
Former CalPERS investment committee chairman and private equity executive Michael Flaherman took issue with CalPERS’ claims of powerlessness and described some concrete measures the giant fund could take.
Michael Flaherman: What I was struck by in terms of what I had kind of hoped for for this presentation to be about that was really missing was that there’s an enormous opportunity right now in private equity and I felt there was a lot of emphasis on what you can’t do and what you can’t achieve and what the constraints are, but there really wasn’t much opportunity, much discussion of the opportunity.
And the thing I would like to put on the table is I was on the board in 1996 when what was alluded to today as the Mercer Report was commissioned by CalPERS. And this was a report that basically laid out in very strong and plain language what was wrong with private equity in terms of terms and conditions at that moment. Right, it was a different moment than this moment and absolutely as many people have said, it was a worse moment, it was a much worse moment.
But what it did was by putting the gauntlet down, it really shifted the market. Every meeting, every general partner I met for three years after that report came out brought up that report. Right, they hated it, they resented it, but it moved them.
And I think you could do the same today. And what I would actually focus on if I were you is I would focus on portfolio company fees. Because basically portfolio company fees are basically indefensible. There’s really no reason why a dollar should come out of a portfolio company in a non-transparent way, because one of the things that wasn’t discussed today was that portfolio company fees are never paid to the fund, they are paid to the general manager around the fund. That’s why you can’t audit them, that’s the whole problem with portfolio company fees. That’s what the last three SEC settlements have been about, is Blackstone, KKR, and Fenway were all defrauding their investors about portfolio company fees. The industry is on the run regarding these fees right now because they’ve been caught with their hand in the cookie jar. You could beat them if you take them on and you were smart about it. I really believe that that’s the case.
And there’s another problem with portfolio company fees as well, which is they are, in many cases, a tax scam. And the state of California is being defrauded by this tax scam. And the tax scam is very simple, which is that when the private equity firm pays out, when the portfolio company pays out a portfolio company fee to a private equity firm, it’s pretty apparent when you look at it they’re paying it out because the owner says, “Hey, give me a dollar.” Right? And when you say as an owner, “Give me a dollar,” to a company you own, there’s a name for that. That’s called a dividend. Right?
A dividend is not tax deductible to a business, but a fee for service is tax deductible for a business. So guess what? So these are all labeled as “fees for services.” But when you look at the contracts for these fees for services, the contracts actually, literally say, “No services need to be required in order for you to be obligated to make these payments.” So that’s a very significant tax fraud and I’d be very interested to go over to the Franchise Tax Board and make a presentation and public comment about how the Franchise Tax Board actually should be really paying attention to this.
So that’s an example of how I think about how really being smart about how to beat them really could pay dividends.
Here, in the very confined space of a public comments section, were two ideas for how CalPERS could change the power dynamics in private equity.
On a broader basis, it’s been astonishing to see how utterly unwilling limited partners are to take even small steps to better their condition. Have they voiced support for the SEC’s efforts to crack down on private equity abuses? Have they thought more systematically about how to use those issues where the general partners clearly have no defense, like on tax frauds and stealing from limited partners, as a wedge to press for reforms? And this type of effort isn’t just about getting concessions, as important as those are. Even more important, it’s to turn around the dynamic of investors as patsies.
It’s telling that the most important initiative out of CalPERS on the private equity front was not from its captured staff, but from its board member, State Treasurer John Chiang, that of his legislative proposal to require full transparency on fees and costs in private equity, and full disclosure of related party transactions, for a government body to be allowed to invest in that fund. This legislation also has the potential to become a model for other states.
Yet the other members of CalPERS board, apparently encouraged by members of staff (see video evidence here, in the clip of Priya Mathur) is preoccupied with helping CEO Anne Stausboll quash dissent, by devoting what she claims to be precious staff and board time on illegal schemes like trying to sanction board member JJ Jelincic for having to resort to Public Records Act requests for obtaining information, when law professors to a person regard the idea that a board member would be denied an information request to be deeply disturbing.
In other words, Stausboll and her team are devoting far too much time and effort to aggrandizing their power at the expense of the board, and are devoting far too little effort to the real challenges facing CalPERS, such as the virtual impossibility of meeting CalPERS’ return target in a low interest rate environment (the Fed’s eagerness to “normalize” rates is likely to produce 1937-type results) and a need to leash and collar a rapacious private equity industry.