How CalPERS Fails to Use Its Leverage in Private Equity

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.

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  1. Steve H.

    It is difficult, as a commentor, to add value to a post when the subject is institutionally arcane and the analysis is very specific. This work deserves more than just emotional gnashing of teeth.

    Theoretically, if a writer were to convey perfect and complete knowledge, nothing would be left to say but variations on Wow and Yup.

    You have been relentless on CalPERS, producing many posts. I can add little value, but have read them all, and learned more from each.

    More importantly, of late there have been indications that people with weight in the decision process have been using your work. This is far more important than the number of comments which may or not appear on your posts. Analysis without agency is often acceptable to the powers that be, as Plunkitt of Tammany Hall so kindly elucidated.


    1. tegnost

      I think I’ll draw something like this up for my customers…

      “No services need to be required in order for you to be obligated to make these payments.”

  2. Assolonius

    Its glaringly obvious that the only competent person in those Investmenr Committee meetings is JJ. Stausball and Eliopolus cant handle being asked the tough questions because they dont know what theyre doing, plain and simple, (check that, maybe they know exactly what thyeyre doing and it contravenes Calpers goals)

    When regal Real says there is no room for no negotiating with PE GPs because theres too much money chasing these funds and no one questions what that implies for forward returns (ie get the F out of the space, trim/reduce exposure asap!) you know its amateur hour

  3. John Zelnicker

    Ironic typo in the text of the RSS feed for this article – “CalPERS ‘ belief that it cannot change the rules of the game in private equity is a symptom of earned helplessness, not power relationships.”


  4. flora

    “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….”

    What’s the old saying: It wasn’t the crime, it was the cover-up that did them in ?

    Thanks for these posts.

  5. Chauncey Gardiner

    There is another aspect of many private equity deals that I feel is being largely ignored in these discussions. This is the broad ethical consideration of public employees essentially funding transactions through their pension plans that result in widespread job losses and related increased social costs.

    Many of these private equity deals are structured as leveraged buyouts under which the acquired entity takes on material incremental debt to pay prior shareholders a stock price that is above market. Upon acquisition, new management is appointed by the general partner to “cuts costs” at the acquired entity in order to meet the increased debt payments. These “cost efficiencies” generally entail both reductions in the number of jobs at the acquired entity and the compensation levels of the acquired businesses’ employees. The resultant debt-laden balance sheets at the acquired entities can also impair research and development initiatives, resiliency in inevitable business cycle downturns, the capacity to respond to foreign competition, and even deferral of basic maintenance expenditures.

    Taking a broader and longer term view, I don’t believe this type of “investment” is where most public employees and taxpayers want their money to go.

    1. flora

      You are right. Makes me think of Jay Gould’s infamous line:
      “I can hire one-half of the working class to kill the other half.”
      Only this time using finance and PE middlemen using smoke and mirrors and obfuscation. Agree completely with your conclusion: ” I don’t believe this type of “investment” is where most public employees and taxpayers want their money to go.”

    2. Yves Smith Post author

      Yes, CalPERS once in a great while gives lip service to this issue. And the unions, which ought to be most concerned, are silent. Public employee unions are under attack precisely because they are now such outliers. Yet they sit back, let public pension funds invest in PE, let PE crush what is left of unions, and wonder why public employee unions are demonized even more than ever.

      And of course, the PE wage crushing operation lowers wages in those companies (certainly total labor payments, and often pay per hour/year). That lowers the amount of incomes in those communities, which has to cycle though to tax receipts (sales taxes, income taxes, real estate taxes). That will make it even more costly on a relative basis for these communities to make up for the shortfalls in public pension funds, which are pretty widespread. The solution for many will be to cut benefits. So these unions are increasing the odds the beneficiaries get screwed in the end.

      Oh, but CalPERS does take steps to limit the outsourcing of jobs…..but only for public sector workers. A tad hypocritical, no?

      And I have not bothered looking, but the odds are high that CalPERS is an investor in funds that operate charter schools, and in funds that invest in the surveillance industrial complex, which also outsources government jobs (recall that Snowden was working for a private contractor, not as a government employee, for much of his career….)

      1. RUKidding

        And I have not bothered looking, but the odds are high that CalPERS is an investor in funds that operate charter schools, and in funds that invest in the surveillance industrial complex, which also outsources government jobs…

        Almost guaranteed these days. No links, but I wouldn’t be surprised either.

  6. TheCatSaid

    Who are the PEOPLE–with NAMES–representing CalPERS who do the actual “negotiating” with various PE funds?

    Is it one person, Real Disgorger?
    Is it a small team, with different individuals depending on the “hot” target fund? (Yes, I know, CalPERS is the actual target, though the other participants in this game pretend otherwise.)
    They should all be named and shamed, and then fired.

    Is there some way of finding out if some kind of nice backhander (i.e., a special private pension fund for Special People, or brown envelopes, or nice vacations / “educational trips”) have been given to any of the key people involved in these giveaways “negotiations” regarding how to invest the hard-earned pension funds of CA pension beneficiaries?

    Are we meant to seriously believe that the top CalPERS staff are just really, really, really nice people who love meeting any and all requests of PE GPs? Most prostitutes get paid. Do the CalPERS staff do it for free? They are either giving away their “services” for free or they are selling themselves. It’s the CA taxpayers and pension beneficiaries who are paying the tab for the others’ “enjoyment” of whatever “services” are being rendered.

    This whole thing is sickening. It should be called by its rightful name: prostitution.

  7. Oregoncharles

    Be patient with me a moment, because I want to ask a big-picture question, expanding on Chauncey’s query about ethics:

    Years ago, the Oregon PERS lost a pile of money on a real estate deal in London that went broke. My immediate response:

    “LONDON?!!! WTF?” Why were they investing in LONDON? How would they know whether it was any good – as they obviously didn’t? Obviously, the same question looms over the whole private-equity issue. The overriding point here is that they’re clueless; it’s a black box. (OK, thanks to Yves, not as black as it was; but still pretty dark, from their point of view.)

    And a bigger question yet: why not invest mainly in your own state? Even Oregon, let alone California, should be a big enough universe. This is the inverse of the ethical question: focusing investment dollars close to home would not only raise the intelligence quotient; it would also stimulate the economy, with great benefit to the taxpayers and employees of the state. In fact, the model exists: the State Bank of N. Dakota. It isn’t a retirement fund, of course, it’s a depository for the state (and local?) governments, but it functions in much the same way.

    So, my question for Yves: what’s the cost of this approach? I can see that you might want a percentage of diversification outside the state, just to play it safe; but is there a strong investment reason not to use the pension funds in this way?

    Of course, there’s a political problem: even ultra-blue Oregon can’t seem to imitate the well-established Dakota model. IOW, corruption. But it seems like a strategy worth promoting.

    1. Assolonius

      Because you dont put all your eggs in one basket. Additionally, if their mandate was a CA focus can you imagine what conflicts would arise? A giant slush fund for Calpers to fund their friends and families

      Calpers does track how much they “invest” in CA companies and the supposed jobs theyve “created”. But they also think that buying equity in secondary markets “provides financing to those CA companies” and probably believe that Algore invented the internet

  8. RUKidding

    Thanks, Yves, for your ongoing stunning investigative journalism into what ails CalPers. I haven’t commented in a while, but I continue to read your articles. Keep up the good work!! In the best possible sense of the words, you are tenacious at nipping at CalPers’ very exposed “heals” (use your own definition).

    I have written to John Chiang and Betty Yee several times and Jerry Brown once, referencing your excellent series of CalPers exposes. I encourage others to do likewise.

    This situation really needs to change, and as a CalPers contributor, I will look closely at the next Board election.

    These people! They are either pitifully incompetent, on the take or both.

    This is a real blight on all citizens of CA, who feel the impact from these disingenuous PE investment decisions. Time for it to stop.

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