What does it mean when the backers of a “must pass” bill present a case for it that is not only weak but also fails to mention the bad conduct it is designed to correct?
The bill is California’s AB 2833: landmark private equity legislation. It provides for extensive disclosure of private equity fees and costs, most importantly, those charged directly by general partners to the portfolio companies they’ve acquired on behalf of investors (the “limited partners”).
This bill, proposed by California Treasurer John Ching and launched by Assemblyman Ken Cooley, came in the wake of the SEC’s 2014 revelation that private equity firms were engaged in widespread abuses, including waht normally be called embezzlement but the general partners dressed up as “unauthorized fees”. To add insult to injury, complacent and clueless limited partners seemed more upset by the fact that these bogus charges weren’t being largely kicked back to them. That reaction revealed another sad fact about private equity: the limited partners are no match for general partners. Not only, as the SEC pointed out, have the limited partners signed agreements that are disconcertingly vague on too many key issues, but the limited partners, as evidenced by their bleats about not sharing in the general partners’ pilfering as they had assumed, didn’t even understand the agreements they had signed.*
The SEC’s disclosures kicked off a series of articles in the New York Times and Wall Street Journal (as well as posts here) that described how many of the biggest firms in the industry were engaged in the sort of misconduct that the SEC had called out. We took this line of inquiry further by focusing on capture of limited partners by the private equity general partners, with the giant public pension fund CalPERS, and to a lesser degree, its Sacramento sister CalSTRS, as case studies.
Yet despite the range and extent of malfeasance exposed (guaranteed to be only a small fraction of what had actually taken place), limited partners sided with the general partners rather than admit that they were part of the problem.
Readers may recall that their letters to Chiang, who sits on the boards of CalPERS and CalSTRS, criticizing the fecklessness and cognitive capture of both funds on the private equity front. led him to announce that he would be proposing private equity transparency legislation, including not just disclosure of heretofore opaque charges levied directly on portfolio companies, but also the disclosure of related party transactions (see the example of KKR Capstone for why that matters).
Assemblyman Cooley introduced AB 2833 in February. It is expected to be included in hearings before the Assembly’s public employees and retirement committee in April. According to an article in the Financial Times’ FundFire last week (no online version), “Chiang has said the bill is on his ‘must pass’ list, and so far, his staff and Cooley’s office say they have heard no organized opposition to the measure.” That should be encouraging, until you look at the fact sheet Cooley’s staff put out about the pending legislation, as well as the silence of CalPERS and CalSTRS about the measure.
We’ve embedded that fact sheet at the end of the post, as well as a document on the bill prepared by former private equity executive and CalPERS investment committee chairman Michael Flaherman, who has become a major voice for private equity reform (you can also read it on his site, Why AB 2833). Now a visiting scholar at UC Berkeley, he publishes a newsletter whose revelations have rattled some general partners (see here, here and here for examples of his research).
The contrast between the two documents supposedly pumping for the passage of the same bill is stark. Admittedly, Cooley’s fact sheet is constrained by a prescribed format. Nevertheless, it has a leisurely “Background” section, with more detail than is germane about the holdings of the biggest California public pension funds, including inaccurate data on fees. For instance, it cites CalPERS’ data that shows that CalPERS “paid” $414 million in management fees to private equity firms. But that omits the portion of those fees shifted on the portfolio companies acquired with CalPERS’ and other investors’ money. CalPERS’ own consultant, CEM Benchmarking, stated in a widely-cited report last April that this type of fee understatement is incorrect. Yet bizarrely, this is the very sort of problem the legislation is designed to clean up, yet the fact sheet blandly reinforces CalPERS’ fee misdirection.
However, alert readers may also notice that the Background section also includes language about hedge funds, which would seem to be off-topic. In fact, if you look at the bill, you will see that it has been amended to include alternative investments, defined broadly. So Naked Capitalism readers should pat themselves on the back, in that your efforts on the private equity front have played a significant role in producing broad reforms.
Nevertheless, the length of “Background” section is at the expense of the “Why This is Needed” section. Whether by accident or design, it comes off as not terribly persuasive:
All public pension plans are funded by employee contributions and taxpayer dollars. These funds pay significant fees to its alternative investment general partners but lack sufficient insight into the amount and nature of those fees. The investment portfolios of California’s public pension plans require certain levels of returns to fund constitutionally guaranteed benefits for government workers. Both management and carried interest payments to general partners decrease the net returns on the portfolio. If net returns of the portfolio are reported to pension plans without specific disclosure of the amount of fees paid to general partners, public pension plans have no means of assessing whether the amount of compensation paid to private equity managers or hedge fund managers is appropriate.
It’s not as if the one argument mades, that the public pension funds have no idea what they are paying, and thus can’t begin to tell if the charges are justified, is invalid. But the fact sheet fails even to hint at the fact that private equity firms have been caught cheating investors, and that all the SEC has seen fit to do is make noise and issue some parking-ticket-level fines. The SEC’s excuse is that private equity limited partners are accredited investors and are thus able to protect themselves. The agency due to understaffing, ideological bias, and the fact that political appointees have the final say, will not go to war with the private equity industry, which is what it would take for a real clean-up to occur. Having alerted the supposedly capable investors of the magnitude of the problem, the SEC has effectively washed its hands of the matter.
By contrast, Flaherman’s FAQ for the bill is highly readable and detailed, and makes clear what is at stake. He focuses on the issue of how general partners extract hidden compensation from portfolio companies and why those charges are dubious, gives an illustration of their size, and debunks the idea that limited partners are close to getting to their hands around the problem. As he points out, many players, like CalPERS, have been investing in private equity for decades. If they had the will or the ability to get this information, they would have done so long ago.
Chiang and Cooley appear unwilling to deal with the elephant in the room, meaning the real reason the legislation is desperately needed. It’s a well-established principle that a fiduciary must assess the reasonableness of fees and costs of any investment strategy or product in which he invests. Fiduciaries who invest in private equity have flagrantly violated that standard. And the failure to perform that duty is what has allowed general partners to cheat them and to levy charges in aggregate that result in private equity being a lousy deal on a risk/return basis.
The SEC in 2014 made clear the consequences of private equity limited partners placing too much trust in the general partners. Yet the limited partners still refuse to stand up for themselves. So this sort of bill is a desperately-needed deus ex machina. Since the SEC will not ride in to protect clueless, cowed, and captured investors from themselves, the alternative is state-level measures.
Of course, one can argue that the conundrum that Chiang faces is that he can’t criticize the public pension funds openly, since if they were to oppose the bill, that would be likely prove to be a death sentence. And suggesting that California public pension funds have been derelict in performing their fiduciary duties would also raise the uncomfortable question of why it has taken Chiang, who has been on the CalPERS and CalSTRS boards since 2009, so long to figure that out?
There is additional good news and bad news. The influential union AFSCME has endorsed the bill. One can hope that the American Federation of Teachers, whose spokesman Dennak Murphy recently stated that investors like CalSTRS needed to get full transparency on private equity fees and costs, will also back the legislation. By contrast, it is disturbing to see CalPERS engage in bait and switch. Its staff, encroaching on the role of the board, said it supported Chiang’s transparency bill hot on the heels of his announcement last November. But what do we see now in the FundFire article?
The CalSTRS government affairs office is currently analyzing the bill and does not have public comment on it yet, a spokeswoman says. CalPERS similarly has its legislative staff reviewing the bill. “We don’t have a position at this time,” a spokeswoman says.
It’s actually a bit worrisome to read that:
So far, the private equity industry has been relatively quiet on the matter. The four largest private equity managers – Blackstone Group, Carlyle Group, Apollo Global Management, and KKR – did not list the bill as a pending regulatory risk in their recent SEC annual report filings.
Our understanding is that the private equity is firmly set against complying with the newly-promulgated-but-toothless private equity fee reporting template from the Institutional Limited Partners Association. You’d expect the private equity industry to be working against Chiang’s bill if they thought it was likely to pass. Does their inaction indicate that they know that Chiang and Cooley only want credit for proposing a bill, as opposed to having it pass? Or are they confident that they have enough California public pension funds who will come out in opposition if need be so as to keep their hands clean?
So it is important once again for Naked Capitalism readers, particularly those of you in or with friends, family, and colleagues in California, to ontact elected official by letter or e-mail. And better yet, the same missive can serve as an important prod to the many parties that can help move this bill forward.
Most important is to write your state Senator and Assemblyman to tell them how important it is for them to back this legislation. Crib arguments from the Flaherman document. The overarching theme should be that the public pension funds have shown themselves to be so badly captured as to be incapable of acting in the best interests of beneficiaries and California taxpayers. It is important to depict the funds as being remiss and needing the legislature to force the disclosure of information that the limited partners should have insisted on getting from the very outset. You can find the contact information for your state Senator and Assemblyman here.
Send a copy of this letter to the editorial board of the Sacramento Bee:
The Sacramento Bee
2100 Q. St.
Sacramento, CA, 95816
Or you can rework it as a letter to the editor or an op-ed and submit it using this form.
Please also send copies or letters to the editor to your local paper. They carry a great deal of weight with elected officials.
Last but critically important, please send a copy to John Chiang and CalPERS and CalSTRS board member, state Controller Betty Yee, or give them a call:
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 tell them that you are disappointed that CalPERS and CalSTRS have not yet backed AB 2833 and you trust they will do everything within their power to make sure that happens.
Or if you prefer to use e-mail (you can attach your letter as a .pdf), you can let all the members of the CalPERS board that you know that staff initially endorsed Chiang’s bill, and you expect them to follow through and voice their support. Be sure to let them know if you are a current or prospective CalPERS beneficiary, or a concerned California taxpayer.
Robert Feckner (President) email@example.com
Henry Jones (Chairman of the Investment Committee) firstname.lastname@example.org
Michael Bilbrey Michael.email@example.com
John Chiang firstname.lastname@example.org; Grant Boyken (Chiang’s staffer; quoted in FundFire) email@example.com
Richard Costigan firstname.lastname@example.org
Richard Gillihan email@example.com; Katie Hagen (one of Gillian’s staffers) firstname.lastname@example.org
Dana Hollinger Dana.Hollinger@calpers.ca.gov
Ron Lind email@example.com
JJ Jelincic firstname.lastname@example.org
Priya Mathur Priya.email@example.com
Bill Stanton firstname.lastname@example.org
Theresa Taylor Theresa.email@example.com
Betty Yee firstname.lastname@example.org; Alan LoFaso (one of Yee’s staffers) email@example.com
And again, thanks for your efforts! The fact that this proposal has gotten this far is a testament to your being willing to roll up your sleeves. But the pressure needs to stay on for this initiative to come to fruition. So pull our your keyboards and go to work.
* The private equity contracts (“limited partnership agreements”) are clearly set up so that only certain specified fees are partly rebated (more technically, “offset” against management fees; the current average across the industry, as reported by CEM Benchmarking, is 85%. But notice that the structure of using a fee offset also means that the total amount of the offsets is limited to the amount of the management fee).