More Proof of CalSTRS’ Misrepresentations and Foot-Dragging in the Private Equity Carry Fee Scandal

Readers may recall last year, when we broke the story that CalPERS had no idea what it was paying in carried interest fees, one of the largest fees it pays to private equity firms, other news outlets quickly picked up on what was correctly regarded as a major lapse. To its credit, CalPERS did a quick about face and set out to get the information for the entire history of its private equity program, which it disclosed with some fanfare last November.

Yet CalPERS’ Sacramento sister CalSTRS, which also admitted that it did not track carry fees, instead has engaged in obfuscation and flat out lying rather than take the simple step, as CalPERS has, of contacting the general partners and getting the information. The message is all too clear: CalSTRS puts maintaining friction-free relationships with private equity firms over performing its fiduciary duties. Bear in mind that fiduciaries are tasked with assessing the level of fees and costs when deciding whether to commit funds to an investment strategy. Yet CalSTRS, like many other investors in private equity, has rationalized flying blind.

As we pointed out in an earlier CalSTRS post:

The only way to assess the reasonableness of private equity fees and costs if you can see all of them. If private equity funds are making a handsome, or indeed overly handsome living on carry fees and management fees alone, private equity limited partners should refuse to invest in any fund that charges other fees, such as transaction fees, which are simply an abuse (they are set at the level of investment banking fees or even higher, when the funds hire investment banks to provide those services, and those costs are charged to fund investors). It isn’t simply that those fees are excessive; they also create bad incentives. For instance, transaction fees reward private equity firms for churn rather than making good investments. They are why, as has been documented at length in numerous studies on private equity, like Eileen Appelbaum’s and Rosemary Batt’s Private Equity at Work, or Josh Kosman’s The Buyout of America, that private equity firms earn juicy returns irrespective of whether they make money for their investors.

Contrast what CalSTRS should have been doing with its statement to the Sacramento Bee last July, that it had did not keep tabs of the carry fees charged:

Ricardo Duran, a spokesman for the California State Teachers’ Retirement System, said CalSTRS can estimate the fees “within a couple of percentage points” but doesn’t report the figure.

“It’s not a number that we track,” Duran said. “It’s not that important to us as a measure of performance.”

As we’ve detailed in past posts, CalSTRS’ position is so untenable that its officials have made increasingly absurd statements trying to reconcile their keep-their-head-in-the-sand position with their claims about their commitment to transparency and putting the interests of their beneficiaries first. CalPERS at least had the good grace to be sheepish when caught out, while CalSTRS keeps trying to brazen out its ever more indefensible position.

For instance, its head of private equity, Margot Wirth, tried claiming that carry fees weren’t fees because they were taken from profits. Huh? That’s tantamount to saying that a class action lawyers who receive a percentage of their clients’ awards are not getting fees either because they are getting a profit participation. Similarly, the chairman of its board, Harry Keiley, tried claiming in an op-ed that he was lucky the Financial Times declined to publish, that CalSTRS reporting its total return, which are net of carry fees, enabled “the public to know the estimated amount of carried interest investment managers are earning.” First, obviously, outsides can’t guess, much the less “know” a gross amount when presented only with the net. Second, how can California taxpayers possibly “know” what CalSTRS has refused to grasp?

CalSTRS did return to the issue of its large gaps in its capture of private equity fees and costs in its February board meeting, but only in a board document (there was no mention of fees and costs in the board meeting proper). Notice the effort to put a smiley face on the situation:

Cost Reporting Background: Industry standards are evolving rapidly with respect to collecting and reporting data related to all payments that General Partners receive in association with managing private equity funds. In recent years, limited partners have successfully negotiated for offsets against their management fee for items such as transaction, advisory, and other fees that the General Partner had historically retained the bulk of. Many General Partners report just the net management fee costs (i.e., after the effect of fee offsets) to the limited partners. Additionally, partnership costs are typically aggregated into large line items on the partnership’s financial statement. The transparency and reporting by General Partner on fees, offsets, calculation of carried interest, partnership costs, and affiliated party transactions has not conformed to an industry standard and has been highly variable by General Partner.

Current status: Staff is developing a fee reporting project to receive information on “indirect costs” from managers across the CalSTRS portfolio. CalSTRS does not currently directly or systematically collect the data that will be sought in this project. The PE Program relies upon the State Street Bank Private Edge service for data. Staff has been conducting internal and external reviews of costs and CalSTRS appears to be meeting industry standards in obtaining fee and cost information.

Observation: Appropriately, CalSTRS is aiming to develop industry-leading fee reporting capabilities across all of its investments, including private equity. Ready access to this data should allow for more timely and sophisticated analysis of the private equity portfolio and, thus, better inform Staff and trustees.

In the first paragraph, there’s nary a mention of the elephant in the room: the SEC’s warning in 2014 that investors were “having their pockets picked” and the subsequent, extensive media reports on various fees, like termination of monitoring fees, that limited partners had no idea were being charged and were thus not being largely rebated to them, contrary to their naive beliefs otherwise. In other words, the CalSTRS document maintains the fiction that the limited partners have done a good job of negotiating fees when even the normally supine SEC felt compelled to clear its throat and say how shocked it was to see how vague and in many key respects, one-sided that private equity agreements were.

Worse, staff is misleading the board and the public. CalSTRS acts as if they are hamstrung by the fact that most general partners report management fees net of offsets, when they can compute the gross amounts precisely during the investment period, and reasonably accurately after that (and again, they could always check their figures with the general partners in case of doubt). And by discussing how partnership costs are tallied only in large and often not reveling categories, and next stating how reporting on various items, including “calculation of carried interest” is “highly variable” gives the impression that the “calculation of carried interest” IS often reported in these periodic documents, when in fact it’s not. As an expert said via e-mail:

They also imply that collecting the carry data is difficult because of inconsistent GP reporting formats, as if the information is sitting in CalSTRS file cabinets but just needs an IT initiative to organize it, as opposed to the GPs refusing to provide it in many cases.

Similarly, in the next paragraph, CalSTRS tries claiming its is meeting “industry standards” when limited partner fee capture and reporting is all over the map, which means there is no such thing as an industry standard. Moreover, its own consultant, CEM Benchmarking, stated that most public pension funds were missing rougly half their fees and costs (ex carried interest fees) and the failure to identify “separable costs” arguably fell short of the recent changes in standards by the Governmental Accounting Standards Board.

And the last paragraph is a handwave. CalSTRS is planning to develop a plan for better fee reporting. Lordie. In light of all the furor about private equity fees and costs, this is at best lackadaisical and at worst a delaying tactic.

Pray tell, is it credible for CalSTRS to become “industry leading” when its own consultant, CEM, effectively said last year that the South Carolina and Texas public pension funds were running rings around everyone else in gathering fee and cost data? There’s absolutely no evidence of any intent to live up to these empty promises, particularly since CalSTRS seems to prefer to hide in the middle of the pack so as to not risk annoying those all-mighty general partners.

CalPERS has already invested a fair bit of time and money in creating its own private equity reporting system, PEARS. If CalSTRS were remotely serious about living up to its PR, why isn’t it looking into licensing PEARS from CalPERS and paying for (or co-developing) any additional modules that CalSTRS might want? Why reinvent the wheel?

Let’s go back to what CalSTRS spokesman Roberto Duran asserted last year:

CalSTRS can estimate the fees “within a couple of percentage points”

And what head of private equity, told the Financial Times then:

Margot Wirth, director of private equity at Calstrs, said it used “rigorous checks” to ensure private equity managers took the right amount of carried interest.

Both statements were abject lies. If CalSTRS does not know what general partners are deducting in the way of carry fees, it has no way of arriving at its own estimate. And it beggars belief that CalSTRS can claim that it checks the accuracy of carried interest payments retained when it does not know what those amounts are and further admits it has (at best) incomplete information on how they are computed.

Duran can be forgiven since he’s the head of public relations and he’s in the business of putting the best spin on what he is told. It’s much harder to defend Wirth, since if she’s at all competent, she has to know that she’s selling a garbage barge. And let us not forget that these falsehoods are almost certainly approved of, if not coming from, more senior levels at CalSTRS, and some individuals there make a regular public show of how lofty their moral standards are. Can one really claim to be ethical when getting subordinates to sin on your behalf?

And let us also not forget the role of the board. State Treasurer John Chiang and Comptroller Betty Yee sit on CalPERS’ and CalSTRS’ boards. How can Chiang have insisted that he wanted CalPERS to explain why it had no information on what it had been charged in carry fees, yet not say a peep about carry fees at CalSTRS? And why is Yee mum on the subject of fees and costs at both institutions? The lesson seems to be that only CalPERS is held to account because the media focuses on its at the expense of CalSTRS. CalSTRS staff might be able to hide behind the CalPERS media windbreak, but there’s no excuse for board members playing along.

Time for readers to call, write, or e-mail Chaing and Yee and ask why they are applying a double standard at CalSTRS versus CalPERS on private equity fees and costs, particularly carry fees. And if Chiang’s staff tries arguing that his legislation will take care of the matter, please point out that neither CalPERS nor CalSTRS board has endorsed the legislation, and he needs to secure that for the public to be sure that he’s serious about the bill, as opposed to merely out to get favorable press on the cheap. Their contact details:

Mr. John Chiang
California State Treasurer
Post Office Box 942809
Sacramento, CA 94209-0001
(916) 653-2995

Ms. Betty Yee
California State Controller
P.O. Box 942850
Sacramento, California 94250-5872
(916) 445-2636

Please circulate this post to any friend and colleagues in California, since CalPERS and CalSTRS are both ultimately backstopped by taxpayers, so they have a vested interest in keeping both institutions on the straight and narrow.

And again, thanks for your calls and missives! They’ve made a real difference in the past. I hope you’ll be willing to saddle up again and let elected officials know that the public understands and cares about these issues. Private equity sleight of hand relies on the idea that no one is paying close enough attention to understand the ruses. The time has come to let captured officials know that you know better, and they should too.

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  1. Steve H.

    A quick elementary question: why not just recalculate the principal every year? From my microperspective, if I’m looking at my account, it’s a tax on time to work through the handwaving. What I care about is how much I get if I close the account. I don’t care if you’re earning 20% if you’re charging 19%, my net is 1% and I can tell that from the bottom line without the extra calculations.

    1. Yves Smith Post author

      Sorry, you are ignoring both fiduciary duty and the basic rule of investing: fees matter, and fiduciaries are required to assess the reasonableness of fees and costs. There’s a lot of case law on this issue.

      The SEC has said that most general partners are cheating, either engaging in what they are perversely refusing to call embezzlement or other serious compliance violations. Yet you blithely advocate a “oh sure, trust these people and only look at the net” when 1. private equity hasn’t delivered enough in the way of returns to justify its outsized risks over the last decade, and with PE firms paying the highest prices evah, there’s no reason to expect this to get better and 2. if the limited partners put down their feet on the stealing and the excessive and hidden fees, at least over the last decade, they could have earned adequate return.

      In other words, you are falling in line with the attitude that has allowed limited partners to be fleeced. Are you looking for a job with one of them and practicing your lines here?

      1. Steve H.

        Are you saying there is no end-of-year assessment that has all the debits accounted for? I don’t trust these people, that’s the point. Or is it that the contractual obligations are set for so far in the future that no change is possible even if a bottom-line net were known?

        What I’m looking for is a number to compare with a simple strategy, say splitting between U.S. Bonds and a no-load index fund. How else are we to assess the value of the extra complexity and secrecy?

      2. Steve H.

        Okay, I think I’ve got what you’re saying. I’m seeing 2009, Total Fund Cumulative Returns at -23.6%. But Assets As A Percent Of Accrued Liabilities as peaking between 1995 and 2000 and then dropping below 100. So the combination of risk and fees is failing to meet liabilities, despite better than simple-strategy returns most years.

        When I say elementary question, I may be phrasing something in a way that has a deeper technical meaning. I do come here to get set right.

  2. RUKidding

    Will write and call Chiang and Yee yet again. I’m a CalPers contributer, but as you say, as a CA taxpayer, I am contributing to CalSTRS. This is just egregious.

    It’s much harder to defend Wirth, since if she’s at all competent, she has to know that she’s selling a garbage barge. And let us not forget that these falsehoods are almost certainly approved of, if not coming from, more senior levels at CalSTRS, and some individuals there make a regular public show of how lofty their moral standards are. Can one really claim to be ethical when getting subordinates to sin on your behalf?

    Who’s PAYING OFF Wirth? That’s my question. How much payola is Wirth getting? Does she feel entitled to it? And if she’s not bought off, then WHY is someone this incompetent on the Board??? These are MY tax dollars. I demand better ethics and job competency than this.

    If I was as incompetent at my job, as Wirth appears to be, I would’ve been fired a long time ago, I can assure you. Wirth is someone who gives good, hard worked, ethical, competent public service employees a bad name. Thanks for nothing, Wirth.

  3. flora

    Can’t imagine that California teachers appreciate CalSTRS refusal to learn.
    With CalPERS taking in new information and adopting better policy re: fee reporting I’d think CalSTRS would follow suit. Why aren’t they?

    Thanks so much for your continued reporting on pensions and PE.

    1. flora

      anecdote: Every year my univ hosts a multi-day series of investments/retirement seminars open to all faculty/staff. There’s always one seminar covering 403b (education’s 401k plan) investing. Presenters are from the private investment companies offering plans approved by the univ. Presenters talk about the basics of investing, stocks, bonds, their various types, balanced portfolio, risk, etc. Standard stuff.
      This year, for the first time that I can recall, one presenter specifically singled out junk bonds and PE and said, “don’t invest in those. too much risk for retirement portfolio.” I pay attention (mostly) in seminars and don’t remember being specifically warned off these products in prior years’ seminars. Maybe reading your PE posts made it stand out more this year. Tought it was interesting the presenter took special care to warn people off including those products in a personal retirement portfolio.

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