CalPERS Reported That It Made Less in Private Equity Than Its General Partners Did (Updated: As Did CalSTRS)

CalPERS is a prototypical example of the Wall Street cliche, “Where are the customers’ yachts?,” except in the case of private equity, that saying needed to be updated to “megayachts”.

As we mentioned earlier this week, CalPERS reported preliminary investment results for its fiscal year ended June, 30, 2016 of 0.6%.. Its press release stated that its private equity returns were 1.7% based on data through March 31.

While CalPERS is likely to report somewhat better final results from private equity, given that US stock indices were higher at the end of June than the end of March, it’s a given that the private equity firms did better than they did.

Just consider management fees alone. Even though these are stated at the prototypical 2% of the “2 and 20” formula, most observers fail to understand that that 2% is not 2% of assets under management. For the first 5 years of the fund, it is 2% of the commitment amount. Remember that the general partner is in the process of buying companies and calls the capital from investors like CalPERS only when it needs it. After the investment period, the management fee level typically steps down. Most often it to a percentage of invested capital.

The net result is that the management fees as a percent of assets under management are much higher than 2%. Oxford Professor Ludovic Phaillpou has estimated them at 4%, based on typical patterns of capital calls and distributions. And don’t forget that the management fees are paid in full whether they are paid directly by the limited partners or shifted onto the portfolio companies via management fee offsets.

In recent years, CalPERS has been able to lower its management fees on new investments due to the size of its commitments. General partners have what amount to fee schedules, and investors that make commitments over certain size levels get breaks on fees. Mega funds also have lower management fees than smaller funds. And general partners also sometimes offer fee breaks for limited partners that make early commitments.

We checked in with Professor Phalippou to see if he thought his estimate applied to CalPERS. His comment by e-mail:

My best guess for fixed fees (management fees, organizational expenses etc.) for most funds CalPERS has invested in are about 4% of invested capital. It may be less for the new contracts they have signed; and it is less as a fraction of AUM when returns are positive. This total applies regardless of whether the fees are paid by the LPs or shifted to the portfolio companies.

Note that in its investment cost report in 2015, which was for fiscal year 2014, CalPERS claimed its private equity management fees were a mere 140 basis points of assets under management. Despite presenting a new, and supposedly improved investment cost report in 2016, it stopped breaking out private equity costs separately. CalPERS staff maintained in the 2016 report that this report included gross fees, not net fees.

We’ll return to this topic with a more detailed analysis in a future post, but we spoke to Phalippou last month about this claim. He found it to be “extremely unlikely”. First, CalPERS would have to be invested almost entirely very old funds to have such low fees. Second, it’s computationally difficult to figure out what the gross fees ought to be after the investment period. And on top of that, CalPERS would probably want to make sure its calculation of the gross management fee tallied with what the general partner actually charged, making the exercise even more laborious.

So to put it another way, Phalippou has considered CalPERS’ official stance on this issue and he does not buy it.

And let us not forget that the management fees are far from the sum total of fees charged. Private equity funds impose a raft of fees on portfolio companies, and in many cases, those fees are not fully offset against the management fees. Moreover, as the SEC and media have revealed, private equity firms also charge fees to portfolio companies that are not subject to management fee offsets, meaning those costs come fully at investors’ expense. Finally, despite last year being an overall crappy year for private equity, there still were no doubt some companies sold at high enough profits so as to have resulted in CalPERS paying some carry fees. That means that CalPERS’ general partners as as whole unquestionably profited more than the giant pension fund did last year. And this result gives a more vivd illustration than usual of the “heads I win, tails you lose” nature of investing in private equity.

Update 6:00 PM: Reader j3 pointed out by e-mail that CalSTRS whose preliminary reports show it doing better than CalPERS in private equity, at a 2.9% preliminary return versus CalPERS’ 1.7%, still fell below the 4% fixed cost level estimate of Phallippou. CalSTRS’ estimated net return of 1.4% was also better than CalPERS’. Interestingly, its press release shows private equity falling short of its benchmarks by 170 basis points, while CalPERS claimed its lower private equity return of 1.7% ” bested its benchmark by 253 basis points.”. We had found that to be implausible but don’t have access to the indexes they use (and yes, we did Google a bit). However, if you look at the table it lists the performance by asset class and says “Versus Indexes” and shows the same 253 basis point alleged outperformance. But the private equity benchmark is not the same as the indexes; CalPERS also adds a 300 basis point risk premium. sDid CalPERS omit the risk premium to make PE look better than it was? It seemed so implausible that CalPERS would dare lie so flagrantly in an official press release on such widely followed information that we assumed that they got lucky with their index choice and it delivered lower results than most equity indices last year, making PE look better. We’ll now have to give that a closer look….

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  1. flora

    This total [of fixed fees] applies regardless of whether the fees are paid by the LPs or shifted to the portfolio companies.

    CalPERS made less in private equity than its PE General Partners made?

    What a surprise…..

    Thanks for your continued PE and pension reporting.

    1. flora

      adding: if this is a one-year situation, a one off situation, that’s not too alarming. If it is a 3-4-5 year situation, a pattern, that’s very alarming for CalPERS active members, retirees, and Cal. tax payers.

      1. TheCatSaid

        The obfuscation about GP fees makes it hard to evaluate, doesn’t it. A feature of PE from the GP perspective. Let’s hope this great reporting creates effective moves towards genuine transparency.

    2. Yves Smith Post author

      Phalippou estimates that total PE fees are 7% per annum and CalPERS affirmed that as reasonable by including that figure in its private equity workshop last November (without citing Phallippou). 7% is grotesquely, indefensibly high. It’s proof of dereliction of duty by the investors. Admittedly that includes carry fees, which will be much lower when overall returns are lousy. However, one study found that approximately of the fees private equity earns are fees not at risk of performance, which if you use Phallippos’s 7% in normal times, gets yo to over 4.5% in charges ex carry fees. And that study probably didn’t catch some of the sneaky fees that the SEC and media have exposed since 2014.

      Moreover, at the industry conference, SALT, earlier this year, heads of private equity firms virtually to a person said to expect lower returns going forward. So while PE may not do as badly as it did this year, with their rapacious fees and grifting, the GPs are going to be sucking more out of any value they create than they did in the past. And remember, the PE funds pull out those non-performance related charges regardless of whether the fund makes any money.

  2. RUKidding

    Thanks for keeping your eye on the CalPers hair ball. It’s just unconcionable what they’re doing.

    What’s that definition of insanity? Keep doing the same thing but expecting different results?

    It’s been clearly proven that PE is not a good investment. Why does the CalPers Board continue to do it?? What’s they’re motivation here? Who’s buying them off??

    1. Yves Smith Post author

      CalPERS staff and board believe firmly otherwise, that PE is a good investment and indeed the only investment that can regularly beat their portfolio goal of 7.5%.

      Reader Scrooge McDuck has a good take on the situation:

      My sense is that a significant number of the Calpers board really thinks that they are acting in the best interest of their retirees by playing nice with their PE pals. They truly believe that without PE’s “spectacular” returns they cannot possibly meet their pension obligations. That’s what their staff, consultants, lawyers and GPs pound into their heads at meetings, conferences, summits, annual investor meetings, in reports and so on. And as we all know fear is an excellent motivator. And when they go to bed and begin to ask themselves real questions, they tell themselves that it’s all for the greater good. And then there are other members, like Slaton, who are there for only one purpose, to carry water for his pals. You could chalk up the board’s attitude towards PE the result of incompetence, sure there is some of that, laziness, of course there is a little of that, or carrying favors, duh!, but for my taste it’s mostly fear. Fear of not meeting their pension obligations, fear of being exposed as being unsophisticated investors, fear of upsetting people they see on a regular basis, and fear of losing the blissful hope that PE provides them.

  3. Blue Meme

    The psychology at work here is easy to imagine.

    CalPERS has been “planning” based on staff promises of overall returns that will be virtually impossible to achieve. As fiduciaries, the trustees should be sounding the alarm. But very few of us have the courage to face disaster head-on, and this is a disaster of epic proportion. The gap between reality and the promise will cost the trustees their jobs and reputations…but only when it is finally acknowledged.

    Enter the PE grifters: amoral con artists willing to promise that they will be the cavalry riding to the rescue of the trustees and staff. Even if the trustees are not fully convinced, going along is the easier play: at the very least, it postpones the day of reckoning.

    Making sure the music keeps playing does not affect the pace at which chairs are being removed.

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