The Los Angeles Times weighed in on how the Calfornia private equity fee transparency legislation sponsored by Treasurer John Chiang, who sits on the boards of CalPERS and CalSTRS, has had one of its initial supporters, himself a former head of CalPERS Investment Committee, go into opposition against the bill. We wrote earlier about how Michael Flaherman, who has also been a private equity executive and now is a visiting scholar at UC Berkeley, who not only backed the bill but actually provided some of its original language, is campaigning actively against the bill, AB 2833.
As much as it is gratifying to see the Los Angeles Times take up the controversy, it is also frustrating to see it miss or mischaracterize some of the underlying issues. The reason legislation like this is so important is that the SEC described the private equity industry as engaging in widespread abuses, including what amounted to embezzlement, in a landmark 2014 speech. Note that we had written about private equity abuses the year before. In addition, the agency made clear that investors like CalPERS and CalSTRS enabled these violations by entering into agreements that did a poor job of protecting their interests.
Shortly after the SEC revelations, major stories in the New York Times and Wall Street Journal described a wide range of misconduct in detail, implicating major firms like KKR, Blackstone, Apollo, Carlyle, and TPG. The SEC has entered into settlements with some of these players and has said more enforcement actions are coming. This is weak tea compared to the scale of the grifting, but at least one can no longer deny that there is gambling in Casablanca.
Yet the Los Angles Times does not make clear that the most important motive for transparency legislation it to expose all the ways that the private equity firms are hoovering cash from the companies they control. That will reduce the amount of misconduct, and also reveal the true cost of investing in private equity. Professor Ludovic Phalippou of Oxford has estimated it at a staggering 7% per annum of funds invested; CalPERS confirmed that it viewed this estimate as reasonable by including it in a private equity workshop last year.
Bear in mind that there is no excuse for fiduciaries like CalPERS and CalSTRS to have only a dim idea of the fee and expense drag of investing in private equity. Fiduciaries are obligated to consider the reasonableness of fees and costs when evaluating an investment strategy.
So the Los Angeles Times unwittingly does Chiang and his fellow complacent CalPERS and CalSTRS board members a favor (save CalPERS’ JJ Jelnicic, the only board member who has kept after these issues). The story attributes Chiang’s initiative as the result of an embarrassing episode at CalPERS last year. We broke the story that Chief Operating Investment Officer Wylie Tollette said CalPERS had no idea what it was paying in carry fees, and further compounded the damage by falsely claiming that no one got the information. That incident was one of several in which CalPERS’ staff was caught out not understanding the basics of how private equity fees work.
So while the Los Angeles Times is narrowly correct in that Chiang was trying to position himself as being on the right side of an escalating controversy, it misses the what is really at stake: the regularity with which private equity firms either outright violate their own agreements, the fact that those contracts also have “gotcha” provisions that investors appear not to understand, and the degree to which limited partners like CalPERS and CalSTRS are captured by private equity. These investors are not only afraid to rock the boat; they regularly side with private equity to the detriment of their beneficiaries and California taxpayers.
Nevertheless, the article does make clear that AB 2833, which was supposed to sail through the California legislature and give Chiang a talking point in his gubernatorial bid, has become controversial:
A bill that would require more disclosure from private equity firms that manage money for California’s public pension plans has been weakened, prompting a former state investment official and early backer of the legislation to pull his support…
Michael Flaherman, a former board member of the California Public Employees’ Retirement System who had promoted the legislation, argues that the change has gutted the bill.
“The private equity industry clearly intends to fool the Legislature and the public with the most recent amendments to AB 2833,” Flaherman, who has also worked for private equity firms, wrote in a letter sent to legislators last week…
The original bill would have required firms to report the total fees paid by the companies within a particular private equity fund. Now the bill only requires the firms to report the share of fees proportional to a California public pension’s investment in a particular fund.
Flaherman said that’s a crucial change. Because of the way that private equity deals are often structured, it would make it impossible to know how much companies are really paying.
That’s a problem, he said, because the fees, which can add up to millions of dollars, can be a big burden for the companies paying them – potentially cutting into their profitability or ability to grow – and therefore harmful to investors.
Mind you, this isn’t the only serious failing of the bill. We’ve described others: that general partners can structure related party payments to escape reporting and that the definition of “portfolio company” allows payment to be routed through other entities. Taken together, these shortcomings mean the bill is fatally flawed.
Notice the misleading defense that Chiang’s office gives for this Potemkin measure:
Deputy Treasurer Grant Boyken said a complete accounting of fees – the kind that the bill originally called for – is an admirable goal but that getting the share of fees paid by pension funds is Chiang’s main concern.
“Our immediate goal is to look at what California pension funds are paying,” Boyken said. “The language we have now does that. The bigger story with private equity is not how much we’re paying, but are we paying too much? We can’t have that conversation until we know how much we are paying.”
You can see how much of a backtrack this is when you go back to Chiang’s announcement last fall. He deemed the more detailed Institutional Limited Partners Association fee template (then in an advanced draft state) to be insufficient.
And the Los Angeles Times finds a dubious “expert” to provide the obligatory limited partner and industry PR:
CalSTRS in particular had raised concerns that if the bill became law it could endanger those returns because some private equity firms might choose not to work with California pension funds, preferring instead to take money from investors who don’t have such strict disclosure requirements.
Timothy Spangler, a UCLA law professor who has worked with private equity firms and investors, said that’s a legitimate concern.
“If you’re producing 30% returns year in, year out, you have a lot of people who want to invest in your funds,” he said.
Spangler, a law professor and not a finance expert, shows he is not competent to discuss private equity returns. Just a few of the many reasons his flip statement is incorrect. Private equity funds do not deliver returns remotely as high as he says, much the less with machine-lke regularity. First, it’s been well documented that there has not been “persistence” in top private equity returns in this century. In fact, the most recent studies have found that a top-tier firm is slightly less likely to deliver top-tier performance in its next fund than by merely investing randomly! Second, these returns need to be adjusted for the idiosyncratic risks of investing in private equity. When all those risks are included, private equity not only does not outperform, but it underperforms. Third, private equity executives have warned that private equity returns are going to fall, and stock market valuations of the public equity fund managers that are private say that they expect the decline to be significant.
Spangler also makes the intellectually dishonest argument that the SEC should ride into the rescue and impose transparency regulations. As we pointed out in a Bloomberg op-ed last year:
One can only conclude that the state and local officials are trying to shift responsibility to the SEC for their own failure to perform their fiduciary duties. This is clearly cynical, because there’s not much the SEC can do. The agency is already struggling to get private equity managers to improve the very general annual disclosures that regulations currently require. Often masterpieces of obfuscation, the documents describe the types of fees received, but not the amount. More detailed disclosure would require a radical rewrite of existing rules.
Private equity executives would argue that they give investors plenty of opportunity to do due diligence and that the investors all have their own lawyers who signed off on these deals. What is seldom acknowledged is the public funds’ outside counsel often invest in private equity funds, sometimes on a preferred basis relative to their clients, and typically earn far more working for private equity portfolio companies than advising public funds. Moreover, private equity firms are big political contributors: They have been barred from contributing to state treasurer elections, but they still spread vast sums around state legislatures.
The most realistic solution lies with the SEC — but it won’t be what the state officials have in mind. If public pension funds persist in feigning helplessness, the agency should consider rescinding their accredited status. This designation allows large and sophisticated investors to operate with minimal oversight. It requires that they be competent to review legal agreements and negotiate terms, including disclosure and audit rights, when the SEC has not reviewed the offering documents for accuracy and completeness. Without it, the pension funds would not be able to invest in private equity unless the latter submitted to the higher cost and disclosure of registering their offerings with the SEC.
Losing accredited status would be a huge embarrassment. As such, it could serve as a wake-up call, forcing complacent and captured public pension fund trustees and staff to just say no to private equity shenanigans.
Despite its shortcomings, the Los Angeles Times article does hit the most important issues: that Chiang’s bill fails to achieve its original promise, and that big investors like CalPERS and CalSTRS are doing an poor job of oversight through their longstanding failure to understand the economics of investing in private equity. The more heat on these issues, the better.
Update July 9, 9:45 PM: A law professor who has written extensively on private equity sent this message:
Spangler is actually not a law professor at UCLA. Maybe he has taught as an adjunct, but he’s just a practitioner with PE clients.
If you check the UCLA law school’s website, it has only only dead links to some courses Spangler taught (presumably as an adjunct). More important, Spangler is not listed on the UCLA law faculty profile page. So why didn’t the Los Angeles Times do basic fact checking?
Another reader e-mailed later:
Spangler’s UCLA connection is on behalf of federal felon Michael Milkin and his brother Lowell as an adjunct of their funded program at UCLA Law and as a lecturer at the brand-new UCI law program, probably also funded by the Milkens. He recently got hired at Dechert LLP ad a PE guy. Some “law professor…” He’s just another PE shill.