As we’ve chronicled over recent months, a California private equity reform bill sponsored by state Treasurer John Chiang, in which he promised to provide full transparency for all fees and costs, has been amended from its original strong form version into a fig leaf for complicit public pension funds and board members…like Chiang himself, who sits on the boards of CalPERS and CalSTRS. See this post for a long-form discussion as to why the bill, AB 2833, can easily be circumvented by private equity general partners.
One proof is that any reform effort that goes up against powerful interests runs into serious opposition. But the bill Chiang sponsored, AB 2833, went through both houses of the California legislature without getting a single nay vote.
Another proof is that Bloomberg, which normally does not pay much attention to the ins and outs of state-level sausage-making, had one of its senior reporters take up AB 2833. His latest story, filed right after governor Jerry Brown signed the bill, gave prominent play to critics’ charges:
Private equity firms collect management and performance fees from investors. They also charge companies in their portfolios for services like consulting. Under the new law, California investors will learn what portion of these fees portfolio companies are paying on the pension funds’ behalf, but they won’t necessarily learn how much the private equity firms are charging the portfolio companies in total.
Without that information, some critics say, there’s no way to measure the full financial impact on the portfolio companies of the fees they pay to private equity fund managers. An early draft of the law would have required such a disclosure.
“The law is a big disappointment relative to what was possible in terms of transparency improvements,” said Michael Flaherman, a former member of the Calpers board who consulted with the legislation’s backers early on. Flaherman withdrew his support for the bill after it was amended.
But perhaps the most persuasive evidence that AB 2833 fails to deliver on Chiang’s transparency promises come from an analysis by Ropes & Gray, which is Bain’s lead law firm and represents other large private equity general partners. Ropes & Gray seems genuinely puzzled as to why a transparency bill has such a glaring drafting defect (emphasis ours):
Initial drafts of the law required disclosure of total fees paid to the Fund manager by Fund portfolio companies. This was revised to require only disclosure of the PPP [pubic pension fund]’s pro rata share of fees paid by the Fund investment vehicle through which the PPP invests. Arguably, providing just the PPP’s pro rata share of these fees achieves the Fee Disclosure Law’s goal of transparency on fees paid by a PPP. However, if, on the other hand, reduced profitability of the portfolio company as a whole is seen as a “cost” to investors, disclosing the entire amount would have provided greater insight into the impact of fees on PPPs. Where a Fund uses multiple investment vehicles to buy a portfolio company, the aggregate amount of fees borne by the portfolio company cannot be ascertained when only the PPP’s pro rata share of a given vehicle is disclosed.
Tbis was precisely the objection that Flaherman, this site, and others raised. We gave an example in a June as to how the bill leaves investors in the dark about the fees private equity firms are hoovering out:
Bear in mind that the previous version of the bill required that all related party transactions be reported. The current version calls only for providing each CA public fund with its pro rata share of those fees.
This example illustrates of how this newly proposed reporting structure would cause vast under-reporting of the total amount of fees that a portfolio company is paying to a private equity firm:
• PE firm “Deal Guys” makes a $100 million equity investment in “Widget, Inc.”
• Deal Guys Fund V, L.P., its current flagship buyout fund contributes $65 million of equity
• CalPERS has contributed 5% of the capital in Deal Guys Fund V, L.P.
• The of the remaining $35 million of equity, $20 million is contributed by a friends and family fund ($5 million), and an “offshore” fund ($15 million) that holds the capital of non-U.S. investors, both of which are required by the LPA of Deal Guys Fund V, L.P. to invest alongside it pro rata. The final $15 million is contributed by an LP co-investor (not CalPERS).
• Upon purchasing Widget, Inc., Deal Guys forces it to execute a monitoring agreement calling for an annual payment of $5 million to a Deal Guys affiliate.
What is CalPERS’ pro rata share of this $5 million? It is five percent (CalPERS’ interest in the fund) of 65 percent (the fund’s interest in the Widget, Inc. deal) =(5,000,000 X .05 X.65) = $162,500.
From this $162,500 number, CalPERS would either 1) erroneously infer that the total amount of money being taken by Deal Guys from Widget, Inc. annually is $3.25 million (162,500 X 20), a conclusion they might reach because they incorrectly think that the fund in which they are invested is the only vehicle invested in Widget; or, if they are more sophisticated, they would recognize that there is no conclusion they can reach about the total amount being sucked out of Widget by Deal Guys.
Further, because CalPERS has no visibility into the other Deal Guys entities in the transaction, it does not know that the $20 million contributed from the friends and family fund and the co-investor do not give rise to any management fee offsets, meaning that the Deal Guys affiliate just keeps the full $1 million annually (20 percent of the annual monitoring fee) attributable to this capital.
Mind you, this is only one of major three deficiencies that we flagged, but it’s the one that has gotten the most media attention.
So it is disappointing, but not as all surprising, to see public officials, including public pension fund staffers, pretend that they are on the side of fund beneficiaries and taxpayers when they continue to be in thrall to the private equity industry. One can only hope that continued media coverage of the private equity industry, including the failure of fiduciaries to do their jobs, will make it untenable for public pension funds to continue to serve two masters.