Last week, we said we’d discuss an attorney-client privileged report by FTI Consulting on some of CalPERS’ private equity investments. Violating attorney-client privilege, FTI provided a redacted copy to another California public pension fund, LACERA, as part of a business pitch. Several parties, including your humble blogger, obtained the report via California’s Public Records Act and were able to expose the redacted parts.
The document shows the lengths to which CalPERS is willing to go to whitewash private equity misconduct. The study took place in 2015 and appears to be in response to the hard-hitting reporting by Mark Maremont of the Wall Street Journal and Gretchen Morgenson of the New York Times about private equity fee abuses, along with knowledgeable outsiders pressing CalPERS about them at the time.
But this wasn’t an effort to get to the bottom of things and set the table for demanding restitution from private equity grifters. It’s obviously a garbage-in, garbage-out purposeful whitewash. CalPERS’ staff, if they are remotely competent, had to have recognized that. Not only was the methodology hopelessly deficient, but as we will demonstrate, public records, which FTI’s project scope shows it was not directed to check, reveal that s some of its positive assessments are false. Given how little it is possible to observe directly about private equity, this level of verifiable failure is damning.
The contracting of the report, via a law firm, was designed so that the CalPERS staff would keep it top secret, with the consultant’s actual data and analysis presumably withheld even from the CalPERS board. Nevertheless, the report’s purpose was to provide a mechanism for reassuring the board that all was well with the CalPERS private equity program. Recall that CalPERS held a private equity workshop later that year for that very purpose.
With both the workshop and the report, CalPERS staff treated the board as lacking the sophistication or knowledge to recognize how inherently deficient the information provided actually was.
But was this costly con even shared with board members or were they simply told “FTI says everything is fine with our biggest PE managers, all those critics don’t know what they are talking about”? We don’t know. However, we have seen other instances, such as the organization’s annual “Cost Effectiveness Report” produced by consulting firm CEM, where the board was routinely not provided with the actual document even though other pension systems typically provide that document to their trustees.
In addition to CalPERS not wanting a serious review, there’s another reason FTI was almost guaranteed not to press private equity firms too hard. As we discussed last week, FTI stated in its proposal to LACERA that it had worked for Apollo. Not only is this a direct conflict of interest, since Apollo was one of the five general partners included in this review, but the Apollo project also confirms that FTI has a major business conflict of interest. Private equity firms are a vastly more lucrative client prospects than public pension funds. FTI could be predicted not to do anything to ruffle their feathers.
Why the FTI Report Is Inherently Unable to Deliver on Its Promises
The FTI report cannot be taken seriously because its methodology is defective. Recall that the underlying problem is that private equity firms were caught out lying and cheating. In April 2014, the SEC’s examination chief Andrew Bowden had given what amounted to a blistering speech for a regulator, that over half the private equity firms examined so far had been found to be engaging in what would normally be called embezzlement or other serious compliance violations. A series of press stories exposed specific abuses, most of which the investors had no idea were occurring, such as private equity fund managers presenting some staffers as part of “the team” meaning they were presumed to be paid for out of general partner overheads, but instead were being charged to portfolio companies (and ultimately the investors) as consultants.
It is also critical to understand how this sort of grifting can and does take place. The general partners are in complete control of the money. Investors (a.k.a.”limited partners”) have to answer their capital calls on very short notice or face draconian punishments. The limited partners don’t get their money back until the private equity manager sells businesses and decides to return the proceeds. The managers compute what they charge against these distributions, with no third party review, and in the majority of cases, with little or no reconciliation of what the gross amounts were and what the particular deductions were.
While the limited partners do get audited financial statements for each fund, that is far from sufficient to protect their interests. PE fund managers charge many large fees, such as transaction fees, monitoring fees, and the aforementioned consulting charges, not to the fund but at the level of the portfolio companies in the fund, meaning those charges never appear in fund financial statements. Limited partners have no right to see the financial statements of the entities where these expenses do appear, nor do they typically receive any other disclosure regarding the fees that the PE managers are taking from these businesses. Needless to say, this is where the abuses have been occurring.
Given that the PE managers have established that they are less than trustworthy, how did FTI conduct its investigation to determine whether or not their conduct was on the up and up? From its report:
FTI reviewed documents received from CalPERS including the LPA [the fund contract with CalPERS and other investors], fund audited financial statements, advisory board reports and capital account statements and then we provided the Management Questionnaire to point person(s) at each of the PE Firms as identified by CalPERS.
FTI also chose a sample fund and portfolio company to test calculations of, but not limited to, the allocation of fees, investment allocations, management fees and distributions. In some cases and after consultation with us, the PE Firm chose a different portfolio company that was more relevant to our testing.
FTI met with personnel at each PE Firm (See Appendix F for comprehensive list of personnel), which included the PE Firm’s private equity compliance and finance personnel, such as their private equity chief compliance officer and private equity chief financial officer, and other PE Firm personnel as deemed necessary.
Charming. Looking at a single fund and a single company in a fund is utterly useless as far as unearthing dubious practices is concerned.
Keep in mind that the overarching contracts, the limited partnership agreements, require the PE managers to “offset” a stipulated percentage, which now averages 85%, of specified portfolio company expenses from all portfolio companies that the general partners pay to themselves against the management fees. Looking at one company tells you squat about whether CalPERS is being cheated or not. This is true for two reasons. First, a PE firm may be on the up-and-up in how it dealt with fees from the one portfolio company it disclosed. Second, and more importantly, you can’t tell if a sum total is correct if you are only provided with one of many numbers that went into creating that sum total.
And it’s ludicrous that FTI (presumably with CalPERS’ approval) allowed the PE firms to choose a portfolio company different from the one CalPERS had selected for examination.
And consider this from FTI’s Disclaimer section: “The work performed has been limited to the specific activities that you requested.” That means there was no effort to check the veracity of answers to questions like whether “Notice was given for all events that require notice.” Do you think any of these PE managers, in a tea and cookies chat with FTI, would admit to a violation if there was one?
Out of this list of question, we’ve bolded the matters from what FTI describes as a “detailed regulatory and compliance review” that cannot have been performed reliably, given these issues:
1. Assessment of the severity of SEC examination findings if applicable, and controls and enhancements implemented in response.
2. Assessment of the severity of most recent mock exam or compliance review findings if applicable, and controls and enhancements implemented in response.
3. Management fee calculation; including the offsets and determining whether it is in accordance with the LPA; acceleration or continuation of fees after exit.
4. Transaction Fees or other types of fees and any payments, including those made to affiliates, (other than those applied as management fee offsets) and determination of whether they should not be subject to management fee offset, and are in accordance with relevant policies and agreements (including LPA), and review any related disclosures.
5. Contribution and proceed distributions and determination of whether they follow the waterfall in the LPA.
6. Cross-fund investments and policies, procedures and related disclosures.
7. Allocation of fund fees and expenses in accordance with the LPA or other policies and related disclosures.
8. Valuation processes at year end and at interim periods, including any valuations that are performed at non-reporting periods.
9. Compliance with CalPERS side letter and Placement Agent Disclosure form and the process for ensuring compliance with side letter agreements.
10. Key financial reporting processes and relevant policies and procedures.2
11. Recent material changes to firm-level policies and procedures related to compliance, valuation, management fees, distributions, expense and investment allocation, and fee reimbursements any.
Places in the FTI Report Where the General Partners Lied or FTI Gave Incorrect Answers
The FTI report covers five large private equity fund managers: Apollo, Blackstone, Carlyle, Cerberus, and CVC. Despite the intensely secrecy regime established by PE firms, there is still some information in the public domain that can be used to check the truthfulness of some of the answers provided by these five general partners. All five of the firms reviewed either made identifiable misrepresentations or were the subject of misrepresentations made by FTI. In the embedded version of the report below, we’ve put a red box around each false score by FTI.
First we’ll discuss how FTI gave bogus approval to several PE fund managers for a particular review topic. Then we’ll go firm by firm for the ones that applied only to a single player.
Basis for fee is at cost or market rates. The far left column at the top of numbered page 5 describes that the topic under review is fees charged to portfolio companies that are not offset against the management fee. This is a significant topic because it’s been shown to be a vehicle for general partner chicanery.
Near the top of the page, the report shows that Apollo, Blackstone, and Cerberus all have in-house consulting groups, which knowledgeable readers would recognize charge fees that have not been offset against the management fee. Two rows further down on the same page, FTI shows Apollo and Cerberus as charging those (and perhaps others) fees at “cost or market rates” and Blackstone levying them at “Historical Overhead Cost”.
It is widely understood that private equity firms charge out their in-house consulting operations at McKinsey-type rates. Yet unlike McKinsey, these in-house consulting firms have skeletal staffs and are largely if not entirely in the business of baby-sitting firms like McKinsey. Thus their work isn’t remotely comparable to what McKinsey does, which is both leveraging existing expertise, as well as having some of its high cost being the result of quality controls, a.k.a. partner oversight and review. So the idea that Apollo and Cerberus are using bona fide market comps is specious.
As for Blackstone, as anyone will tell you, accounting is very malleable. For instance, some public companies shift as much of their overhead cost as possible to high margin operations. Blackstone would have incentives to load as much overhead as it could into the activities of this unit, making the notion that it was “cost based” technically accurate but substantively misleading.
Apollo FTI gave Apollo a checkmark, which is a mark of approval3, for ” Offsets that exceed management fees do not benefit GP/Affiliates>”. Apparently despite having claimed to do so, FTI did not read Apollo’s Limited Partnership agreement with sufficient care. On numbered page 79 of Apollo VIII, from our Document Trove:
To the extent that any such excess of Offsetable Amounts exceeds the amounts of Management Fees due for all future periods (the “Final Excess Offsetable Amount”), upon liquidation of the Partnership, the Final Excess Offsetable Amount shall be for the benefit of the General Partner and its Affiliates.
Blackstone. Blackstone got the FTI check of approval in this box: “Manager cannot continue to earn fees on exited investments” when it told the Illinois Investment Board something very different (see embedded letter below) The answer to Item 7 includes: “Historically we have very rarely received any fees from portfolio companies following a full exit and we do not expect this practice to change in the future.”
Carlyle. FTI listed “No [SEC] exam during relevant period”. This is false unless the undisclosed “relevant period” was circumscribed to be so short as to be totally meaningless. In its Q1 2014 Earnings Call on April 30, 2014, Adrena T. Friedman, the Chief Financial Officer, stated:
And we’ve been very disclosive to our LPs and we actually had a recent visit from the SEC just on a normal basis, they do that for all of the investment advisors…
Under “No fees that give rise to a conflict of interest,” FTI gives Carlyle a check of approval. Funny then that Carlyle saw fit to warn investors otherwise to the SEC in its Form ADV for March 30, 2016 on page 66:
CIM [Carlyle Investment Management ]generally has a conflict of interest to the extent it has the opportunity to earn such a fee [acquisition, monitoring, disposition and certain other fees] in connection with investments by Advisory Clients.
CVC. FTI asserts about CVC that “Manager cannot accelerate fees upon exit.” That’s contradicted by Brit PLC, a portfolio company, in its 2014 annual report. From page 204:
The Group has paid monitoring fees to Apollo and CVC-affiliated investment funds amounting to £7.4m (31 December 2013: £2.0m) of which £5.4m (31 December 2013: £nil) was paid in connection with the termination of those monitoring fee arrangements on 27 March 2014.
Similarly, CVC failed to disclose termination of monitoring fees with respect to Univar, an investment it initially made through two funds, CVC European Equity Partners IV and CVC European Equity Partners Tandem Fund, in 2007. In a 2010 recapitalization, Univar, which as a nearly-wholly owned by CVC funds, was not operating independently, signed a ten-year monitoring fee agreement which among other things provided for Univar to terminate the agreement early in the event of a change in control or IPO, and an early termination would result in a termination fee payment equal to the net present value of outstanding payments. In June 2015, CVC made Univar sign a termination agreement which specified that a $13.1 termination payment be made to CVC.
Other Dodgy Items
To keep this post to a manageable length, we’ll limit ourselves to discussing only three other topics that FTI said it subjected to a “detailed regulatory and compliance review” to give you a feel for the superficial nature of this exercise.
Finessing private equity double dipping. The report’s structure conveniently sidesteps a major private equity abuse: that of monitoring fees charged to portfolio companies. They are presented to limited partners as being valuable oversight. There are several problems with this argument. First, as Professor Ludovic Phalippou has discussed, based on extensive review of monitoring fees agreements, these fees are pure extraction, or as he called it “money for nothing“. The general partner has no obligation to do any work whatsoever, and the fee is the same per quarter (sometimes accruing if a profit level is not met), again reflecting that it is a disguised dividend rather than payment for services. Second, the management fee is envisioned as paying the private equity firms for doing their jobs, meaning finding companies and supervising their management. So pray tell why do they need to be paid twice for that?
And on top of that, now that limited partners are having monitoring fees subject to higher and higher management fee offsets, meaning that the PE managers’ double dipping game was cut back to a significant degree, what have they done? As the report shows, set up in-house consulting firms to allow them to resurrect this scam through a different set of legal arrangements.
Distributions of capital contributions and investment proceeds; waterfall distributions. The “waterfall” defines the priority of payments. What is left over goes to general partner carry fees and limited partner distributions. FTI claims to have “Tested Calculations [of the waterfall] (no exceptions noted)”.
Due to its lack of expertise, and perhaps also CalPERS’ misinformation, FTI is replicating the industry canard that the waterfall calculation does not take into account fees charged to portfolio companies. But that is incorrect.
One of the items in the computation is management fees….which for this purpose are net of management fee offsets. That includes the utterly opaque charges made at the portfolio company level and whether or not they were properly offset against the management fee. As various SEC settlements have shown, general partners cannot be relied upon to be honest operators on this front.
The only way this question could have been examined reliably would be for FTI to have examined the financial records of all portfolio companies in a particular fund. The PE firms would never permit that even if CalPERS had asked.
Valuation. This section refers to the valuation of portfolio companies, which PE fund managers typically prepare quarterly in order to value the fund as a whole. These valuations are performed by the general partners. In no other type of investment made by fiduciaries do they tolerate such a “trust me” approach. Valuations for other types of investments are performed by independent parties.
This section includes a section with “Third Party Review” as if that is a reasonable standard for valuations. While “third party” review is better than nothing, it’s not all that much better than nothing. These “reviews” can consist of a look-see by the accounting firm the general partner uses for the fund’s books and records. An accountant will not have any basis for questioning the valuation; he won’t know typical EBITDAs in various industries and what discounts might be warranted for various portfolio company warts. All it can do is question certain items and ask for the general partner to provide more backup for its opinion. A firm that actually does middle-market mergers & acquisitions on a routine basis like Houlihan Lokey would be able to kick the valuation tires a bit more seriously, but it is similarly unlikely to challenge a valuation. Word of such disruptive behavior would shortly be all over the general partner community via the unhappy general partner and its law firm, killing any future business.
Sadly, this incident demonstrates yet again how CalPERS gives precedence to protecting its relationship with abusive private equity firms. It created a costly, empty exercise tantamount to a coverup to snooker any overly inquisitive board members.
Not only was FTI conflicted by virtue of having Apollo as a client, but if you look at FTI’s pitch to LACERA, which we embedded in a post last week, you’ll see that LACERA was soliciting proposals to examine private equity fees and costs. The only directly relevant project that FTI could cite was its report for CalPERS, which may be why FTI was so reckless as to violate attorney-client privilege by providing the actual document: they thought it would shore up their obviously meager experience. That in turn means CalPERS hired a rookie, and the lack of relevant expertise shows. But in light of CalPERS’ true objectives, that was a feature, not a bug.CalPERS_FTI Report NC 2
Blackstone Response to Illinois Investment Board
2 We’ve written before how portfolio company reporting is inherently compromised and thus it is hard to fathom how FTI could have looked into this issue and given a clean bill of health. Notice in the chart overview of the report, there is no assessment corresponding to this item.
3. In FTI’s words: “Check marks (√ ) indicate that the PE Firm satisfactorily met our test without exception.”