It’s remarkable to see that some private equity general partners, who above all are experts at increasing their own net worths, are concerned about a gimmick that boosts reported private equity fund returns. By contrast, limited partners like CalPERS are in “Nothing to see here” mode on the increase risks and costs, which include being forced to liquidate investments at the worst possible time to pay down these extra private equity borrowings.
The gimmick is subscription lines of credit. They allow private equity fund managers to borrow at the level of the investment fund, in addition to the debt they heap onto the portfolio companies they buy. We had heard of them over two years ago, but didn’t write them up then because they weren’t being used all that much back then. Last August, we discussed them after a Pension & Investments article described how they had become mainstream. From our post:
The Bank of Montreal created subscription financing and it was always intended as a way to improve investors’ reported returns at the expense of the economics of the investment.
Early in the life of a specific private equity fund, investors will report negative returns. This will occur in the first year or two, after the investor has incurred management fees and had some initial capital calls. Unless the general partner has an aggressive, fast strategy for monetizing the investment (say the now out-of-favor “dividend recap” in which the GP loads the acquired company with lots of debt and pays investors a large special dividend), for at least the initial year after making an acquisition, the GP is likely to report the value of the portfolio company as par value, meaning the acquisition price. So when you include the management fees and the cost of closing the deal, the limited partners’ reported returns will be negative. This pattern is called the “J curve”.
Despite the impact on the level of individual fund, this J curve effect has been seen as more of an annoyance than a serious problem, since private equity investors are committing new monies to private equity every year and reaping returns over time from mature funds…
But now that private equity returns are flagging, investors are willing to turn a blind eye to any gimmick that improves results. Here is where the subscription lines of credit come in…
Subscription line financing makes it possible for general partners to borrow at the fund level on a routine basis, as opposed to its previous status as an unusual event. The bank provides a credit line with that borrowing secured not by the assets of any portfolio companies, but by the unused capital commitments of the limited partners. In other words, while these borrowings were expected to be rare and repaid by other means, from the lender’s perspective, legally they are advances against the limited partners’ capital commitments.
And who in the Pensions & Investments article was sounding alarms? Not the investors, who are fiduciaries and ought to be worried about leverage on leverage, since structures like that can and do blow up spectacularly. Remarkably, it was a general partner:
John Connaughton, co-managing partner and head of global private equity at Bain Capital, who spoke on the same panel, said leveraging portfolio companies and then leveraging equity on top of that “could be like the boiling frog.”
“It’s not a good idea,” he said.
Not surprisingly, CalPERS has had to be forced to even acknowledge that this sort of gambling is going on in Casablanca. In December 2015, former CalPERS board member and private equity expert Michael Flaherman alerted CalPERS to the risks of subscription lines. The committee chairman Henry Jones directed staff to bring back a report. That would normally imply putting the matter on the agenda and having formal briefing and taking questions from the board, but that never occurred.
Flaherman brought up the issue again in the May board meeting (watch below or here starting at 36:45):
Michael Flaherman, Visiting Scholar, UC Berkeley: The reason I wanted to talk is that in December 2015 I gave public comment before the board about an issue which is fund level leverage in private equity. This is an increasingly common practice and raises significant concerns of systemic risk for your private equity portfolio.
The reason why I bring it up today is that the chair instructed the staff at the time to bring back a report on the issue and to my awareness that never happened. There was never a report brought back. That’s particularly interesting because this issue got a lot of attention just in the last few weeks. There is a gentleman named Howard Marks who is the CEO of a firm called Oaktree Capital in Los Angeles. He publishes a quarterly letter is probably the most second most widely read letter in the financial world after Warren Buffett’s communications. And he wrote the last quarterly letter a couple weeks ago it about the dangers of this fund level leverage in private equity and he really kind of reprised some of the issues that I raised.
And he raised another really important issue which is that he said you know, something that is really troubling about this is that the fund level leverage can be used to bump up intermediate-term returns in private equity while hurting long-term returns. And he asked the question why do people do this?
People do this, he argued, to game their own compensation.
And I think this loops back to this organization into your role as a board. Because it seems to me that it is especially concerning when the chair instructs the staff to bring back a report about hidden risks in your portfolio and they do not do it, and then you have some be like Howard Marks pointing out that the hidden risk serves to bump up people’s compensation. And so I hope that there might be some effort to address this especially just recognizing that this is a conflict of interest that your staff has where this helps their compensation and you might even invite Mr. Marks to come give you a presentation on the topic. He’s down in LA. He has a lot of CalPERS money. And so I think there’s an excellent chance that he would do it if you asked him. And I also hope that you would ask your staff to respond to this concern.
It turns out CalPERS did prepare a document which it presented privately to the board. However, Flaherman was correct when he said, “…it is especially concerning when the chair instructs the staff to bring back a report about hidden risks in your portfolio and they do not do it.”
That “report,” which we’ve embedded at the end of this post, does not discuss risk anywhere. And that shows yet again how CalPERS keeps its board in the dark. Instead, it discusses CalPERS’ procedures, as if to imply a mere staff review makes everything safe.
As Flaherman pointed out via e-mail:
Note that insofar as the memo even engages any substantive issues, it extols the credit lines for boosting net IRR, even while acknowledging that it is done by increasing the velocity of capital distributions while hurting the total dollar amount of profits.
It also notes that the use of the lines helps GPs earn carry that they would not otherwise receive but offers this observation in a way that, again, seems devoid of concern.
Here are some of the risk and consequences:
Higher fees to general partners
Increased risk of UBTI (unrelated business income tax)
Forced dissolution of private equity funds
Payment notices to limited partners at the worst possible time, when markets are distressed
Increased systemic risk
Oh, and that the metric being gamed, IRR, winds up being abandoned because it becomes meaningless. And a perverse aspect of this scheme is that one of the alleged benefits of private equity is that it allows long-term investors like CalPERS to invest on a time frame that is more consistent with their investment exposures. The use of the subscription line means CalPERS’ money would be at work a shorter period of time, undermining this feature.
To the extent that the board members reacted to what Flaherman had to say, it did not reflect well on them. Richard Costigan, who is both an attorney and a member of the State Personnel Board, rejected out of hand the notion that staff was gaming compensation, even after one of CalPERS own general partners, who is in a far better position than Costigan to judge than Costigan, said this was the big reason limited partners were enthusiastic about them, and Flaherman pointing out that there was a conflict of interest (watch below or here starting at 1:47:17):
Board Member Richard Costigan: Okay, and so the other point I want to make is a little bit I guess concerning for me as it relates to compensation. I hear this theme that somehow this is about increasing compensation and I just again want to make it clear to the investment staff, we’ve taken up the issue before. When I look at what you all paid vis-à-vis our friends at the University of California or in the private sector, you are vastly underpaid. I find this line of questioning or line of rationale that somehow we are manipulating a benchmark in order to increase compensation to be somewhat unfathomable. There are multiple benchmarks, there are multiple layers, there’s multiple issues of transparency and I certainly hope this sort of red herring discussion that we are having just ends.
When I look at the compensation issues and I think I have heard it four times, we have talked about it, that we are changing the benchmark in order to increase bonuses, that we are somehow hiding something, I just think it’s inaccurate. I know we are going to set some of this straight later this afternoon and I intend to address some of this tomorrow it finance and admin but number one if all the consultants are in agreement, and I understand you’re not going to put it riskier contract to have it— at CalPERS to do something you believe is accurate because your other clients are looking and I look to you all for that. So again, I just am a little concerned that Mr. Jelincic lost little bit of direction because and it’s a little bit of a red hearing because we think it’s best for the system and transparency invest to achieve the overall objective which I get I think we lose sight of in these discussions to make sure we obtain the benefit that members are entitled to and this goes along the lines of helping us achieve that, I look forward to a further discussion and so thank you Mr. Jones.
Needless to say, if you need confirmation that the board is content to not even do the basics of supervision, like monitor conflicts of interest, you have it on tape.
Can Costigan really be completely ignorant, say, the conflict of interest resulting from the consultants being hired by staff and therefore having incentives to keep them happy? Did he miss the entire financial crisis, in which ratings agencies gave overly rosy grades to subprime related credit vehicles because the structures were their clients? Or that ratings agencies are famously slow to issue downgrades because they want to stay on a good footing with their clients? Or that compensation consultants have managed to devise norms that result in ever-escalating pay irrespective of performance?
More specifically, Professor Ludovic Phallippou of Oxford, who specializes in private equity, has pointed out how consultants and academics had been comparing private returns to that of the S&P 500 from the mid 2000s to mid 2010. In the last two years, MSCI World has become the preferred point of reference. Why? Because the S&P 500 has been doing very well over the last three years, unlike the MSCI World index. And Sam Sutton, a private equity reporter at Buyouts Magazine, told me it was intriguing to see that CalPERS’ consultant CEM Benchmarking has wound up scoring every public pension fund client he’s written about as having above average performance, which would seem to be mathematically impossible until you allow for artful selection of peer groups.
As we reported in 2015, we caught CalPERS’ private equity consultant PCA trying to implement an absolute return for CalPERS and CalSTRS, which essentially meant ignoring the risks of private equity in looking at its returns. As we explained at the time on this site and at Bloomberg, this was not completely bogus analytically and intellectually, but would also throw the idea of risk measurement out the window. No finance academic would back this approach.
The only thing that stopped this scheme from being implemented on a stealth basis was an op ed in Sacramento Bee by private equity expert Eileen Appelbaum.
Costigan is either so clueless or so inattentive that he missed this sorry episode. There was no benefit whatsoever to retirees or system health to this proposed change. The benefits would accrue solely to staff, in terms of much more favorable bonus targets and greater ability to spin CalPERS performance as adequate. Mind you, there are other examples of staff playing fast and loose with numbers, like the one we wrote up yesterday, but this one was outrageous.
Moreover, Costigan admits staff has motive to seek more pay…they make less than their peers! And then he argues that because consultants back staff recommendations, that there is nothing to worry about.
Of course, since the board sat pat when CEO Anne Stausboll gave Chief Investment Officer Ted Eliopoulos a $135,000 gift via a bonus that violated his bonus formula by paying for non-performance, perhaps Costigan has a point. Senior staff gets paid for performance whether they deliver or not, so why would they need to play games?CalPERS Subscription Line memo