As we discussed yesterday, at a board retreat last week, CalPERS’ staff presented the idea of forming an “independent” entity with its own board and staff to make private equity investments.
It may seem odd that we are criticizing this idea. After all, we’ve been advocating for some time that CalPERS needs to find ways to reduce the fees it is paying to private equity firms, given how much they take out of gross returns at a time when private equity hasn’t been and isn’t expected to deliver enough in the way of net returns to justify its extra risks. It would also be desirable for CalPERS to get more control over its own destiny in light of widespread abuses by private equity firms, as demonstrated by a raft of SEC enforcement actions, when CalPERS and other limited partners do not appear to have confronted any general partner about misconduct.1
Our beef is that while the idea of finding ways of making more direct investments and reducing the role of the private equity middleman is sound, the way that CalPERS is proposing to go about it, even at a high concept level, is very poorly thought out and likely to produce bad results. And separately, it’s disturbing to see staff yet again presenting the board with a fait accompli with no stated rationale and glaring inconsistencies with other initiatives, while insulting the board’s intelligence by pretending to involve it in the process.
Why an “Independent” Private Equity Venture is a Prescription for Disaster
CalPERS’ John Cole tried to put some stakes in the ground with respect to the new venture concept by arguing that CalPERS could use real estate “business models” (a term used far too loosely) for private equity, namely, having an operating company in a separate legal entity:
Senior Portfolio Manager for Global Equities, John Cole:
Another parallel is the potential establishment of an operating or investment company, a separate independent legal entity like we have at CenterPoint in our real estate area today. CenterPoint is managed by an external partner, and it has an independent board and an independent staff. Other examples of captive companies are interesting. There are more than a couple, such as Cadillac Fairview, owned by Ontario Teachers’. There are a number of parallels within real assets from which to learn in developing our overall private equity strategy, and clearly having an independent separate entity or entities and owning assets with an indefinite time horizon are two things we think we should do more often.
CenterPoint and Cadillac Fairview are misleading examples. Both were well established companies when CalPERS and Ontario Teachers, respectively, acquired them. Unless CalPERS is planning to acquire a long-lived private equity firm, they are simply not germane.
Moreover, the way Ontario Teachers is managing Cadillac Fairview, which is a large and diversified developer, owner, and manager of malls, office buildings, and residential developments, raises questions about how CalPERS is overseeing the much smaller CenterPoint. The Cadillac Fairview board is not “independent” in the way CalPERS board members almost certainly interpret that word.
Let’s first understand why the phrase “independent board” would elicit a Pavlovian positive reaction from CalPERS board members. None of them have any meaningful experience managing companies. Their frame of reference comes from public companies, where “independent” directors are seen as a critical check on the directors who are members of management. And we can also see in practice, such as how slow Wells Fargo’s board was in ousting CEO John Stumpf when its fake accounts scandal became the focus of Congressional and public ire, that even those “independent” directors are often not independent enough.
But the need for “independent” directors is due to the inherently deficient governance of public companies: that you have diffuse, arm’s length shareholders who find it easier to sell their stock if they don’t like what is happening than to demand change.
In a seminal Harvard Business Review article, Efficient Markets, Deficient Governance, professor Amar Bhide explained why the public company management/oversight structure fostered by SEC regulations is in fact a lousy governance structure:
For Main Street companies, however, the nirvana of perfectly fair and liquid markets fostered by Wall Street’s regulators has a dark side. Unwittingly, the system nurtures market liquidity at the expense of good governance…. In theory, market liquidity makes it easy for investors to diversify their risks and thus reduces the costs of capital for companies. But there’s a catch: U.S. rules that protect investors don’t just sustain market liquidity, they also drive a wedge between shareholders and managers. Instead of yielding long-term shareholders who concentrate their holdings in a few companies, where they provide informed oversight and counsel, the laws promote diffused, arm’s-length stockholding.
Bhide was over two decades early in identifying key factors that are now contributing to the exodus of executives from public to private companies.
Notice what Bhide stresses: the paramount importance of a close, active relationship between a small group of private owners and the management. Needless to say, that is how private equity general partners administer their portfolio companies. Company execs knows full well that they hold their jobs at the pleasure of their private equity overlords and could be turfed out at any time. Even if the general partner formally grants himself a minority of seats on the board, his control over staffing, budgets, and other key decisions means that the management is on a short leash. His considerable influence over management decisions gives him authority well beyond the power conferred by the formalities of what happens at board meetings. For instance, if the general partner were to clear his throat about the law firm that the portfolio company was using and suggested a change, the switch would be made pronto.
Unlike a private equity acquisition, however, where the general partner is typically “sweating the asset” to improve cash flows and speed a profitable sale, Cadillac Fairview is a mature company that Ontario Teachers regards as a permanent holding. The pension fund depicts it as a source of cash flow, not growth.
Yet even a superficial look shows that Ontario Teachers wields influence on the board and presumably even more informal sway. Barbara Zvan, Cadillac Fairview’s Chief Risk & Strategy Officer, not only came from Ontario Teachers but her role is designed to address important concerns of the owners (meaning ultimately the beneficiaries). This is the first and presumably the most important item in her current job description brief bio on the board website:
As Chief Risk & Strategy Officer, she leads the Strategy & Risk team in supporting the Plan Sponsors in plan design decisions and the Board in determining the appropriate benchmarks and risk appetite.
Jane Rowe, the head of Private Capital for Ontario Teachers, also has a seat on the ten-member board. Goldman partner Jack Curtin who holds another board seat, is likely for commercial reasons to be very attentive to the needs and concerns of Ontario Teachers.
It is misleading for CalPERS to depict Cadillac Fairview and its CenterPoint holding as similar “business models” as far as governance is concerned. Yes, both look similar because they are real estate developers and property owner/managers. And they were established companies when both pension funds acquired full ownership, which in CalPERS’ case took place in 2015.
Another reason that Cadillac Fairview is an unsuitable model for CalPERS private equity aspirations is that the nature of the investment activity and risks are wildly different. As we stressed above, Cadillac Fairview and CenterPoint were established businesses where the investors could examine the operations and management teams. A start-up is a completely different kettle of fish and would require and benefit from more oversight.
While CalPERS might claim that that means the entity needs an “independent” meaning expert, board, the danger here is that any “independent” board will be insufficiently loyal to CalPERS unless it has the direct involvement of competent personnel from CalPERS (be it board or staff members) and would be subject to capture by the private equity hired guns. The private equity venture team would have strong incentives to do so particularly if the structural arrangement with CalPERS allowed them to be fired readily.
Moreover, legal structures in the US could also be used by the private equity team to get the board on their side (if they weren’t already by virtue of CalPERS being so unwise as to allow the new team to influence board picks). Board members in the US have a duty of care and loyalty to the corporation. In this case, it would mean to the venture entity, and not to CalPERS. It’s not at all hard to come up with scenarios in which the board members argue for the venture’s interest, when it may not be in CalPERS’ or its beneficiaries interest, claiming that that is where their legal duty lies.
CalPERS may believe it can hire outside experts, such as members of its consultants, to act as its agents on these boards. This isn’t a good idea. It’s become painfully clear that not only does CalPERS not know what it doesn’t know about private equity, the same is true of its consultants. We’ve pointed out that supposed expert Hamilton Lane’s due diligence merely consists of cutting and pasting from private equity pitch books. Similarly, CalPERS has for years been neglecting an opportunity to beat its benchmark at a better risk/return tradeoff than by investing in private equity: that of investing in private debt. It’s an open secret in the private equity industry that even though private debt provides lower net returns than private equity (historically 11%ish versus 13%ish for private equity) the risk of private debt is so much lower that it’s a markedly more attractive investment on a risk-adjusted basis. While CalPERS does buy private debt, its private equity and portfolio consultants have failed to flag the potential of this strategy, indicating they have yawning gaps in their knowledge. And even if they truly were extremely well versed in vetting funds and recommending private market strategies, that does not translate into the oversight of individual investments.
On top of that, both by virtue of temperament and incentives of their employers, private equity fund consultants would never dare challenge a private equity professional.
Finally, real estate is a much less risky business than private equity, which also means with a seasoned management team and a stable operation, lighter-touch supervision is a reasonable approach. By contrast, limited partners have been unable to prevent routine overstatement of the valuations of portfolio companies as well as various types of what in other lines of work would be called embezzlement. The sort of “independent” board approach that CalPERS is proposing preserves the worst aspect of the current limited partnership structure, which is weak oversight and transparency. Bizarrely, fixing that should be one of the big motives for more direct ownership, yet CalPERS seems to want to allow private equity abuses to continue. Is CalPERS so brainwashed that it’s come to believe it has to accept victimization in order to get adequate returns?
Even though the board clearly could not gather the sort of information to think through these issues, at least some members were alert enough to recognize that having an organization removed from CalPERS with little to no oversight by design was asking for trouble. Notice the bobbing and weaving:
Board Member Theresa Taylor: So Ted, let me ask you a question. I understand and I hear what you’re saying is that this would not be successful if we were asking them to be accountable to the board. But then what happens when it hits the news that our supply chain is using slave labor? And we have no accountability?
Chief Investment Officer Ted Eliopoulos: That is the exact conversation for this board to have and in setting up an entity like this, you would set out the culture and values and investment beliefs that would lay out…the need to have a very defined ESG strategy of its own. There are judgement calls for an entity to make investment decisions. Much of our discussion internally, when we look at our investments, are around was that the right judgement for the right real estate manager…for that PE manager…for the internal fixed income trader who chose to buy a certain security. Did they implement the investment belief?
The fact is that the CalPERS board, and not staff, is the fiduciary on behalf of the beneficiaries. They will be in the line of fire if there are any bad media stories or worse, frauds and abuses. And those happen, as the panelists stressed. Just looks again at the poster child, Ontario Teachers. In comments, Matthew Cunnningham-Cook flagged Buyer beware: How the Ontario Teachers’ Pension Plan got caught in the fallout of Brazil’s biggest scandal. Key sections:
An investigation into money laundering at gas stations and laundromats that began two years ago in southern Brazil has since mushroomed into a wide sweeping corruption scandal, creating a national soap opera that has enthralled Brazilians as it reaches into the upper echelons of the country’s political and corporate elites…
The fallout has included the recent impeachment of President Dilma Rousseff and the arrest of dozens of senior politicians and business leaders. But also caught up in the tumult are hundreds of millions of dollars managed by some of the world’s biggest investors, including Ontario Teachers’ Pension Plan, one of Canada’s biggest and most respected publicly funded pension funds…
Teachers’ original $206-million private-placement investment made in December 2010 is now worth less than $150 million.
The point isn’t that bad deals won’t happen. They are certain to take place. The question, as Theresa Taylor’s slave labor question suggests, that certain types of due diligence failures may be unacceptable, and what if anything can CaLPERS do to prevent them? It appears that one reason CalPERS never concerned itself adequately about the fat fees it has been paying to private equity is that it sees the lack of transparency as a feature, not a bug, that it prefers not to know too much about what those general partners are really up to. It needs to get over its pretense that it can have the upside without taking on more responsibility.
The board can and regularly does delegate authority to staff, but then letting staff set up an organization which it acts as if it can control merely through lofty policy statements is barmy. Pray tell, how many companies live up to their policies on sexual harassment and the treatment of whistleblowers?
Moreover, CalPERS has failed to clue the board in that the most successful example of a pension fund participating in private equity directly, which is the aforementioned Ontario Teachers, runs its private equity direct and co-investing in house. And if you look at its website, it also sets forth investment priority areas, showing that unlike CalPERS, it has a strategy. Mirabile dictu!
What Problem is CalPERS Trying to Solve?
CalPERS has come up with a bizarre and counterproductive remedy to a glaring problem: it is wanting in private equity expertise. But as we’ll discuss in future posts, it has also fallen for the industry myth of “talent” when much of what passes for “talent” in the private equity industry is merely narrow types of expertise that insiders try to keep to themselves. However, private equity has now become such a large industry that many critical elements are no longer state secrets.
The workshop also suggests that CalPERS has fallen for the private equity sales talk that private equity firms have deep industry expertise. Once you get outside some venture funds (recall Theranos got lots of Silicon Valley backing despite all the top life sciences investors turning it down for its refusal to discuss its research) and certain niche private equity funds, the idea that the fund managers themselves have extensive industry know-how is overblown. To the extent they need specialist insight, they hire consulting firms or rent experts as “senior advisers”
CalPERS could get down the curve if it wanted to. The fact that CalSTRS’ board is vastly more knowledgeable about private equity than CalPERS’ is, and that some public pension funds with much smaller resources than CalPERS have successful co-investment programs says that CalPERS’ staff has only itself to blame for the fix it is in now. It is hoist on its own petard of its long-standing effort to render the board passive and minimally informed on private equity.
Similarly, there’s no excuse for CalPERS’ failure to address staff shortcomings. When Mark Anson became Chief Investment Officer of CalPERS in the early 2000s, he saw that members of the investment team needed additional training. Anson, who had a PhD in Finance from Columbia, a JD from Northwestern, and is a chartered financial analyst and a CPA, led twice-weekly after hours sessions himself. Today, CalPERS could require ongoing study from senior investment professionals, organize video courses from top experts, and encourage junior staff members to join in.
In later posts, we’ll give further consideration to the question of how CalPERS can participate more directly in private equity given its skill gaps and its considerable weakness at the board level. It does not help that the most influential board members, Treasurer John Chiang and Controller Betty Yee, have failed to roll up their sleeves and signal to other members of the board and staff that they recognize that private equity requires far more supervision than any of CalPERS other investment strategies. They need to participate more often in private equity sessions, stop deferring to staff and start asking pointed questions. Pretending CalPERS’ expertise problem is insurmountable and continuing to let private equity foxes run the henhouse while CalPERS takes bigger risks is just about the worst approach imaginable.
1 This is not a theoretical issue. Many general partners have admitted to engaging in abuses similar to the ones for which the SEC issued sanctions and ordered restitution. The implicit stance appears to be “If we admit to it, the limited partners can’t say they don’t know about it and are therefore effectively consenting.” But these are clear violations of the limited partnership agreements. Admitting to a contractual violation does not cure it, much the less amount to restitution.