In a bit of synchronicity, Pensions & Investments published a story based on an interview with incoming CalPERS board member Margaret Brown in which she discussed the glaringly obvious reasons why CalPERS’ plans to hire high-priced private equity middlemen like Blackrock is a bad idea.
I was planning to write on the dodgy “outsource private equity” scheme today for a different reason: I’ve been very tardy in writing up two important stories by Sam Sutton of PE Hub. As we’ll discuss below Sutton reported on how CalPERS has been moving these plans forward out of public view. Not only is this at odds with how CalPERS staff said it intended to proceed at an offsite last July, when they first broached the idea. Advancing this program in private is a violation of California’s Bagley-Keene Open Meeting Act. CalPERS isn’t entitled to shield hot topics from the public just because it feels like it. And the fact that CalPERS is unwilling to have proper public disclosure and decision-making on a plan that flies in the face of industry trends and will hurt beneficiaries by increasing costs, confirms that the staff and board know they can’t defend what they are up to.
Background: Why Hiring Pricey Private Equity Middlemen is an Indefensible Idea
If you are up to speed on this issue, skip down to the next bold heading. But this is important background if you are new to this topic or have only a dim recollection of our earlier posts.
CalPERS first introduced the astonishing idea of outsourcing its private equity program to middlemen at a board offsite last July. The presentation included a discussion with experts, all of whom either are in the private equity industry or have financial disincentives to rock the boat; there was no independent viewpoint.
In yet another example of the culture of casual lying that has become institutionalized at CalPERS, staff falsely depicted CalPERS as considering a range of options, including building up an in-house team and doing more co-investments, and said they would come back to the board to brief them with more developed ideas. Instead, as the Sutton articles we will discuss later reveal, rather than look at all options further, staff has moved as quickly as possible with the scheme of outsourcing private equity, and even worse, potentially on a very large scale, when the staff gave the impression in July that even if they went the outsourcing route, only a relatively small portion of the portfolio was up for grabs.
A particularly ugly bit is that CalPERS staff presented BlackRock’s Mark Wiseman as an independent expert in July. Less than two months later, Bloomberg reported that CalPERS was negotiating with BlackRock to outsource some or all of its private equity business. This was totally improper on multiple levels: failure to hold further discussions in public (as board member JJ Jelincic has pointed out, this matter is not entitled to state secret treatment, since it is neither an investment nor a personnel matter), failure to appraise and get approval from the board, failure to go through a request for proposal process. This is so corrupt-looking one has to wonder what the real motivations are.
CalPERS’ sense of entitlement to move forward without board involvement was so strong that when CEO Marcie Frost contacted me in early September just before the Bloomberg story broke to propose an in-person meeting (which I initially accepted but later fell apart due to my insisting any conversation be on the record). When we settled on New York in late September, she mentioned wanting to schedule meetings with BlackRock and Wilshire around the time she would see me. She would not have made that comment if she thought the meetings were controversial, when she should have recognized it as such. BlackRock is not currently a consultant to CalPERS. It is hard to imagine any reason for someone at Frost’s level to have wanted to meet with BlackRock save to advance the private equity scheme.
Caught out by Bloomberg, CalPERS then included a “Follow Up on Private Equity Business Models” as a closed session item, meaning secret from the public, to cover its tracks with the board. Again, there is no legal justification whatsoever to hold discussions of strategy or possible outsourcing in private. As JJ Jelincic said at the time, “I have read the agenda item and can see no reason that it’s in closed session except to save staff from embarrassment.”
We’ve covered the glaring problems with this outsourcing plan in previous posts, such as CalPERS Board Uncomfortable With Staff’s “Fire, Aim, Ready” Plan to Create Unaccountable Private Equity Vehicle; here is a recap from September:
We described at length in an earlier post what a bad idea this is. It is made even worse by the fact that it is a bait and switch. It is inconsistent with the “business models” that CalPERS presented to the board at an offsite in July. As we wrote:
CalPERS will pay more in fees with BlackRock and there is no reason to expect improved performance. As the former Chief Investment Officer for North Carolina, Andrew Silton, stressed, CalPERS is such a large investor in private equity that is unlikely to achieve better than index-like returns. And it’s a no-brainer that introducing another intermediary means more fees and costs.
BlackRock would effectively be a dedicated fund of funds manager for CalPERS, an approach that is typically used only by small fry, like high net worth individuals and and smaller institutional investors, or for bigger players, to achieve adequate diversification for small, niche-y strategies (say if CalPERS decided to make an allocation to infrastructure in Latin America).
It is remarkable to see CalPERS consider outsourcing, since going in the direction of increasing its cost flies in the face of prudent investment management. It also contradicts the approach CalPERS takes in all other strategies in which it invests, where it has a strong focus on expense reduction and manages many of its investments in house because it is cheaper.
Private equity expert and board candidate Mike Flaherman estimated that even if CalPERS negotiated “heroically” that it would pay an additional .20% in fees plus a share of the profits. That means $50 million at a bare minimum versus the roughly $5 million of cost for CalPERS’ current internal team. Moreover:
…it is likely that BlackRock’s compensation will rise over time, as CalPERS will likely pay a much lower fee for BlackRock to monitor legacy investments made by the CalPERS team compared to the compensation paid for new investments sourced by BlackRock. Over time, the CalPERS-sourced investments will be harvested and replaced by BlackRock-sourced ones, likely leading to large cost increases.
To add insult to injury, CalPERS staff failed to tell the board that Mark Wiseman of BlackRock, who staff presented as an independent expert at the July offsite, was very much an interested party.
Even if you were to accept the premise that this outsourcing scheme is a good idea, it is also remarkable to see CalPERS considering only one vendor for it, when many firms would likely be interested in managing the program, and on top of that, a firm that has treated CalPERS badly in the past. The Stuy Town deal was controversial internally when it was under consideration, and there were multiple parties who argued that it was a bad deal .Some people directly involved say that BlackRock had made misleading representations in marketing the deal and also treated CalPERS unfairly as it unravelled. Unless BlackRock has somehow made up to CalPERS for the loss, which seems impossible given its magnitude, it is hard to fathom why CalPERS would be willing to do business with an organization that has dealt with them in bad faith in the past.
Brown’s Criticism of the CalPERS Scheme in Pensions & Investments
It’s a good sign that the press is keen to talk to Margaret Brown. Randy Diamond’s story, New CalPERS board member leery of private equity takeover, recapped three points Brown made in her chat:
“We don’t need another layer of fees,” said Margaret Brown in a phone interview on the potential hiring of BlackRock….
Ms. Brown also questioned the propriety of BlackRock’s head of global active equity, Mark Wiseman, participating in a public discussion at a July retreat meeting on the future of the system’s private equity program…
At the time Mr. Wiseman was making public comments, Ms. Brown said she wanted to know whether the negotiations between CalPERS and BlackRock were already underway. Mr. Wiseman did not comment specifically about a relationship between CalPERS and BlackRock at the meeting, centering his remarks on the direct investment private equity model and pitfalls CalPERS might encounter if it tried that direction.
“We need transparency here,” said Ms. Brown…
She also said that she is concerned that CalPERS has not filled the vacancy of Real Desrochers, managing investment director of private equity at the pension system, who left in April…
Ms. Brown said leaving the position open can enhance the case to turn over the program to BlackRock because CalPERS can claim it does not have a leader of the program and needs outside help.
CalPERS made a non-substantive comment and BlackRock declined to comment.
CalPERS Has Been Moving Forward in Secret….Which It Wouldn’t Be Doing if This Scheme Were Good for Beneficiaries
Sam Sutton published two important articles giving more details on how CalPERS has been working to advance this scheme secretly. In an October 18 article, CalPERS weighs bringing in UC Regents in creation of separate PE entity:
California Public Employees’ Retirement System is considering partnering with other institutions like UC Board of Regents in its construction of separate entities to invest in private equity, a
document obtained by Buyouts shows.
The document, from the closed session of its Sept. 18 board meeting, sketches a number of ideas for creating separate PE investment entities. Among those are “partnerships with others like UC Regents,” according to the document.
Again, there’s no justification for keeping beneficiaries and California taxpayers in the dark, particularly when CalPERS plans to or actually has put out feelers to third parties like UC Regents.
In mid November, PE Hub published CalPERS hopes to have finalists for independent PE platform by early 2018. From Sutton’s story:
California Public Employees’ Retirement System is moving forward with plans to bring on an outside firm to manage its $25.9 billion private equity program, internal documents obtained by Buyouts show..
CalPERS sta? plans to introduce the two best candidates to manage the platform to CalPERS’s investment committee in the frst quarter. The goal is to launch the new partnership “as close to the new fiscal year (July 1, 2018) as possible,” the staff presentation says…
CalPERS’s criteria for a potential outside manager includes an ability to commit “a material amount of their own capital alongside the investments they select for CalPERS,” the sta? presentation says. The ?rm would also have to act as a ?duciary and “champion” of the system’s guidelines on environmental, social and governance issues, as well as sustainability.
Notice how utterly dishonest this is. Contrary to the clear requirements of California’s Bagley Keene Open Meeting Act, the public has been denied the opportunity to review and provide input on this program to enrich the private equity industrial complex further at the expense of CalPERS’ beneficiaries.
Not only will the costs for this program unquestionably be higher, there is no reason to expect any improved performance. CalPERS is so large that the best it can expect to be is de facto indexer.
Moreover, CalPERS is certain to be unable to get real “talent” to manage this program, save by taking the time to build an in-house team (Ludovic Phalippou of Oxford says he has qualified former students who would make very good hires for CalPERS, so the idea that CalPERS would not be able to build an internal effort is a myth the current leadership seems desperate to propagate). The false deadline of the next fiscal year looks like a deliberate effort to rule out courses of action that have vastly more upside for CalPERS but would make current management work, something they appear loath to do.
Top tier players like KKR and Silver Lake would not accept, say, a Carlyle managing their funds. The fact that CalPERS is relying on the advice of conflicted consultant Hamilton Lane, whose fund level due diligence consists mainly of cutting and pasting general partner documents, illustrates what a garbage-in, garbage out exercise this is.
Finally, this sorry discussion leaves us with only one reason that CalPERS is moving forward with this dreadful idea: it finds it more expedient to engage in more and more cover-ups, via shielding private equity from scrutiny, rather than grapple with the drivers of its poor performance. That would include first and foremost, addressing the fact that the current Chief Investment Officer Ted Eliopoulos isn’t capable of doing the job. This proposed program is thus a hugely costly effort to cover for his shortcomings by dumping the highest-risk but also highest-upside-potential investment on outside parties.
Readers need to rally behind Brown’s efforts to demand that CalPERS do better. Let’s hope for the sake of CalPERS’ beneficiaries and California taxpayers that she makes real headway.