A remarkable section of an official training session for CalPERS board encapsulates much of what is wrong with public pension fund governance as well as the excessive deference of public pension funds to private equity. We will discuss how Ashley Dunning, a partner at Nossaman LLP, lied to CalPERS’ board in its most recent fiduciary training in an apparent effort to defend the staff’s ability to control information flows to the board and disempower it. That is not only a chronic problem at CalPERS but widespread across public pension funds. And as this short vignette demonstrates, fiduciary counsels have become critical enablers of weak boards and staffs run amok.
Background: How Fiduciary Counsels Have Been Weaponized to Disempower Boards and Enlarge Staff’s Turf
One of the big reasons for this pathology is that fiduciary counsels nominally represent the board as their client. But this is a fiction, since at most public pension funds, the very same fiduciary counsel is also counsel to staff. This bizarre dual role establishes a pretense that the interests of the board and staff are aligned. In any supervisor/subordinate relationship, there is a conflict of interest. This conflict is even more acute in financial institutions where employees have access to funds. Why do you think, for instance, that regulators require that bank employees take at least one full week off a year? So that if they are up to no good, someone will be stepping into their shoes for long enough to detect if anything is not on the up and up. The premise that employee who handle funds can be given carte blanche is simply not accepted in the financial services industry, which is rife with checks and supervision of the “trust but verify” sort.
Aside from the problem financial firms worry about most, potential embezzlement or other misuse of funds, there are numerous soft conflicts. At an institution like CalPERS, the biggest is that internal staff members in its funds management operations aspire to better-paid jobs in the private sector. That can foster a mind set of wanting to curry favor with counterparties who have financial interests that are in many ways opposed to those of investors like CalPERS, such as in matters like fees and other investment fund terms. Insiders tell me that public pension fund employees often believe that private equity general partners would be willing to give them referrals when they were looking for a job. That is a powerful inducement for favoring their career interest over the interest of their current employer.
The role of a fiduciary counsel would be less problematic if pension fund boards and staff each had their own legal representation. While CalPERS has never had two separate fiduciary advisors with distinct roles, in the past, there was a very clear emphasis on the primacy of the fiduciary counsel’s role representing the board. .1 With the way this dual role operates at CalPERS, it is ludicrous to think that the fiduciary counsel has the board as its primary client in practice. Among other things:
The staff screens candidates for the fiduciary counsel role, interviews them and presents its scoring and de facto recommendation to the board. Staff has its finger very heavily on the dial of fiduciary counsel selection. The proof at CalPERS is that in the selection of its previous fiduciary counsel, staff withheld from the board critically important information, that its pick, Robert Klausner, which the board approved, had been involved in questionable behavior since the late 1990s that had been repeatedly reported in the media, including the New York Times and Forbes, and was currently involved in a potentially criminal scandal in Jacksonville, Florida.
Staff directs the work of the fiduciary counsel, receives its invoices, and pays its bills.
How Ashley Dunning Lied to the CalPERS’ Board
The key segment is short. The key part starts at 36:50 in the video below:
Board Member Margaret Brown: So when I look at this duty of prudence regarding terms, so are we talking about terms of the agreements we sign with general partners in private equity, because I go back to page 5 and you talk about the changing legal landscape. And we are supposed to have increased tolerance, you say for less LP friendly terms, so I assume that means worse terms. And then here, we’re supposed to have a duty of prudence regarding terms, except my understanding is the agreements are secret because they are trade secrets so we don’t get to see the terms a lot of times, that’s my understanding. So I’m just wondering how do we have our fiduciary duty regarding the terms when we don’t see them.
Ashley Dunning, Partner, Nossaman LLP : So there was a lot packed into that question. Let me see if I can address a couple of components of it. The first point is on slide 5 when I say increased tolerance for less LP friendly terms. I’m not suggesting that’s a good thing. What I’m saying it that is a reality I understand exists, particularly in certain asset classes. And I’m basing that on my partners very close to this in terms of the investment side of it, what she’s seeing.
The fiduciary duty applies to the big picture. Is this a prudent investment under all of these circumstances, one component of which is terms, the other, another component is is this a great fund for us to get into, and are we willing to sacrifice on some terms in order to be able to get into the fund? That’s the analysis.
When one says, “We don’t get to see the terms,” we CalPERS see the terms. Those are negotiated, you have delegated some of that authority to your trusted staff, and that is fundamental to that relationship, that those terms be negotiated in a way that your staff can say to you, “We believe these terms are prudent. And here’s why.” And if there are reasons why the document itself is not to be shared more broadly, those may be to protect the value of your investment as well ’cause you won’t get into a particular fund if those terms were specifically provided to the full board.
Notice the position that Dunning is taking: that is it kosher for the staff to withhold fund documents from the board, even though the board is in a fiduciary role and is ultimately responsible for any decision. 2
Dunning falsely pretended she had actual knowledge based on the reading of a partner that she presented as being on the investment side. That amounts to hearsay and is also from a party who has a commercial conflict, since anyone working on limited partnership agreements, even if they are nominally representing investors, are reluctant to upset the private equity apple cart, since representing the general partners or their portfolio companies is vastly more lucrative. The sorry fact is that it is well nigh impossible for someone like CalPERS to get truly independent advice from someone seasoned in the private equity space.
The problem of a business conflict is even more acute at a San Francisco law firm like Nossaman, where any firm with a corporate law practice will have private equity portfolio companies as a large amount of its practice and will be seeking to cultivate good relationships with private equity general partners to get even more business with them. Serving CalPERS is pocket change compared to the private-equity related opportunities.
More troublingly, Dunning presented the utterly bogus idea that some funds would insist as a condition of investing in the fund that the board of the institution considering an investment commitment not be allowed to see the offering or contract documents.
No competent investor would allow that. The most sought after investors, such as prestigious endowments like Yale, as well as heavyweight fund of funds like JP Morgan, would never tolerate such a requirement and therefore it never happens. At a large number of very important investors, the boards are integrally involved in making decisions on private equity investments. Moreover, unlike CalPERS, many institutional investors have professional investors on their boards who would never accept not being allowed to see the key documents describing an investment. Generally, investors have “most favored nation” clauses which would entitle them all to the same privileges, so it’s not even feasible to say, “Your board can see the documents but that other board can’t.” Either Dunning fabricated this idea on the fly to get herself out of a corner or she parroting false information given to her by staff.
Moreover, Dunning also sells the urban legend that there is such a thing as being able to pick a “great fund” ex ante. There are such things as “hot funds” that investors think will perform well. However, even with private equity academics being overwhelmingly captured by the industry due to the fact that they can earn vastly more in consulting fees from them than they can from their day jobs, recent studies have demolished the myth that private equity investors can pick funds that will outperform. In fact, the approach that did work back in the 1990s, of trying to pick the “top quartile” funds that did well on their most recent fund, produces results worse than just using a dartboard. Top quartile funds are slightly more likely to underperform on their next fund than a random pick.
Dunning provides additional misinformation with the notion that CalPERS staff negotiates private equity terms. As CalPERS’ own staff ‘fessed up in its 2015 private equity workshop, limited partners like CalPERS do not negotiate private equity terms in any meaningful sense. For instance, fees are set by the general partner and at most vary by the amount of fund commitment. Limited partners have little say over vast swathes of critical language, such as indemnification, the de facto waiver of fiduciary duty, and clawbacks. To the extent there are negotiations, they focus on a few terms, like “key man” provisions, which almost never comes into play. This ritual keeps private equity staffers employed and perpetuates the myth that these documents are negotiated, as opposed to almost entirely “take it or leave it.”
It is also noteworthy that when board member Brown focused on it, Dunning didn’t retreat from her statement that investors were seeing less favorable terms. The financial press has repeatedly pointed out that this is the result of investor desperation for returns as a result of many years of super low interest rates. Most articles also describe the market as frothy and the tight terms being a cyclical phenomenon. It is curious, to say the least, to see a nominal advocate for the board not present a more balanced picture.
Finally, Dunning also subtly reinforces the notion that the board has to be utterly passive if it “trusts” staff. This is nonsense. No one who is competent delegates authority fully; that sort of thing occurs only in with impaired or extremely unsophisticated principals, the cliched widows and orphans. Dunning’s position is even more reckless for an institution which has a former CEO now in Federal prison for literally taking cash in a paper bag from a private equity placement agent.
Yet Dunning acts as if the board, which is supposed to be in the ultimate “buck stops here” role, must kow-tow to staff if it has delegated a duty to them as opposed to do what bosses do with subordinates, monitor how they are doing on an ongoing basis, and that is more than just an annual review.
This incident is yet another manifestation of the culture of casual lying at CalPERS. The time is long overdue that it stop. It enables poor decisions, inadequate risk controls, and in this instance, undue deference to private equity firms when academic studies have shown that investors can attain similar and even higher net returns through public market investment strategies. A $300 billion pot of money with inadequate supervision is a prescription for disaster. CalPERS’ flagging performance bears that risk out. But there appear to be way too many people who profit from poor governance for that to change any time soon.
1 We say only “less problematic” because private equity firms are the single largest customer for law firms in the US. It is very difficult to find truly independent representation because law firms have such powerful economic incentives not to cross swords with them.
2 It is unfortunate that new board member Margaret Brown repeated the private equity industry myth that private equity fund documents have anything in them that even remotely approaches trade secret status, a notion we have debunked repeatedly based on having published and examined many limited partnership agreements and having spoken to insiders who have read other agreements and confirmed that there is nothing particularly distinctive about any they have seen. However, Dunning didn’t pick up on that as the basis of her argument.