A few weeks ago, we obtained the text of a memo from Silicon Valley lawyer Larry Sonsini of Wilson Sonsini Goodrich & Rosati fame, to key CalPERS executives. It came from someone not with CalPERS. An insider confirmed that this memo, created in January, was presented to the board in May during its meetings.1 We’ve embedded the document at the end of the post.2
Overview of Sonsini Memo and Its Implications
This memo raises huge red flags about the caliber and honesty of CalPERS’ initiative, including:
The Sonsini document is pathetic. The fact that Sonsini would provide it and CalPERS would accept it shows how cavalierly the key players are treating what would be CalPERS’ biggest decision in the last ten years
Sonsini blows off the idea that CalPERS’ fiduciary duty is important when that is its paramount legal duty
Sonsini misleadingly presents a limited partnership as CalPERS’ only option, when that is not only unnecessary but also serves to institutionalize the worst features of private equity governance
Sonsini and CalPERS are also pointedly ignoring real opportunities for CalPERS to cut a better deal
The only plausible theories for what CalPERS is planning to do are utter incompetence or rank corruption
The Sonsini piece is an incredibly shoddy work product. One private equity professional said it didn’t even rise to the level of being bad.
The most charitable thing one can say about it is that it appears not to have any typos. If I had received a document like this from a lawyer, particularly from a high priced one, I’d demand to have the charges related to it removed from the bill.
It’s one thing if Larry Sonsini sent this napkin doodle to CalPERS executives to play back to them what they said they wanted. But if Sonsini were acting as a lawyer, or even a professional, even this rationale does not pass muster. And since this memo from Sonsini has been presented to the CalPERS board, the only conclusion one can reach is that Sonsini is willing to have this joke of a document treated seriously.
But the fact that CalPERS isn’t getting anything that approaches legal thinking isn’t the biggest reason to be concerned, although it does speak volumes about the utter lack of care with which CalPERS and its supposed professional advisors are approaching this very risky project. It’s that it confirms yet again that CalPERS is not placing beneficiary interests first, when that is its paramount duty.
The only conceivable justification for the approach CalPERS is taking is that CalPERS is giving top priority to reducing transparency. And as we’ll discuss, one of the side effects of that will be to increase the odds of fraud, which should in and of itself make this idea unacceptable.
Background: Brief Overview of What We Know About CalPERS’ Plans
Even though CalPERS has said inconsistent things about its planned private equity outsourcing (for instance, Chief Investment Officer Ted Eliopoulos brushed off the idea that CalPERS intended to reduce fees, while CalPERS’ head of PR Brad Pacheco said the reverse), this chart below is current state of play. The marked-up image comes from one of the slides that accompanied a CalPERS press release:
Notice that the board mentioned in the text in the slide would have members from “subsidiary boards.” That implies that each of the two investment approaches will have its own board, with the result that there would be two layers of boards between the funds and the CalPERS board. Talk about a lot of opportunities to distribute political favors at beneficiary expense via the fees paid to all these directors!
Notice also that these two investment approaches are labeled 3 and 4. Page 3 of the slides CalPERS published showed that approach 1 would be “Emerging Managers”. That is an existing program that also happens to be CalPERS’ worst performing sub-strategy within private equity. CalPERS intends to double down on failure by expanding that.
Approach 2 is the “Partnership Model, which we assume is the fund of funds program for which CalPERS solicited proposals in December, in a cronyistic process designed to favor BlackRock. It has been far too clear that Chief Investment Officer Ted Eliopoulos and perhaps other members of staff have been laboring mightily to throw this business to BlackRock. If that is correct, it is an explicit violation of the “Fiduciary Duties” section of the California Public Employees’ Retirement Law and would automatically disqualify BlackRock as a potential vendor. 3.
Putting aside the obvious corruption in steering an investment mandate to a pre-chosen vendor through a sham competitive process, we have described at length how this funds of funds scheme represents violation of CalPERS’ fiduciary duty based on its economics alone. It would introduce an unnecessary middleman and lead to another layer of fees and costs.
There is no justification for a large institutional investor like CalPERS to use a fund of funds except in niche strategies, and that would be because the amount of money at issue would be small and CalPERS would have difficulty getting a diversified portfolio within that strategy.
How the Sonsini Memo Shows Sonsini and CalPERS Are Violating Their Fiduciary Duties
Let’s start from the very end, where Sonsini shrugs off CalPERS’ fiduciary duties:
The imposition of a Fiduciary Duty standard (e.g.. a duty of loyalty and a duty of care) will be considered and taken into account in balancing and formulating the foregoing Roles and Responsibilities of the various constituencies.
All CalPERS beneficiaries reading this post should stop now and send an e-mail to their Assemblyman and Senator expressing their alarm and outrage. CalPERS fiduciary duty to its beneficiaries is imposed by the California constitution and the Public Employees Retirement Law.
CalPERS cannot contract its way out of or compromise its fiduciary duty, as Sonsini suggests. He appears to be unfamiliar with the standards that apply to actual fiduciaries like retirement funds and trustees, as opposed to the lower standard that applies to corporate officers and boards. The fact that he committed this idea to writing says he is unfit to advise CalPERS.
Sonsini is laying bare one of the dirty secrets of private equity and hedge fund investing: the documents routinely give lip service to the notion they they respect all applicable law, which would include their and their investors’ fiduciary duties, and sometimes even specifically acknowledge that they have a fiduciary duty. Yet other sections of the very same agreement contradict these provisions, such as through indemnification language that sheds key elements of fiduciary obligations, as well as terms that allow the general partner to consider other interests, including his own interest, when a fiduciary duty standard means he has to put the interest of the beneficiaries over all other interests. We’ve provided examples from our trove of private equity limited partnership agreements. A May 31 filing by the plaintiffs in Mayberry v. KKR discusses this issue at great length, arguing that the fiduciary duties are “non-dilutable non-evadable legal obligations” imposed by both Federal and state law.
Sonsini serves up a limited partnership as if it were the only option… when there are only bad reasons to do that.
One of the striking things about the memo is that it assumes that CalPERS will use a limited partnership structure for its new InDirect initiatives. From the beneficiaries’ perspective, there is no valid reason for CalPERS to relegate itself to being a passive investor in investment vehicles it is creating de novo where it is providing all the money for them, particularly when CalPERS has been maintaining it will be hiring new staff for them.4
A limited partnership structure unnecessarily institutionalizes the bad governance features of investing in private equity. The disadvantages include:
No control over the investments and the operation of the funds. Don’t kid yourself, the Advisory Board is purely advisory. The Sonsini memo makes clear that the “General Partner” would have “sole authority over investment decisions.” Sonsini is so clearly out to protect his industry meal tickets and not CalPERS that he won’t even provide for improved governance rights even within the inherently disadvantaged framework of a limited partnership, like veto rights over investments and other important decisions.
And CalPERS doesn’t even get to pick the Advisory Board members. CalPERS’ choices are made “in consultation with the General Partner.” That assures that, as occurs now with private equity funds, the wily General Partner will be able to stack the Advisory Board with individuals who have suitable-looking backgrounds but are sure not to cross swords with the General Partner. So even the weak powers that Advisory Boards would have on paper are sure to be diluted further in practice.
Lack of influence over staffing or pay levels. Despite Eliopoulos maintaining otherwise, the new vehicle, not CalPERS, would be in charge of staffing and compensation.
Premier venture capital investor the Kauffman Foundation wrote at length in a classic study, We Have Met the Enemy and He Is Us, about how the tacit acceptance of the limited partner community of one-sided compensation structures that failed to reward performance even when 89% of the limited partners said management fees were excessive. Kauffman also described at length why the conventional 20% carry fee also produced misaligned incentives.
Yet when CalPERS is in a position to do something about these prevailing bad terms, CalPERS staff and Sonsini seem utterly uninterested in this issue.
Kauffman is equally adamant about the importance of understanding how the general partner structures its own arrangements…a topic that Sonsini and CalPERS staff bizarrely avoid when CalPERS plans to be the sole investor in each fund and is creating the new entities. Recall that by contrast, Kauffman is always and ever a limited partner in existing funds, yet argues that the failure of limited partners to get this vital information is due to a combination of ignorance and cowardice:
When VCs conduct due diligence on potential portfolio companies, they carry out a comprehensive assessment of the company’s financials (cash flow, burn rate, keyexpenses, and stock option plans, etc.) and require complete detail on senior management team salaries, bonus amounts, ‘skin in the game,’ and equity ownership. GPs know this information is crucial to understanding company financial health as well as management team incentives, stability, and succession. Every GP we interviewed acknowledged the essential importance of senior management team compensation in their portfolio company investments. One GP emphasized its significance, saying that not only does his firm “know everything about the compensation…a lot of times we structure it.”
LPs have the exact same interest in understanding the firm economics of the partnerships in which we invest, and the compensation structure of the GPs investing our capital. LPs also have the same fiduciary obligation as GPs to understand the economics and incentives that underlie investments, and to evaluate how fees, carry, and ownership align investor and investee interests. What LPs seem to lack is the conviction to require the information from GPs in the same way the GPs themselves require it. Even more disconcerting, investment committees and trustees fail to require a disciplined approach to understanding and evaluating firm economics of VC partnerships to which they allocate, approve, and oversee large capital investments.
That lack of influence also means if any scandals, say involving allegations of sexual misconduct or discrimination, were to arise (see Steve Jurvetson as an example), CalPERS would have no ability to intervene.
Similarly, the Sonsini document gives lip service to CalPERS’ ESG [environmental, social, and governance] concerns, but how those were implemented (if at all) is up to the General Partner, meaning outside CalPERS’ control.
Continued sketchy to non-existent portfolio-company level reporting. It is hard to think that Sonsini has CalPERS’ best interests at heart given language like this:
Provide full transparency as to portfolio company performance, Direct Investment Entity performance and overall investment policy guidelines consistent with regulatory requirements, CalPERS guidelines, and industry best practices.
This statement is shockingly short of what any company owner would demand, and therefore what would be required if Sonsini took fiduciary duty seriously. CalPERS stipulating an even lower standard of fee and cost disclosure than is now provided for in the watered-down private equity transparency bill, AB 2833.
More importantly, this language does not require that CalPERS board and staff receive copies of the full audited financial statements of all portfolio companies, copies of all interim financial statements, and full and timely disclosure of all fees and costs paid to the General Partner and any affiliates, most importantly including those paid by portfolio companies.
You can drive a truck through the loophole that Sonsini has included on behalf of his meal tickets in the private equity industry:5 “industry best practices.”
The Japanese call this sort of thing “a height competition among peanuts,” meaning the standards are so low it is hard for any non-peanut to see the difference.
Private equity industry norms are appallingly anti-investor. For instance, after the SEC found that more than half the private equity firms were cheating, which often meant stealing from investors, the firms’ answer was typically not to stop cheating, but to act as if admitting to the abuses in their annual SEC filing, the form ADV, made it all OK. Similarly, only a small number of general partners have endorsed the Institutional Limited Partners’ Association’s recent fee disclosure template.
Lack of influence over how the companies are operated. Sacramento political commentator Dan Walters pointed out that one reason to be concerned about private equity investing was its track record of asset stripping and employee layoffs. Again, CalPERS would have no ability to intercede even if a CalPERS fund were cutting jobs in California and thus hurting the ability of CalPERS’ employers to make their contributions because the fund’s own actions were damaging local tax bases.
Sonsini also perversely seeks to further weaken this already poor arrangement by the unnecessary stipulation that the Advisory Board be “independent of all the other constituencies.” What kind of rubbish is that?
The intent of the Advisory Board, even in its very weak way, is to protect CalPERS’ interest (this is the primary role they are depicted at playing in private equity limited partnerships now). It is therefore essential that CalPERS’ interests are well represented and that parties loyal to CalPERS dominate the board. Fetishizing independence in this context looks like Sonsini is scheming on behalf of his other clients against CalPERS.
Moreover, it is hard to dream up any justification for using limited partnerships:
The business models CalPERS cited at its workshop last July weren’t limited partnerships. Cadillac Fairview, the real estate firm owed by Ontario Teachers, and its own Centerpoint, which was a REIT CalPERS took private, are not limited partnerships. With Centerpoint, CaLPERS has contracted with an outside fund manager to oversee its interests in the company.
CalPERS has the authority to hire private equity professionals on competitive terms. It does not need to use a limited partnership or even an independent company to pay market rates.
CalPERS has the ability to pay fully competitive prices to employ private equity professionals as staff members. Contrary to the palaver regularly peddled by uninformed commentators like Leo Kovilakis, CalPERS does not have to use an outside entity, much the less one it chooses not to control, to attract private equity “talent.”
Per California Government Code Section 20098, CalPERS’ board had the authority to set the compensation level of “investment officers and portfolio managers whose positions are designated managerial.” Board member Richard Gillihan, the governor-appointed Director of the California Department of Human Resources. has pointed out that CalPERS could pay $10 million a year as long as it could justify the comp level. Other experts have pointed out that the legislature would agree to a CalPERS request for a narrowly-tailored waiver to allow CalPERS employees to have a carry-pool-type incentive structure.
Aside from rank corruption, the only other rationale for the proposed structure is indefensible: to escape disclosure and transparency. This scheme would mean CalPERES beneficiaries and California taxpayers would have virtually no idea what was happening with 10% to 15% of CalPERS’ funds. CalPERS would wriggle out of the quarterly fund by fund performance report mandated by a 2002 settlement with the Mercury News. CalPERS InDirect, and thus all of the private equity activities CalPERS shifted over to it, would not be subject to the Public Records Act. The top brass of the new entities would not have to show up occasionally at CalPERS public board meetings and have to ‘splain themselves.
This is consistent with what we surmised earlier based on CalPERS’ PR push last month:
Eliopoulos apparently wants to relegate CalPERS not only to being a mere limited partner, as in a passive investor, in its two additional investment rackets, but to interpose two layers of boards between them and CalPERS. One can only conclude he wants to make damned sure CalPERS has no idea what is going on with the money it commits to these vehicles, and that they are even more of a black box than private equity is already. It appears that avoiding even the weak disclosure called for by California law is of paramount importance.
The limited partnerships’ weak reporting, non-existent control, in combination with CalPERS’ plan that they be evergreen is an invitation to valuation fraud. Valuation abuses are already widespread in venture capital and private equity. A recent study found that every one of the 116 unicorns where the researchers could obtain the needed data was overvalued, with the average overvaluation a stunning 49%. Similarly, private equity portfolio companies are regularly overvalued around the time the general partner is raising a new flagship fund, during bear equity markets, and late in a funds’ life.
One check on private equity overvaluation is that fund managers are under pressure to realize profits.6 A reason limited partners aren’t exercised about the open secret of general partners inflating their companies’ values from time to time is that the relatively short holding period of the typical company means that serious lies get caught out when the companies get sold at a loss. That sort of things makes a general partner look bad.
The widespread assumption is that the fibbing, while widespread, nevertheless gets eased out of the valuations before a sale catches the general partner out. Long investment time frames in combination with lax reporting and oversight make it too easy for the fund managers to engage in flagrant overvaluation.
CalPERS and Sonsini are failing to meet the duty of care. A fiduciary is required to meet a duty of care, which Law.com defines as: “a requirement that a person act toward others and the public with the watchfulness, attention, caution and prudence that a reasonable person in the circumstances would use.”
Deficient legal work, and on top of that, presenting outdated documents to a governing body as if they were current, fall visibly short of that standard. But we have also documented at length how regularly staff lies to the board, to its beneficiaries, and California taxpayers. We see here that the board members are so clueless or lazy that they don’t even catch when they are enlisted to lie on behalf of staff.
Consider this statement by Investment Committee Chairman Henry Jones in CalPERS’ May 17 press release, made after the Sonsini memo was presented to the board:
That long horizon also gives the CalPERS Board an opportunity to influence the culture of CalPERS Direct to ensure their actions are in sync with our Investment Beliefs.
CalPERS board will have absolutely zero influence over CalPERS InDirect. It will barely even have any access to its professionals. You can be sure that even when that does happen, it will be highly staged events. Jones looks like a fool for saying otherwise. But the staff appears to have chosen its marks well, because Jones looks like the sort who will reject any negative information out of hand, most of all when it involves him.
It is a slap in the board’s face to be presented with a sketchy memo that is more than four months old. No explanation is pretty. One indicator of how stale this document is: it refers to only one Advisory Board when CalPERS now plans to have at least two Advisory Boards, one for each fund that will implement its two whiz-bang InDirect investment strategies.
Also notice a topic in the memo we have skipped over due to not wanting to tax reader patience further: that of the Private Equity Strategic Partner.
What Sonsini has set forth is CalPERS entering into a well-established type of investment arrangement, a separately managed account, with an existing private equiy general partner, dressed up to satisfy CalPERS unwarranted sense of self-importance as a Private Equity Strategic Partner.
The fact that there is nothing new here might be Sonsini’s excuse for dialing his work in. He may have see himself as doing CalPERS a favor by not trying to gild a tired old lily. But the comments of Ted Eliopoulos, Henry Jones, and other board members suggest that they don’t understand the basic of private equity investing or are choosing to deceive themselves.
Now it is possible that CalPERS and Sonsini have changed their thinking since January, but that means the board is being given the mushroom treatment.
I’m sure the lawyers in the house will have great fun with the memo, so let me limit myself to just one glaring deficiency: the failure to define key terms.
If this document were meant to be legal work, it should define terms clearly. You can see the memo instead takes up the widespread, and imprecise use of the term “general partner,” which is used colloquially to mean any of the legal entities that comprise a private equity firm used to make the general partner’s financial contribution to the investment fund (and that legal vehicle is typically a corporation), the investment firm that the general partner contracts with to provide investment management services to the investment partnership, or the specific natural persons employed by that investment firm who provide those services to a particular fund. Sonsini couldn’t be be bothered to sort that out.
Even back in January, independent parties who were paying attention to CalPERS’ private equity plans could see CalPERS’ conduct was not on the up and up. We wrote then:
As a Harvard Business School contemporary who has spent his career in investment management said, based on reviewing CalPERS’ materials:
For a public pension fund well known for corruption and “pay for play” activities, this under-the-coat activity is astounding. Every current and future pension recipient should question the Watergate-like behavior of CalPERS.
Last week, highly respected Sacramento columnist Dan Walters also wrote about the whiff of corruption coming from CalPERS’ private equity restructuring scheme. Even for those like Walters who don’t know much about private equity, there is too much that is obviously wrong here, from CalPERS not dropping or at least suspending its plans now that its cheerleader in chief is quitting, to CalPERS branding and too many other claims being obviously demonstrably false, to the scheme going firmly against the positive steps other large limited partners are taking, that of building staff skills and bringing more deal-makgin and management in house.
The only two explanations are utter incompetence or rank corruption in the form of Ted Eliopoulos trying to curry favor with BlackRock and other influential players in order to bolster his future employment prospects. And before allies of Eliopoulos in and outside CalPERS act outraged, this suspicion is widespread among the journalists and limited partner community. You are only shooting the messenger.
The more and more CalPERS sticks to this plan in the face of deservedly critical press, the more it looks like dirty dealing. And with CEO Marcie Frost having amassed decision-making authority in her office, she will have nowhere to hide if this scheme blows up on her watch, as we fully expect it will.
1 And, no, it was not Margaret Brown. She refused to comment on the story off or on the record. It should occur to CalPERS that at this point that I have multiple CalPERS sources.
2 Some may question the validity of this document, not only as a result of its embarrassing poor quality (it is hard to imagine anyone who passed a bar exam being willing to put their name on it) but also the lack of the Wilson Sonsini logo, which presumably would have been part of the original.
CalPERS would deny the validity of a leaked document whether or not it was authentic. In this case, what has been leaked is not a copy or electronic version of an actual document, but its text only, with no firm letterhead or signature. Our understanding is that CalPERS has become very aggressive in trying to identify and punish leakers, so one anyone who leaked a document would be prudent to go to unusual lengths to break the connection between the original and the version it sent out. The most extreme approach would be to retype the text from the source record. Thus it is possible that this document is a close copy of the original but not an exact replica.
One also has to bear in mind that there are plenty of reasons for people at or connected to CalPERS to be leaking documents to discredit the private equity initiative. This document is sufficiently lame that circulating it would have that effect.
Aside from the fact that principled insiders would opposed this private equity restructuring plan as offering no potential benefits to CalPERS beneficiaries while being almost certain to result in more costs and worse performance (the late stage venture capital idea is harebrained), there are also constituencies that stand to lose, starting with current private equity staff members. That would give them cause to release embarrassing material.
The alternative theory is that CalPERS created a document to try to ensnare and damage the reputation of journalists who have been critical of CalPERS. But this idea does not make sense. First, had CalPERS wanted to do so, it would made sure that the document would have looked like a copy of an original, as opposed to mere extracted text. Second, CalPERS would still want to make sure that any false leak did not potentially damage CalPERS, when this document does. Third, a phony leak would also entangle CalPERS in the question of how the document did originate, which would also not reflect well on CalPERS. Fourth, CalPERS would presumably have wanted to damage a high priority target. While the original recipient of this document is very respected, he writes for a paywalled journal, which means his reach is limited. This would represent a lot of risk and bother for limited gain.
3 This is an open secret among journalists on the CalPERS beat as well as potentially in the private equity community generally. I have heard from reporters with deeper connections at the CalPERS staff level than I have that the staffers perceive that CalPERS senior executives to be putting shoulder to wheel to give the fund of funds business and perhaps all the private equity management (save the emerging manager program) to BlackRock, even though BlackRock submitted a bid on the private equity fund of funds component that is also widely rumored to have been vastly in excess of the pricing of the other candidates.
Since CalPERS launched a formal contracting process, merely communicating with BlackRock about the possible fund of funds business in any way other than as set forth in it is a violation of Section 20153 of the PERL:
§ 20153. Restriction on Communication with Applicant or Bidder
(a) During the process leading to an award of any contract by the system, no
member of the board or its staff shall knowingly communicate concerning any
matter relating to the contract or selection process with any party financially
interested in the contract or an officer or employee of that party, unless the
communication is (1) part of the process expressly described in the request for
proposal or other solicitation invitation, or (2) part of a noticed board meeting, or
(3) as provided in subdivision (c). Any applicant or bidder who knowingly
participates in a communication that is prohibited by this subdivision shall be
disqualified from the contract award.
Section (c) excludes only:
(1) Communications that are incidental, exclusively social, and do not involve
the system or its business, or the board or staff member’s role as a system official.
(2) Communications that do not involve the system or its business and that are
within the scope of the board or staff member’s private business or public office
wholly unrelated to the system.
4 For instance, CalPERS’ May 17 press release stated:
CalPERS’ Investment Office will now begin talking with industry professionals about the makeup of both the independent advisory boards and the management teams.
According to the Sonsini memo, this is false. Go read the sections on the powers of the General Partner, the Limited Partner, the CalPERS Board and Investment Committee, and CalPERS staff. It makes clears that the only role that CalPERS will have regarding staffing is to “evaluate Advisory Board performance and selection of the independent Advisory Board members in consultation with the General Partner.”
So how can we believe anything that CalPERS says about this initiative when documents presented to the board on the same timeframe as public announcements contradict each other? This means either the board is cooperating with the misrepresentations or is a victim of staff’s and Sonsini’s con.
5 Sonsini defenders may say that his firm does not have private equity firms (including venture capital firms) as clients, ergo we are being unfair. That defense is a willfully naive reading of Wilson Sonsini’s interest. As one of the premier representatives of Silicon Valley companies, who overwhelmingly are or want to be funded by venture capital firms, Sonsini’s firm depends on venture capital, albeit laundered through the portfolio companies that constitute a significant portion of his firm’s client base.
6 While the Kauffman Foundation argues that evergreen funds align incentives better than private equity and venture capital limited partnerships, the structure they describe bears little resemblance to what CalPERS is proposing:
Evergreen funds are structured to better align the incentives between GPs and LPs. They have just one annual management fee (not a series of fees that accumulate from subsequent funds), and raise capital from a limited number of LPs on a rolling basis. Investors receive gains from successful exits, which they can choose to reinvest. The fund restructures every few years (usually every four years) and investors can decide whether to continue investing or withdraw their investment based on current values.
CalPERS does not appear to have looked at Sutter Hills Ventures or General Atlantic, which have operated for a long time under the evergreen model. Even with the periodic restructurings, the firms maintain that they can focus on cash-on-cash returns rather than misleading IRRs and look at ten year horizons when it makes sense for the investee company, rather than fixating on shorter time cycles due to “next fund” demands.Sonsini Memo