CalPERS stakeholder groups are refusing to buy what CalPERS is trying to sell, namely, an untested, poorly conceived private equity scheme that will increase risks and costs and is therefore clearly a bad idea for beneficiaries and California taxpayers.
As we’ll discuss in more detail, CalPERS sent a piece under CEO Marcie Frost’s byline, entitled Taking Action: Exploring a New Private Equity Model, which it wanted stakeholder groups to include in newsletters to CalPERS members. Not only did virtually all of these organizations refuse to reproduce the article, but some were offended by the request, since they recognized it as CalPERS attempting to bulldoze beneficiaries rather than look out for their interest.
These e-mails come from senior individuals and/or board members of different groups. The first one:
Did you see what David Teykaerts sent out to the retiree groups which was nothing new on the direct PE? He asked the retiree groups to post it. Other than CSEA, I’m assuming no one is going to do this because it doesn’t answer any of the questions we’ve asked about no fiduciary responsibility no transparency no PRA.
It is very risky and it looks like [Board President] Priya [Mathur] is trying to go out with one last stand in December. XXXX [from a different group] has a copy of the memo. It didn’t address any of our concerns.
Here is a second:
I just had an email forwarded to me from XXX at YYY. He is describing the pressure his organization is receiving to run Marcie’s puff-piece in favor of the PE re-structuring even though the materials that CalPERS has shown him to justify the program are nothing but a “colorful brochure full of graphs and buzz words, almost completely lacking in detail.”
And a third:
I talked about not running this. FYI people are annoyed that they were asked to do this.
In fact, from what we can tell, none of the groups asked to run it agreed to do so, save perhaps CSEA, whose Executive Director, Dave Low, is one of the hidden hands at CaLPERS. CalPERS had to settle for posting the article on its website.
CalPERS’ refusal to provide either a coherent justification for its private equity “new business model” or anything more than napkin-doodle-level details about how it would work says the fund’s leaders are doing their very best to keep the public, which ultimately backstops the risk of CalPERS’ underfunding, and even its board in the dark.
That suggests that CalPERS knows full well that even basic due diligence on this “new business model” would lead to it being rejected. Recall that last May, CalPERS tried to present its sketchy private equity planl as largely approved by the board, forcing board member Margaret Brown to issue a press release saying not only that that was false, but that the board had not been given any research, budget, business plan, or analysis of risks and projected returns.
So why is staff and CEO Marcie Frost pushing so hard for an idea when their refusal to describe its private equity plan in detail says they know it’s a turkey? This smacks of either world class incompetence or corruption.
As we go thorough Frost’s unconvincing sales pitch, you will see that not once does she even attempt to argue that the new scheme will improve returns or lower risks, which are the only defensible reasons to pursue it. In fact, there are three obvious reasons why this program will almost certainly harm CalPERS beneficiaries.
According to the plan, CalPERS would continue to do its current investing in existing private equity funds on a much reduced scale. In place of the curtailed fund investing, CalPERS will allocate more money to “emerging managers”. That is code for women and minority managers, but to comply with anti-discrimination laws in California,it is presented as meaning something different, which is managers starting their first fund. The other two “pillars” of this program is for CalPERS to fund two dedicated, external private equity entities…which astonishingly, CalPERS would not control or meaningfully oversee. The two boards would be chosen by the management of the entities themselves. By law, the boards’ duties of loyalty and care would be to the new ventures, and not to CalPERS.
As one private equity professional said:
Imagine the most terrible governance arrangement you’ve ever come across in the private sector. This is worse.
Here are the reasons this “new business model” is guaranteed to perform worse than what CalPERS is doing now:
No savings on fees and costs. Industry professionals will demand competitive terms to join a new entity. CalPERS will not do any better than it would by setting up a similar-sized dedicated fund with an existing major fund group. On top of that, it will have large startup costs.
Lower returns by relying on first time funds. Bear in mind that the two new general partners that CalPERS will sponsor are by definition “emerging managers” as in these have been presented by CalPERS as new firms. They will have all of the growing pains of starting a new business, like having to hire staff members, possibly having some members in the top management group who have not worked together before and have some initial frictions, needed to set up banking relations, reporting, and other systems. All of these come at the expense of buying good companies at a decent price.
Academic studies have consistently found that first-time funds perform worse than later funds by the same fund manager. By putting most of its new money to first time funds (the emerging manager program and the two new funds it is creating), CalPERS is almost assuring itself of poor performance. Note that CalPERS existing program for “emerging managers” now delivers the worst results of all of its private equity sub-strategies.
Less diversification. No competent investment professional would recommend putting 40% or 50% of your money in only two investments. Yet that is how CalPERS is proposing to invest its new funds. There is considerable business risk in relying heavily on only two fund managers. What if a key manager is caught in a sex scandal and is forced to resign, like Steve Jurvetson of DFJ (Draper Fisher Jurvetson)? What if a top partner gets divorced, which not only damages his performance but can even lead to a firm restructuring if that partner has to liquidate his investment in the company to pay off his ex? What if some key partners die in a plane crash, as one did at Summit Partners a few years ago? Those small planes that private equity types love are more accident prone than commercial jets. Recall that CalPERS own consultant, Meketa, deemed CalPERS reduction in the number of its private equity fund managers to have hurt returns. Why is CalPERS doubling down on a failed approach?
CalPERS has even gone so far as to mislead its own cheerleaders. The pension fund invited Dr. Ashby Monk of Stanford to speak at a public board meeting in August, and Frost quotes Dr. Monk in her promotional article. Dr. Monk took a generally positive tone but pointed out that what CalPERS was planning to do was not direct investing, which means having CalPERS staff make private equity investments itself, but was forming its own general partners. Dr. Monk then described how some large investors had used “pick the pickers” methods to assure that the board was loyal to the organization that provided the money.
I spoke with Dr. Monk for a half-hour after his CalPERS presentation. He acknowledged in our conversation that CalPERS had not disclosed to him that the board of the new entity would be chosen by its management and CalPERS would have no say in the board’s selection. Thus he cannot be deemed to have approved what CalPERS is doing, since he was misinformed.
Frost also relies on Dr. Monk to justify continuing to invest in private equity, when Dr. Monk is not an expert in investment management performance. Frost also cites CalPERS’ returns over the last 20 years, which includes a period of stellar private equity performance, from 1995 to 1999. Private equity has changed structurally since then, with the private equity share of global equity more than doubling from the early 2000s to 2014. Too much money chasing too few deals kills returns. And with even more funding being dedicated to private equity, nothing CalPERS can do will change this unfavorable picture.
Over the last ten years, private equity has failed to meet CalPERS’ benchmarks, meaning CalPERS is not getting paid enough for the risks it is taking. On top of that, Oxford professor Ludovic Phalippou, who is an expert on private equity returns, ascertained that since 2006, even using favorable assumptions, private equity on average has not even beaten the S&P 500. So the entire premise, that CalPERS needs private equity because it delivers superior returns, is false.
Frost makes more misrepresentations in her patter. She cites a study that showed that CalPERS had done well in its buyouts, which she does not make clear is only one strategy within its private equity portfolio. She further falsely depicts the study as being done “at the international business school HEC Paris” when the study was performed by a private consulting firm (a “corporate partner”) whose principals have connections to HEC. On top of that, the study itself looks dodgy. It uses Value at Risk, which was developed to measure downside risk of portfolio positions, not investment performance. It uses both a proprietary model and proprietary data, which means its results cannot be independently verified. In addition, we’ve repeatedly criticized CalPERS for using “assumed volatility” assumptions which are completely out of line with what anyone, including CalPERS’ own consultants, use. Assumed vol is an input in Value at Risk models. It’s quite possible that the favorable results CalPERS got was garbage-in, garbage-out from using CalPERS unrealistically flattering volatility assumptions.
And the piece de resistance? One of the members of the Private Equity Observatory, Oliver Gottschalg, who is also a HEC professor, wrote a paper in 2012 with Oxford’s Ludovic Phalippou, Publication Preview
The Party should be over: Why Private Equity is much less attractive than it looks. One has to wonder why Frost didn’t see fit to mention that.
Frost also implies that CalPERS can get to an 80% or 90% funded status through investing. This is false. CalPERS has gotten to 71% only by virtue of a $6 billion mini-bailout by the State of California in the form of pre-funding some of its underfunding. The stock market and other risky assets have been at nosebleed levels until the recent corrections, which are not yet reflected in CalPERS’ estimates. CalPERS’ own aggressive increases in employer payments shows the fund knows full well it cannot invest its way out of this hole.
Finally, Frost’s main selling point for this scheme is that it is “innovative”. Help me. Innovation in finance means using complexity, opacity, and leverage to pluck the feathers from unsuspecting geese. The fact that Frost is shilling for “innovation” says she’s either not remotely qualified to make financial decisions or is expecting somehow to profit personally by being cut in by the “innovators”.
Let us turn over the microphone to former Federal Reserve chairman Paul Volcker:
I hear about these wonderful innovations in the financial markets and they sure as hell need a lot of innovation. I can tell you of two — Credit Default Swaps and CDOs — which took us right to the brink of disaster: were they wonderful innovations that we want to create more of? You want boards of directors to be informed about all of these innovative new products and to understand them but I do not know what boards of directors you are talking about. I have been on boards of directors and the chances that they are going to understand these products that you are dishing out or that you are going to want to explain it to them, quite frankly, is nil.
I mean wake up, gentlemen — I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.
A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.
I was listening to this and I found myself sitting next to one of the inventors of financial engineering who I did not know, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity. Much to my surprise he leaned over and whispered in my ear that it does nothing. I asked him what it did do and he said that it moves around the rents in the financial system and besides that it was a lot of intellectual fun.
In his presentation to CalPERS, Dr. Monk said someone was twice as likely to become a billionaire by working in investment management as in technology. Having marks like Marcie Frost in charge of large pools of money is a big reason why this happens.Marcie Frost Private Equtiy Propaganda