By Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader. She is currently writing a book about textile artisans.
Embattled CalPERS CEO Marcie Frost is pressing full speed ahead, damn the torpedoes, with an utterly ridiculous “new business model” for half of CalPERS’ private equity investments.
CalPERS proposes outsourcing these investments to two newly-created firms. CalPERS will not select the boards of these new special purpose entities; their managements will do that. Nor, despite the billions of dollars CalPERS will invest in these funds, under well-settled principles of fiduciary duty, will their boards owe any fiduciary duty to CalPERS.
Investing in two entities reduces diversification and thus increases risk. Investing in newly-created firms is unlikely to produce superior results, as new funds typically achieve weaker returns than do more seasoned managers. Why? Private equity is a difficult game. One’s performance improves the more one plays. Stronger managers survive, and by surviving, are allowed to continue to play.
Yves has covered CalPERS new private equity fiasco in detail, and at length in posts including CalPERS CEO Marcie Frost Describes Her Intent to Leave the CalPERS Board Holding the Bag for Flawed Private Equity Scheme She’s Pushing Them to Approve; CalPERS Stakeholder Groups Refuse to Run CEO Marcie Frost’s Misrepresentations About Its Reckless, Unjustified Private Equity Scheme; Leaked Memo by Larry Sonsini Shows Sonsini and CalPERS Violating Fiduciary Duty With Proposed Private Equity Outsourcing Scheme ; CalPERS CIO Ted Eliopoulos Tells 5 Big Lies in Presenting Super Indirect Private Equity Scheme; and CalPERS Issues False and Misleading Press Release to Try to Railroad Board on Private Equity Industry Enrichment Scheme.
I’m not looking to duplicate her comprehensive analysis, as interested readers can read her posts, which provide far greater detail and context than I’ll attempt here.
I’ll instead confine myself to highlighting some obvious corporate governance problems, as well as glaring conflicts of interest, that arise from the proposed new structure.
Ideally, there should be robust honest debate about the proposed changes, and the onus should be on CalPERS to circulate substantive details about its proposals.
Instead, the secrecy surrounding this new business model makes that which swaddled the Manhattan Project look leaky. And as Yves has documented here, we see lots of handwaving, regurgitation of word salad, and chanting of bullshit tell-word mantras -e.g., “innovation” – that taken together, shriek: Cave! Hic dragones or Warning! Here be dragons.
So here’s my personal message to CalPERS staff, insiders, board members: if, at any point, I’ve gone off the rails in this discussion, I’d be happy to stand corrected by circulation of hard facts and analysis explaining what, exactly, CalPERS is thinking here.
California Law Covering Criminal Conflicts of Interest
Now, having got that off my chest, believe it or not, there is a reason other than sheer lunacy for pursuing this defective governance structure.
Under California law covering criminal conflicts of interest – for the lawyers in the audience, I’m talking about Government Code section 1090:
(a) Members of the Legislature, state, county, district, judicial district, and city officers or employees shall not be financially interested in any contract made by them in their official capacity, or by any body or board of which they are members. Nor shall state, county, district, judicial district, and city officers or employees be purchasers at any sale or vendors at any purchase made by them in their official capacity.
Translation into plain English: This clause has been interpreted to prohibit any CalPERS employee, manager, or board member, from sitting on or appointing members to other boards, such as that of the new special purpose entities CalPERS proposes to invest in.
In enacting this provision, the California legislature saw only the potential for corruption, and didn’t foresee any situations where legitimate reasons exist for allowing state employees or officers to sit on a board.
Yet If the statute prevents CalPERS itself from appointing board members and thus exercising even the most basic oversight of vehicles into which CalPERS proposes investing billions of dollars, what should a prudent investor do?
One option might be to follow an investor’s version of the Hippocratic Oath – first, do no harm – and do nothing. Stick with the status quo.
A second possibility: perhaps sound reasons exist to dump half of CalPERS private equity investments into two captive special purpose entities run by new managers (although I doubt it). In the last part of this post, I’ll consider some possible rationales further. But, rather than surrendering any pretense of accountability – as CalPERS proposes to do – it could instead ask the legislature to change the relevant statute, and create an exemption under which CalPERS staff, board members, or designated candidates, could sit on the board of the new investment vehicle.
The legislature clearly contemplated the possibility of exemptions; the subsequent provisions of the statute, in section 1091 a and b explicitly sets out more than seventeen of them (including subsections). So it would break no new ground here by creating an exemption under which CalPERS could exercise board control over the new firm.
Why hasn’t CalPERS gone that route? I don’t know exactly why, but I suspect one reason may be it doesn’t want to encourage any deeper public scrutiny of its private equity investment plans that would inevitably accompany a request to amend the criminal conflict of interest provisions.
To Whom Does the New Board Owe Fiduciary Duty?
There’s another reason, too, that amending the criminal conflicts of interest statute won’t get CalPERS very far. For even if CalPERS could appoint board members, the fiduciary duty of the board of the new special purpose entity – e.g., duty of care, duty of loyalty – would run to the new firm only. That board would owe no fiduciary duty to CalPERS itself – despite the investment CalPERS proposes to make.
I admit, I’ve been concerned that since this structure makes no sense -is in fact, utterly barmy – I may be overlooking something.
But after reviewing what’s been publicly disclosed: I don’t think so.
CalPERS may delude itself into thinking that by clever negotiating and lawyering, it can create contract rights that might compensate for this grossly deficient governance structure. They are concerned about attracting “talent” to run the entity, which means the “talent” will be able to insist they have similar rights to a general partner in the usual general partner /limited partner structure. So CalPERS’ ability to negotiate tough contractual terms to offset governance deficiencies is, in reality, likely to be quite limited.
A further problem: a common error is to assume that complexity can be managed via contract. In reality, there’s only so much that parties can anticipate and spell out in contractual terms. Boards exist to manage the unexpected.
I’m reminded here of the debate concerning which type of financial regulation works better- the US model of an explicit, rules-based system, where anything goes unless explicitly prohibited- or the more principles-based system that the UK employs, where general principles are laid out, with the expectation they are followed. In each case, it’s necessary to include a strong enforcement capability, to ensure participants conform to the framework.
The defective governance structure CalPERS is considering lacks the most basic elements of accountability. It’s so much air. CalPERS’s governance advisor. Larry Sonsini – of Wilson Sonsini Goodrich & Rosati – surely knows better, and Yves devoted an extended post (see here, also cited above) to picking apart that inadequate governance advice.
I might also point out, in passing, that at an earlier time – about twenty years ago, when CalPERS could still be held out as a model on governance questions and for its investment strategies – it had considered a version of the current proposal, and rejected it, for precisely the reason that Government Code 1090 prohibited CalPERS from controlling the board, which made the entire prospective arrangement a non-starter.
Why the New Structure Is Worse than the Status Quo Limited Partner/General Partner Structure
Now, one might argue that in corporate governance terms, the new structure is no worse than current status quo, in the degree of control CalPERS, as a limited partner, can exercise over general partners that manage its existing private equity investments.
But there’s a huge flaw in this argument. As it stands, general partners must return every four or five years to their existing investors to raise money, so the general partners have to behave, at least minimally. Otherwise, CalPERS could in future redirect its private equity investments if it is dissatisfied with a fund’s performance.
Under the new structure, CalPERS loses even these protections: It would be wedded to these people AND have no diversification in its private equity portfolio.
The other thing I should mention is that the limited partner/general partner structure does provide for limited partners to sit on a fund’s advisory board. Now, the actual real world value of such seats may be equivalent to the influence a football team’s cheerleaders exert on a team’s coaching strategy – despite the significance investors seem to attach to them.
Such advisory boards are limited to approving known conflicts of interest, as well as given an annual ability to approve the fund’s asset valuations: an area rife with conflicts of interest. If the advisory board fails to approve the valuation, that would trigger greater scrutiny. These provisions are weak indeed, but better than nothing at all.
How Will Managers Be Selected?
This is another part of the whole picture that’s especially opaque. As Yves has written here:
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.
Under California law, the state itself cannot practice affirmative action (although companies operating in the state are free to pursue such policies if they wish to).
With my tinfoil hat on, I wonder if going through the charade of pursuing this new business model, through a half obscured wilderness of smoke and mirrors, is designed to make us focus on a Potemkin village. By which I mean, after a suitable interval, perhaps CalPERS will turn around and invest in some new set up by an offshoot of the usual suspects. Blackstone, perhaps? It will try and pass this off as an emerging manager, but will it merely be the same old wine, packaged in a new bottle?
I might mention that I’m hearing that some CalPERS board members are patting themselves on the back for doing the intellectual heavy lifting of vetting this new complex corporate governance structure. Perhaps the reason such lifting is necessary is not because CalPERS has hit upon some super duper cool and groovy governance breakthrough, but because what they’ve come up with doesn’t make a huge amount of sense.
Conflicts of Interest
I spoke further about some of the conflicts in the proposed new structure with Alexander Arapoglou, Professor of the Practice of Finance at the University of North Carolina’s Kenan-Flagler Business School, a former colleague in Chemical Bank’s Interest Rate Management Group, whom I’ve known since 1993. We occasionally co-author articles together.
Alex emphasized that if the new managers fail, “CalPERS will find it very difficult to walk away from their investments” – as I’ve already mentioned above.
He picked up on the significance of CalPERS lack of any input or control over the boards of directors of the new entities and noted how the structure was “opening the door to a whole series of potential conflicts of interest.” Not to mention, I would add, potential lawsuits.
The conflicts inherent in private equity situations are notoriously difficult to manage. Some of these arise from fund directors sitting on the boards of the private companies in which the fund invests, and having fiduciary duties to both the fund and the company. To these known perils, CalPERS proposes a structure that expands rather than contracts this universe of conflicts.
But let’s back up a bit. Alex wondered, “For what purpose is CalPERS creating these new structures? Is it the desire to avoid fees? And is that goal worth assuming the additional conflicts that arise from taking on the general partner role?”
With respect to avoiding fees, there are better ways to do that, such as bringing the private equity investment function in house. To do this effectively, Alex noted that “CalPERS would need to be prepared to offer competitive compensation to in-house fund managers.”
Alternatively, is the new structure instead intended to improve investment performance? It’s hard to see per se how CalPERS can get better performance from an entity that it has less ability to hold accountable than the bog standard limited partner/general partner structure provides. And as I’ve discussed above, the proposed new structure is actually weaker than that more common structure in promoting accountability.
Let’s dig further into the performance question itself. “Suppose the new vehicle underperforms. What does CalPERS propose to do?” Alex asks. “Shut it down? “ At present, when a fund underperforms, CalPERS may elect not to renew or expand its investment. That would be much more difficult to do with a captive investment entity.
“A limited partner can exert some influence on a private equity fund by providing endorsements of a fund or general partner to other investors. With a dedicated investment vehicle, CalPERS loses that potential avenue of influence,” he said.
Let’s examine another scenario. Suppose CalPERS selects an emerging fund manager, and its investment performs spectacularly. “Could CalPERS actually find itself a victim of its own success, in the unlikely event it manages to identify new private equity firms who subsequently outperform the benchmarks. How can it prevent the firm’s talent from leaving and joining or starting another fund while CalPERS is left behind?” Alex asks.
Or, from marketing itself to other investors. Although CalPERS intends to be the sole investor in these new funds – in order to enhance their influence, and possibly improve the terms on which they invest, e.g.lower the fees they pay – that’s a bit of a myth. “The reality,” says Alex, “is that when the new entity sits down and conducts its first meeting, the entity will be seeking ways to attract new investors, as a way of reducing its risk and increasing the fees that it receives.”
How can CalPERS circumvent that problem? It probably cannot. The governance structure it has proposed constrains its ability to influence the firm if it elects to seek out other investors. CalPERS is therefore limited to proposing a contractual solution. But would the new firm agree to such contractual constraints?
So, to summarize the performance considerations. By investing in new funds, CalPERS will most likely earn a lower return than if it invested with more seasoned managers. In the unlikely event the fund’s performance is wildly successful, it risks seeing the fund managers jump ship, or open their fund to other investors.
The Bottom Line
Overall, the CalPERS system is already underfunded. Faced with this problem, CalPERS now proposes directing half of its private equity investments, to unseasoned managers. Who can select their own boards. Who are not subject to any fiduciary duty to CalPERS, and are only bound by whatever contractual terms CalPERS can negotiate. With the whole exercise conducted with minimal outside scrutiny, in a process devoid of basic transparency.
What could possibly go wrong?
California’s pensioners deserve so much better. When is someone in the California state government going to wake up and try to arrest this slow motion train wreck?