More on “Is CalPERS Private Equity Architect John Cole So Clueless He Doesn’t Know He’s Lying?”

Earlier this week, we described how CalPERS’ John Cole, who has been leading the development of the giant fund’s new private equity scheme, tried selling the board on the idea that they were getting a great deal when the terms he presented show that Cole and CalPERS are about to be taken for a costly ride.

As regular readers may recall, the centerpiece of the new private equity scheme is that CalPERS will set up and (at least initially) provide all of the investment capital for two new funds, even though CalPERS will have no control over them, nor will it have any profit participation in the ventures it is creating. At December’s board meeting, Cole claimed CalPERS would have very favorable financial arrangements with these new entities.

While it is true that CalPERS ought to be getting the very best terms for its two new funds, the reverse is happening. CalPERS is paying well above market rate on basic elements of the deal like the management fee. Moreover, as we plan to discuss in a future post, terms that Cole tried to present as special concessions to CalPERS are in fact completely standard provisions found in almost all private equity fund agreements.

On Tuesday, we addressed one of Cole’s flagrant misrepresentations

On Tuesday, we addressed one of Cole’s flagrant misrepresentations to the board and general public: that CalPERS was getting a very attractive “management fee” by virtue of the fee being based on budgets rather than standard rates. Recall that the management fee is the biggest fee paid to private equity firms receive and they receive it regardless of whether they perform well or not.

We discussed that not only is the fee that CalPERS is planning to pay considerably above what CalPERS ought to pay based on industry convention, given that it’s making two ginormous commitments ($5 billion each, with more expected down the road) but that it’s also vastly in excess of what any sensible budget ought to allow. As we showed, each firm’s owner(s) would pocket over $80 million a year, risk free. Nice work if you can get it.

And mind you, that’s only one of the fees paid to private equity managers. Private equity firms have so many layers that compensation in their partnership aggreements that consultants refer to them as a “wedding cake”. Today, we’ll turn to another layer of the wedding cake, a second gift of CalPERS’ monies that Cole also perversely described as a great feature for CalPERS, even though it actually represents a backsliding in terms of the progress that limited partner investors like CalPERS had made in constraining an abusive fee practice.

Cole piously told the board that CalPERS isn’t going to be paying the sort of private equity tricky fees that have been the subject of SEC enforcement actions and critical press coverage…and then, just a moment later, admitted that the pension fund will, in fact, enthusiastically pay them! From the December meeting transcript:

Board Member Margaret Brown: Great. I’d like to make a recommendation that as part of us drafting that agreement, that we — CalPERS also gets to see the portfolio company financials as well, because that’s where a lot of the shenanigans is played in fees. And what we — you can’t really — we can’t tell, unless we can see the financials of the portfolio companies. And I understand that’s all going to be non-transparent to the public. But CalPERS should absolutely make that a requirement that we get to see those as well.

Investment Director Cole: We agree and we will.

And the point of — to finish my thought. I left a dangling edge there. Finish my thought that the idea of portfolio fees we’ve discussed up front, and said it’s a non-starter. We do not want to pay — have portfolio fees of all the different sorts that have been noted and quoted around. They would not occur.
Now, I’ll make a distinction. Let’s take an example of a company that in the Horizon fund [the Warren Buffett with no Warren Buffett fund] that we own. And what we’re trying to do is to provide — or what our investor is trying to do is provide those — the expertise that would allow them to anticipate and manage through disruption. Maybe it’s technology disruption in their business model.

And as a result, they may engage an executive or a consulting arrangement that will come in and work with the company in order to help them deal with their strategy and make operating decisions.

What we’ve been very clear about is that that’s a good thing. We want there to be an operating overlay that we think helps the growth of the company.

What is not acceptable is that there’s a profit margin put on top of that, and it accrues to the benefit of the GP or the LLC.

Help me. This is just pathetic. CalPERS is asked to be ripped off and will be.

The key issue here is that Cole is discussing that the private equity firm may “engage an executive or consulting arrangement…. We want there to be an operating overlay that we think helps the growth of the company.”

This is “operating overlay’ is what the management fee is supposed to cover! The two funds are going to get $100 million a year each for overseeing the investments. So Cole is blithely proposing to pay twice for this sort of assistance and is trying to pass that off to the board as a great benefit to CalPERS.

The management fee isn’t just to buy the company, have the private equity firm sit on its hands for years, and then sell it when the market looks right. The private equity firm’s professionals also meet with management often (the staff at these companies might say relentlessly), review performance and plans, and apply lots of pressure to Do Better, often accompanied with specific recommendations. Moreover, private equity firms have long marketed that they have seasoned industry executives or individuals with other relevant expertise to help improve the portfolio companies’ operations.

Cole’s “operating overlay” comment means he has bought into a thoroughly discredited practice where the PE managers charge investors a management fee for this relentless oversight of portfolio companies, and then charge the portfolio companies “consulting fees” for providing these same services. Until an SEC crackdown in the last few years, U.S. private equity firms almost universally double dipped this way, and with older funds, the public can see that it is still happening due to better disclosure to satisfy the SEC.

This practice was detrimental on many levels. It harmed private equity fund investors by lowering returns; it harmed the portfolio companies by draining their treasuries in return for nothing; and it harmed the public by forcing on it the social cost of weakened portfolio companies and also the fiscal cost of an essentially universal tax scam associated with the practice.

Within the private equity world, pretty much everyone, even the generally clueless investors, knew that these “consulting fees” were indefensible on their face because the PE managers were charging the portfolio companies for services that, by accepting a management fee, the PE managers had already committed to their investors to provide. In the last few years, two academics have uncovered other critical dimensions to the indefensibility.

Presumably, Cole would not be discussing these agreements with the board if CalPERS’ prospective private equity fund managers intended only to have the portfolio company hire truly independent consultants, like IT experts or even a big name management consulting firm. This would be no more controversial than having a portfolio company hire a janitorial or payroll service, and hence not worthy of mention to the board.

Oxford professor Ludovic Phalippou, based on an extensive review of these contracts, called them “money for nothing” agreements. Even though private equity industry participants already knew that these consulting arrangements were a form of double-dippoing, he had determined that they typically didn’t even require the private equity managers to provide any consulting services in order for the portfolio companies to be obligated to pay. The entire video from one of his lectures at Oxford is worth watching, and the critical section starts at 8:00.

Here is his translation of the services agreement:

I may do some work from time to time
I do some work, only if I feel like it. Subjective translation: I won’t do anything.
I’ll get [in this case] at least $30 million a year irrespective of how much I decide to work. Subjective translation: I won’t do anything and get $30 million a year for it.
If I do decide to do something, I’ll charge you extra
I can stop charging when I get out (or not), but if I do I get all the money I was supposed to receive from that point up until 2018.

Note that the final provision in Phalippou’s list, getting all the money through the term of the agreement even if the company is sold earlier, (the so-called “termination of monitoring fee” abuse) received enough bad press and SEC attention that is is hopefully a thing of the past. But the other practices on Phalippou’s list continue.

Law professor Gregg Polsky wrote an academic article on the same topic of the agreements’ “money for nothing” nature, where he made an exhaustive argument that whenever companies make payments to their owners without any corresponding obligation on the owners’ part to provide commensurate services, such payments must be treated under tax law as dividends. Dividends are not tax deductible as expenses of a business, while fees for services are.

Polsky asserted with strong evidence that private equity firms are causing their portfolio companies to take this non-qualifying tax deduction and, as a result, have cost the U.S. Treasury billions of dollars in a form of tax fraud. His article also identified what he described as the “top ten” most egregious situations where these consulting agreements were nakedly indefensible as contracts for services. Among other things, they contained EXPLICIT DISCLAIMERS stating that no work was required in order for the fee to be payable. Here is his list, with the links to the consulting agreements:

HCA Inc., available at;
Berry Plastics Group Inc., available at;
Univision Communications, available at;
West Corp., available at;
Biomet Inc., available at;
Dunkin Brands, Inc., available at;
Sensata Technology Holdings, available at;
SunGard Capital Corp., available at http://;
J Crew Group Inc., available at;
Immucor Inc., available at

Note that CalPERS invested in the majority of these deals. John Cole would do well to study these agreements to understand past mistakes he should be trying to avoid.

Investors in private equity funds certainly never understood the contractual reality and associated tax scam of PE managers disclaiming any obligation to do work for these “consulting fees.” However, they certainly did grasp the reality that the private equity managers were charging amounts (which were undisclosed to the investors) to the portfolio companies for supposed services that the managers were already being paid for via management fees.

As a result, for the last 25 years or more, private equity investors have been able to force the fund managers to credit back to them at least a portion of the consulting fees they received from portfolio companies. We’ve extensively covered on the blog how the SEC has caught private equity managers crediting less than their contracts require, which is the single most common scam in the private equity world. We’ve also covered how investors wildly misunderstand these crediting provisions and think they are far more generous to them than they actually are. But the point is that even if limited partner investors are not getting all the credits they should or they think they are, the almost universal practice in the marketplace is for them to get SOMETHING. Cole, however, is willing to surrender the status quo completely in this respect and accept nothing.

There is a reason that we say that the practice of crediting consulting fees is “almost” universal, which is that a few PE firms have succeeded in pulling off the scam that Cole is now falling prey to. One private equity insider described the new pitch to investors as follows:

Those old money-for-nothing consulting fees, those were naughty, we admit. We’re not trying to defend those and we are giving up the practice. Instead, we’re going to create our own internal consulting division, and we promise that they will do real work with the portfolio companies that justifies them being paid McKinsey scale engagement fees, or maybe a tad less because we are great guys and are looking out for you. And we promise not to make a profit from this activity. But here is what we need from you. We were crediting back to you the old, money-for-nothing fees because we all knew that they were indefensible. But these new consulting fees are for real work! So you have to let us keep them. Otherwise, how can we afford to pay the people who will work in our “consulting” arm? Got it? Good!

Amazingly, there are a meaningful number of limited partner investors in private equity who have fallen for this old-wine-in-new-bottles relabeling scam and haven’t bothered to confront the reality that they are already paying for these services via the management fee. Many limited investors who have signed up to this type of deal seem to take particular comfort in the claim that these consulting arms will be operated on a non-profit basis, which you can see that Cole somehow thinks is important as well. Given that nobody will be able to verify whether there is a profit margin, it seems reasonable to be skeptical about promises of monk-like asceticism, especially since the fees are typically benchmarked against comparables like McKinsey that have enormous gross profit margins on engagements.1

But key point, which Cole seems to miss, is that by being financially self-supporting, the consulting arms,reduce the number of people and activities that need to be supported by the management fee, thus making the management fee an even bigger source of profit. That is true even if they truly are not making a profit on the consulting operation, which would be hard to verify. 2

One firm that has gone down this in-house consulting arm path is KKR, which has a captive consulting firm, KKR Capstone, that performs many of the portfolio oversight functions for KKR funds that would be performed by traditional private equity firm members in other shops.that would be performed by traditional PE firm members in other shops.

KKR Capstone employees work in the same building in New York as KKR employees but KKR takes the position that they are “independent consultants” and therefore allowed to keep all the revenue they earn by charging the portfolio companies for their services. The point though is that a significant portion of the KKR headcount at this point flies under the “Capstone” banner, which, like the proposed CalPERS structure, is held out as not profit-making and, more importantly, allows KKR to dramatically reduce its own headcount relative to what it would otherwise be. Fewer mouths to feed with the management fee—what about this concept does John Cole not understand?

We asked around regarding a reasonable estimate of what history suggests the CalPERS scheme could allow the managers to extract from portfolio companies One academic who is an expert in private equity consulting practices said that the general partner could easily pull out another $50 million a year on top of the $100 million he’s already planning to have CalPERS pay him.3

CalPERS should heed the recommendation of Dr. Ashby Monk, who has spoken to the board twice about private equity in the last six months. Dr. Monk, who is much better schooled than Cole is on the many ways private equity firms profit at the expense of their investors, concluded the only way to win is not to play their game at all by bringing private equity in house. It’s a mystery why CalPERS is so stubbornly refusing to do what is best for the institution and its beneficiaries.


1 In fact, as anyone in consulting will tell you, marketing is a major cost for consulting firms, to the degree that most firms regard 80% utilization of staff as the maximum they can achieve because if they go higher than that, they will be underinvesting in marketing and selling and will pay for it in the not too distant future by not having enough work. So a firm that was assured a steady stream of business from its friendly private equity firms two floors higher in the same building could run at a higher percentage of utilization all the time and charge lower fees while having the same sort of profit margin as a firm that had to price itself to recover its higher marketing and selling costs.

We will put aside the question of whether these less-than-arms’length services would be necessary.

2 Cole’s great pitch for the wondrous benefits of paying the private equity firms for consulting they should have been doing anyhow strongly suggests that there is no offset whatsoever. Otherwise, he’d be implicitly acknowledging that maybe there was something not on the up and up about having the general partners charge any fees to the portfolio companies.

It also isn’t clear that Cole has ruled out a consulting firm charging typical fees and therefore having a profit margin built in if the consulting firm is not part of the fund management firm.

if you read what Cole said carefully, he is arguing that the private equity fund managers won’t be allowed to take a “profit margin.” Cole may actually have been told about how private equity firms often double dip by hiring third parties to perform a task, which in this case would be hiring a consulting firm to work with a portfolio company, and then charge a hefty fee for at most babysitting the consulting firm that the private equity firm brought in. Cole is ruling our that layer of the wedding cake.

3 Remember from our post earlier this week that John Cole said that CalPERS planned to pay roughly 2% in management fees when its two new funds were each at the $5 billion level, and that they expected to pay 1% at $10 billion per fund. That equates to $100 million per year for each. We showed that this translated into profits of over $80 million per year per fund for its owner(s).

One bit of good news is that the consulting fee scam can be executed only at the “Warren Buffett with no Warren Buffett” fund. For the “late stage venture capital fund,” CalPERS would be investing in companies where eaelier-stage venture capital investors would be driving the bus.

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  1. Fledermaus

    Private equity seems to hold a prominent position in the thinking of a lot of non private equity people. Is it envy, a desire to get into the club? I remember when Obama’s SEC enforcer told a room full of PE guys how much he wanted his son to work in PE and one of them promptly offered his son a job

    1. notabanker

      Many of the capital markets businesses are now commoditized and are consolidating under the lowest cost producers. Risk capitalization requirements post crisis have made many of those businesses far less lucrative, investment banking is highly competitive. I can’t speak to American firms, but I know for a fact there are minority yet influential factions in overseas banks that would like to jettision capital markets businesses from their retail businesses. Quality of assets is what kills the discussion. Nobody wants to expose book values to actual markets.

      Hedge funds and PE firms are the last bastion to excessively gouge. Hedge funds at least take on market risks. PE’s, as you’ve seen from Yves plentiful posts, are mostly stripping assets for cash, gouging customers of businesses they own and charging outrageous fees to investors. And it’s private and not subject to anywhere near the same level of regulatory scrutiny. They hit it from every angle and are cutthroat in doing so.

      There is a ton of cash to be made inside a PE firm, it can be very lucrative. I’d just say from personal experience having dealt with a few as an adversary, it would be miserable work inside of those specific firms if you had any kind of conscious.

  2. Synoia

    One of two theories for this behaviors

    1. Upton Sinclair: It is difficult to get a man to understand something, when his salary depends on his not understanding it.

    2. The light’s on, but nobody’s home.

    My money would be on (1).

  3. flora

    KKR Capstone employees work in the same building in New York as KKR employees but KKR takes the position that they are “independent consultants” and therefore allowed to keep all the revenue they earn by charging the portfolio companies for their services.

    hmmm…. “independent consultants” is a very elastic term, so useful for KKR, is it not?

    Thanks for your continued reporting on CalPERS, pension, and PE.

  4. The Rev Kev

    I myself am coming around to the idea that John Cole is really out of his depth here. Of course you do wonder who is more stupid – the one that comes up with such a scheme or the ones that sit and listen and actually consider this idea seriously. Even trying to bring in this dodgy scheme, he is only doing a half-a**ed job of it. Money for nothing? Obviously he forgot the second half of that idea where it is supposed to be ‘Get your money for nothin’ and your chicks for free’-

    Reading the translation of the services agreement as proposed by Cole, they could be like that CEO that signed a great contract that would run for several years and never bothered turning up for work as the contract was written in a way that did not require him ever needing to do any work. And to think, it was only in mid-2017 that the Wall Street Journal carried a story that CalPERS was sick of paying too much for private equity. Must have had a come to Jesus moment there.

    Actually I can see other aspects of how this scheme could be set up. The accountancy firm doing the books would be a PO box in the Caymans. There would be regional offices – paid for by CalPERS – in both Aspen, Colorado and The Hamptons with a sub-office in Martha’s Vineyard. Perhaps an International Office in St. Moritz, Switzerland with extensive consultations with groups in Wall Street and Davos. Nice work if you can get it.

    If I worked at CalPERS, I think that it would be wise to keep a journal at home if they bring this thing in. Even if you did not work in an area connected with this scam, you want to be able to prove it when the wheels come off. After all (and modifying an old saying), that is the difference between CalPERS getting away doing stuff like this and herpes – herpes lasts forever.

  5. David in Santa Cruz

    It’s a mystery why CalPERS is so stubbornly refusing to do what is best for the institution and its beneficiaries.

    Follow the money…

    1. Steve H.

      The mystery is why the Board isn’t being constantly and individually sued by the investors. There’s a reason there’s insurance available for Board members; it covers negligence.

    2. vlade

      I think the mystery is more why no-one in CA seems to be bothered much. Is it really, as Lambert says “everything is CalPERs”, is it ignorance, or what?

      And I don’t mean just the top level pols. I mean the beneficiaries (who may lose out) and CA taxpayers (who will lose out).

      1. tegnost

        I’m surprised about that too, you’d think the comment section would be flooded with aggrieved pensioners. It could be that cali is just too far gone. Go into a beach community coffee shop and ask the denizens what they think about lifeguards having pensions and you’ll find that most people don’t think they deserve it so it should be stolen from them. They’ve, in my opinion, really bought in to the social darwinism thing. Surfers now are doctors, lawyers, mba’s and engineers; or their obnoxious kids. There’s very little in the way of “counter culture” left.

    3. Sinecure at M-Stanley

      Exactly. Would one be pushing a hairbrained, unresearched, total giveaway scheme this relentlessly if they didnt see some avenue for future self enrichment?

      Curiously no board member has pondered whether theres a restriction on current Calpers hucksters from jumping ship to these new entities if/when theyre formed, effectively tripling their salary as I’m sure thats the plan for more than a few.

  6. Clive

    It’s progress that we no longer typically see politicians, executives, crooks and law enforcers on the take busted in seedy motel rooms with suitcases full of high denomination bills. Graft and corruption has had to up its game.

    The downside is that it has indeed upped its game. Out-and-out vanilla version bribery is rare, certainly in western countries, these days. But other methods abound and there’s warning signs and descriptors for those prone to make illicit payments and, more unfortunately, those willing to receive them which are well defined. Most of us who handle large commercial transactions get trained on what to look for, but it’s surprising how little people are aware of possible indicators and inducers — and who might be induced.

    So, while not accusing anyone of anything, I’ll present the tell-tale signs. In no particular order…

    1) High-ticket value dealing (large sums in project funding, invoices, salaries, expenses, that kind of thing)

    2) “Arm’s length” management structures or organisational designs (little day-to-day supervisory involvement, vaguely defined roles and responsibilities, flabby performance objectives and so on)

    3) Lightweight sign-offs of expenditure (maybe only one other approval body in the authorisation chain), self-sign offs or latent sign offs where checks happen months after the liabilities arise

    4) Ambiguous accountability — lack of clarity about who is responsible for what, who reports to whom, multiple or inherently conflicting “dotted lines” (as a worked example, recall President Kennedy’s observations on the Bay of Pigs invasion, recalling that “no one ever seemed to be responsible for it, yet it happened anyway”)

    Given that these risk factors, when present and when glaringly apparent are eminently fixable, the fact that they remain unfixed is a tell in itself. Why is no-one in CalPERS staff willing or able to address these industry-standard potential pain points and resolve to, ah-hem, get resolving them?

  7. Roberto

    I’m curious to know why the portfolio companies agree to pay these consulting fees?
    Is it that they are selling so much of their own stock/bonds in the deal that they won’t quibble about a measly $50MM (collectively)? Is this seen by the portfolio companies as another cost of doing business?

      1. Rating agencies

        Remember Moody’s, Fitch, Morningstar handed out AAA ratings on the mortgage backed securities through 2008 – essentially without penalty.

        In pondering life’s mysteries, I occasionally wonder whatever became of the boxes of assignments (signed in blank) in Countrywide’s backroom. I suspect Angleo M. is unlikely to be pondering the same.

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