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

Today, we’ll turn to a presentation last December by CalPERS’ John Cole, who has been serving as the lead executive on CalPERS “new private equity model”. Cole unintentionally provides so much evidence that he, and by extension CalPERS, are either hopelessly out of their depth or repeatedly lying to the board and general public that we’ll have to spend more than one post dissecting Cole’s troubling claims.

This post will focus on how Cole acknowledged that CalPERS intends to pour $100 million annually of management fees into the owners’ pockets at each of the two private equity entities that it plans to create. Recall that it will give each $5 billion of CalPERS’ investment capital and plans to spend more with each of them over time.

Cole claimed that CalPERS will be getting a great deal with this roughly $100 million in management fees per fund. We’ll show that using generous assumptions about costs, that this would translate into the owners of each firm having a risk-free profit on the order of $80 million per year. To stress what should be obvious, this cannot be construed to be the outcome of a reasonable budgeting process, as Cole tries to pass off, nor a good outcome for CalPERS.

Readers may recall that we’ve criticized CalPERS’ new private equity scheme. The drawbacks include that CalPERS would provide all of the $5 billion in investment dollars to each new venture and would even pay startup costs, yet CalPERS would not control either firm or have any profit participation in them.

CalPERS attempted to brush off these objections by arguing that these new vehicles would have lower fees than traditional private equity fund investments.

CalPERS has already admitted that some of its cost reductions were pure hokum, conceding that the funds will, have even higher costs than private equity fund investments would in their early years.

But it’s even worse than that. CalPERS’ ability to write $5 billion dollar checks enable the giant fund to negotiate the absolute, rock-bottom lowest fees ever granted in the PE marketplace. Instead, as we’ll show, is CalPERS plans to pay vastly above market rates even for a fund one-tenth the size of what CalPERS plans to launch.

Cole slipped his announcement about the crazy-high costs past the board using a tried-and-true tactic of investment managers when they are trying to obfuscate the fees, that of using percentages rather than mentioning any dollar amounts. Here is Cole’s response to a question from Steve Juarez, who was acting as the representative to Treasurer John Chiang. From the December transcript:

Investment Director John Cole: What that leads to is that in an early environment, or an early term of setting up the entity, when assets are relatively small, let’s say a billion or $2 billion, relatively small in CalPERS sense, that the percentage of that amount will be high. And that as that matures over the course of a few years, then it — that and that becomes a much lower percentage. So that by the time we get to, say, $5 billion, that the equivalent of that percentage to the 2 and 20 world is pretty close.

By the time you get to $10 billion, it’s about half — half of what we would be paying otherwise. And all of that is going to be subject to exactly how the calculation

Recall that the management fee is the biggest fee that private equity fund managers receive and that they get it regardless of how the fund does. It is prototypically described as 2% of the amount committed, but in reality, the level is much lower on large commitments, and the $5 billion per fund here is off the charts in terms of size.

Cole says that the applicable percentage varies with the size of the asset base but is 2% when the asset base is $5 billion dollars. Note that two percent of five billion dollars is $100 million, so Cole is saying that the management fee at that point will be $100 million. He then goes on to say that the management fee is roughly half the 2% at $10 billion dollars, which would be 1%. Again, 1% of $10 billion is $100 million. Note how Cole emphasizes the reduction in fee percentage as if these are actual cost savings, when the reality is that the formula will cause the total dollars paid by CalPERS to remain flat. And recall that Cole notes in passing that the percentage will be higher before the $5 billion level is reached, so the management fee in dollar terms may well be near or at $100 million from very early on.

The excessiveness of a two percent management fee on a single investor committing $5 billion dollars is obvious from the fact that, as we’ve already discussed, CalPERS’ peers (as well as CalPERS itself) routinely pays 1.0% to 1.25% management fees for much smaller commitments of around a billion dollars, and survey data supports that conclusion.

But showing either cheekiness or ignorance, Cole justified the absurd fee amount by claiming that, in essence, CalPERS had looked at a proposed firm operating budget of the investment managers and was satisfied that the $100 million was necessary to run the businesses on a lean basis:

Cole: In our construct, in our belief, we will be — go back to the original purpose [of a management fee] and provide the cost and expenses necessary to run the business on an agreed-upon operating budget. So that operating budget would be made up of compensation, that’s comp — this is salary-type compensation, or base compensation — and then as well as those costs associated with running the business – rent, travel, engagement of outside people to help in deal making. And that that number will be in place of a management fee.

This claim is laughable on multiple levels.

First, if you take the entity that will execute what CalPERS self-aggrandizingly calls “the Warren Buffett Strategy” of long-hold investing, by design it will be much more passive than typical private equity firms. By holding on to companies for two to three times as long as is traditional, the firm will intrinsically be looking to make or sell an investment between a half and a third as often as competitors.

Further, CalPERS has talked publicly about this strategy being significantly more concentrated than is typical, meaning that its portfolio would hold, with the fund holding as few as four to eight companies, which would put it lower than a third of the usual number of positions.

When you combine these two factors, you are looking at a level of activity between a quarter and a ninth of what is typical. Staffing may not scale down commensurately with activity, so let’s say it remains at 40 percent of the typical level. A typical pure-play private equity firm managing a single fund of this size might consist of 25 investment professionals, so the “Warren Buffett Strategy” is likely to be staffed with approximately 10 investment professionals.

Cole goes on to say that the budgeted staffing cost would include only “base compensation,” which is generally understood to mean only salaries and not bonuses or carried interest. Throughout the world of finance, base pay makes up only a small portion of total cash compensation, as owners want their employees “at risk” and at their mercy. As a result, non-owner managing director-level PE professionals very seldom receive base pay of more than $1 million a year, and usually less. The annual bonus for such individuals might be $5 million, with annual carried interest awards of a similar scale, but the base pay is modest by comparison, Moreover, like all firms, private equity firms are pyramids of seniority – for every person receiving $1 million in base pay, two are receiving half that and five get $200,000

So you can see that if the “Warren Buffett Strategy” is a ten investment professional person firm including two owners, that’s probably two other senior people each making $1 million in base pay, two mid-level people at $500,000, and four junior people at $200,000. So the base pay staffing costs, excluding the two owners’ pay, is less than four million annually. Let’s throw in a CFO and some secretaries and call it five million annually.

Then there are the other costs Cole cites, “rent, travel, engagement of outside people to help in deal making.” The problem with Cole’s assertion is that these expenses, meaning travel and consultants (but not rent), are virtually always borne by investors via separate charges to the portfolio companies and therefore not paid for out of management fees. Virtually all U.S. private equity firms acknowledge this reality in their SEC Form ADV disclosure statements. To illustrate the point, we’ll quote from the ADV filing of Hellman & Friedman, widely viewed as among the least underhanded of PE firms in its practices and one of the largest private equity investing relationships of CalPERS historically:

Consistent with the Funds’ Governing Documents, H&F incurs expenses, and a portfolio company generally will reimburse H&F for such expenses (including without limitation, expenses for certain entertainment, meals, travel, deal, search firm and other consultancy expenses, and which from time-to-time include expenses for chartered or first class travel) incurred by H&F in connection with its performance of services for such portfolio company, including services as a board member or observer of such portfolio company or services of H&F operating or other investment professionals.

Again, we need to emphasize that virtually every U.S. private equity firm makes a parallel disclosure. That’s also that the way the money flows. “Reimbursements” go from portfolio companies to private equity firm. Private equity firms are free to reimburse all their costs of doing business unless they are explicitly prohibited in fund documents.

Suffice it to say that it is exceedingly unlikely, in light of Cole’s apparent minimal knowledge of widespread tricky practices, that he has succeeded in shutting off this conduit of funds to the private equity firms. That in turn would mean that Cole has volunteered to pay for these “expenses” twice, once by having money taken out of the corpus of his assets (portfolio company reimbursements) and once via the management fee.

Now it is true that PE firms have to pay their own rent, but a 15 person firm, including the secretaries, would be wildly generously provisioned with 1,000 square feet per person. At the luxury price of $100 per square foot, that would be $1.5 million per year.

When you put it all together, you can see that Cole can’t account for even $10 million of annual operating expenses in the “Warren Buffett Strategy” but proposes to pay the owners $100 million for their trouble. And the economics of the other fund CalPERS is trying to launch, its “late stage venture capital” will be similar. It too will, or should be, a very low-staff firm because it will do little of the two most time consuming activities, which is searching for deals and getting companies ready for sale and then selling them. The “late stage venture capital” firm won’t have to look for transactions; it will be on the speed dial of every venture capital player of size. And it won’t be selling the companies; the early stage investors drive that bus.

Cole needs now to step up and explain how he’s not agreed to two owners pocketing $40-odd million dollars each on an annual basis. Even if we grant that the owners will have to pay bonuses out of their own pockets to their employees, outside of the CalPERS budget.1 The CalPERS board, the retirees, and the legislature ought to take an interest in how it came to pass that these guys are to be paid so much.


1 An illustrative breakdown after base pay and bonuses but before carry. You can see it’s still way below $20 million:

2 senior guys @ $5 million = $10 million

2 mid level people @ $1.25 million = $2.5 million

2 junior people @ $500,000 = $1 million

1 CFO @ $350,000 = $0.35 million

1 accountant @ $150,000 ‘ $0.15 million

4 secretaries @ $100,000 – $0.4 million (secretaries are paid for confidentiality as well as work product)

Office rent $100/square foot for 15,000 square feet = $1.5 million

Total = $15.9 million

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  1. Alex V

    Reading Naked Capitalism has taught me a very important thing, applicable to basically any subject: whenever anyone speaks in percentages, prepare yourself for a lie.

    % = 666

    1. TimH

      Also any statistics that just give a single number as “the average” are misdirecting. Ignoring p etc, for most data sets the median is the useful summary, not the arithmetic mean (typically used as average).

  2. The Rev Kev

    So I was reading the illustrative breakdown of what is reckoned for what one of the PE firms would chew up in wages and the penny dropped. For any bureaucratic organization, once they have secured their budget and premises, their expansion is only a matter of time. If you doubt this, recall that at the beginning, the United States government bureaucracy could once all fit inside one building. Imagine these PE firms in 20 years time – hopefully with 5 years off for good behaviour. I have been giving this whole situation some thought about how to solve the Private Equity problem for CalPERS and the enormous costs associated with it and I think that I have a solution. I know that it sounds radical but I think that it will work. They should go to the whole CalPERS Board and make the following offer.

    Offer to pay for each member of the CalPERS Board to cruise the world, take a trip to space, see “Chippendales” & “Thunder From Down Under” in Las Vegas, build them an adult tree house, deliver a Message in the Sky, visit the Schlitterbahn Kansas City Waterpark’s Verrückt – world’s tallest water slide, go on a Safari, buy a $1,000 Golden Opulence Sundae from New York’s restaurant Serendipity 3, take a volcanic mud bath in Colombia, go to the Burning Man festival in Nevada, get a full-body Japanese tattoo – a horimono, get a fish pedicure, go to the North Pole, bungee jump at the Verzasca Dam in Switzerland, rent a Castle, do a shop-‘til-you-drop experience, learn to be a stuntman/woman, take Ice Sculpting Classes, get a Hermès $550 Beach Towel and finally go to the top of the Wells Fargo Center building – Sacramento’s tallest – and throw thousand-dollar bills folded into paper airplanes from it to crowds below.

    Why would I suggest such an insane offer of luxury and experience for the CalPERS Board members? Simple. Tell them that they can have all this for free but they have to agree to never bring up the subject of Private Equity firms ever again – ever!! Yes it may be very, very expensive but it will never be so hideously expensive as the double clusterf*** CalPERS seems determined to embark on with its billions of dollars. And for John Cole? Offer him a luxurious trip to anywhere in the world – one way.

  3. Skip Intro

    Old joke:
    What’s the difference between a used car salesman and a computer salesman?

    The used car salesman knows when he’s lying.

  4. vlade

    Well, he is the investment director. Invest in him and you’ll reap* – invest through him, and you’ll be sorry.

    *) I can see that this level of stupidity can be achieved only on purpose – either by the person himself, or by someone carefuly promoting the “right” (but not b-right) person who will happily listen to what “experts” tell him/her.

    1. flora

      Listening to CalPERS’ “reasons” for PE is like listening to some nonsense magical incantation: “umma zumma flim flam shabbam!” A sure fire investment scheme (emphasis on scheme).

  5. human

    It never ceases to amaze me when I read of $10’s and $100’s of millions being bandied about. For what?

  6. Clive

    Lean operation? That goes to the heart of the problem with CalPERS’ New PE Model. They have absolutely no way of knowing and no way of enforcing any sort of minimum efficiency or cost-reduction measures. The fee they pay is the fee they pay. The distance-relationship model specifically excludes CalPERS having any ability to audit the running of the PE shop, declare it to be a den of, if not inequity, then of extravagant outgoings and rein it all in a bit. Or even have a benefits-sharing programme of targeted cost reductions where the providers get some of the gains and CalPERS get a cut.

    It is the worst sort of perverse incentive — the more the hands-off PE management service spends, the more it looks like it really needs the ginormous fees.

    Round these parts, there’s an ongoing joke that the reason there’s so much road construction at the end of February or March time is because the county wants to make sure that it’s fully spent its budget for road maintenance and so while it keeps a little back at the end of the calendar year so as not to overspend if hit by a genuine high project cost, it has to hurriedly spend it before the end of the fiscal year in April otherwise it worries that it might look like its budget is too generously allocated. There might be a little truth in that, but at least someone, somewhere in the country’s management who can know the reality.

    CalPERS, however, can’t even be in on its own grift! Remarkable. Wasting public funds and the wasters of them don’t even get to put their snouts in the trough. You have to go a long way to find that kind of dumb.

    1. vlade

      Use it or lose it on budgets is a common theme. Saving money is discouraged, because “if you saved, it means we gave you too much money to start with, hence you likely need less..”

    2. flora

      With ‘spend budget before end-of-year’ you at least get improved roads. With CalPERS “plan” nobody gets nuthin’ … except the private PE guys.

      1. Clive

        Ah, but think of all those resort hotels kept busy with “conferences” and “off sites”. It’s like tax credits, but for elites.

  7. Tim

    Study after study and example after example have shown that obscene levels of compensation generally have an inverse correlation with managers’ performance and dedication to the best interests of the organization. I’m sure Calpers would be be better off finding some managers motivated by serving beneficiaries and satisfied with getting by on “only” $1 or $2 million a year.
    Its amazing how stupid and brainwashed buy-side participants still are after events of the last decade.
    “Where are the customers yachts?” is a joke they still don’t get.

  8. Tom Stone

    At ths very moment the most successful investor in the history of the world is at loose ends and available.
    If Cal Pers hired them for $80MM and gave them a completely free hand they could cure their pension shortfall in a matter of months.
    Hillary Rodham Clinton!
    Problem solved.

    1. Clive

      Only if they can’t get John Meriwether. But maybe you’re right, or perhaps they could skip a generation and go for Chelsea. There is nothing like getting ahead of the curve.

  9. David in Santa Cruz

    Paying each outside PE manager a fee of $100 Million a year appears to have become some sort of idée fixe to Marci Frost and her coterie of flatterers.

    This $100M fee number keeps coming up over and over in any presentation about CalPERS Direct to the Board or to the members and beneficiaries, since the original fix-is-in Eliopoulos/BlackRock proposal of 14 months ago. As Dr. Ashby Monk — who was hired by CalPERS to evaluate the strategy — points out in his recent Tweet-storm, the $100M fee number makes absolutely no sense in terms of real-world expenses and incentives.

    When is Marci Frost going to have her feet put to the fire about her inability to understand basic investment finance? CalPERS’s investment performance for 2018 was minus 3.9 percent, and the Board just looks down at their shoes. Frost recently spent the entire year running up and down the state blowing her goody-two-shoes sunshine up peoples’ butts about funded-status using a 7 percent return assumption that she audaciously claimed was conservative. I guess that people really do just love to be lied-to.

    Follow the money…

  10. Sinecure at M-Stanley

    1. I believe Mr Coles investing experience is with passive equity portfolios….what the heck does he know about setting up a business/investment mngmnt firm or private fund structures?
    2. Arent the front runners for the positions wealthy old white males who have already effectively retired from their respective firms?? Gee sounds exactly like the motivated high energy type A personalities needed for the job

  11. EoH

    Imagine the in-house talent a top state pension fund could hire with half the $200 million a year it proposes to gift to outside providers, for whom that would be a down payment on annual compensation. And all of that in-house talent would be directly accountable for everything they do, and their work would be completely transparent to CalPERS’s senior executives and, ultimately, its board.

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