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