This is our third post in a series examining a single presentation to the CalPERS board by John Cole, the senior manager tasked with re-structuring the pension fund’s private equity program. Here are the earlier posts: Is CalPERS Private Equity Architect John Cole So Clueless He Doesn’t Know He’s Lying? and the second, More on “Is CalPERS Private Equity Architect John Cole So Clueless He Doesn’t Know He’s Lying?”
Cole’s presentation caught our attention for its astonishing combination of ignorance and duplicity toward the board. Multiple people had noted to us previously that Cole has no professional background in private equity and is instead a “public markets” professional. But the depth of his ignorance wasn’t quite so apparent until the December presentation and raises serious questions about whether the board relying on him as the architect of a $10+ billion investment program constitutes per se breach of its fiduciary duty.
The object lesson today is a section of Cole’s presentation to the board in December in which he was asked about how CalPERS newfangled vehicles would handle the so-called carry fee. The carry fee is a significant form of compensation to the fund managers, and it is separately considered important because it is supposed to incentivize the manager to deliver superior returns.
The prototypical compensation structure is “2 and 20,” with the “20” being a 20% participation in realized profits. But as we’ll see, determining what should be considered profit needs to be defined carefully. That problem has been largely solved but Cole misleads the board about both some new issues the CalPERS approach raises and the fact that CalPERS elsewhere is relying on well-established provisions.
We’ll boil down the exchange in question into a simple analogy. A man walks into a mobile phone store and says to the sales agent, “I’d like to buy a phone. My wife says I need to ask about what bands the phone transmits on because we travel abroad a lot. I am definitely not an expert in the band stuff, but I need to know so that I can report back to my wife before I decide. She’s an expert in this.” The sales agent then proceeds to ignore the question and offers the bizarre response. “Our phones can all send SMS messages and have built-in speakerphones.” The customer then asks, “Don’t pretty much all phones have speakerphones and send SMS,” to which the sales agent says, “No, most do not. Ours are special, and you are lucky to get these features.”
Here is the private equity version of this mobile phone discussion:
Acting Committee Member Juarez: And so where does the carry equivalent come from for the GP to realize at least some sense of the same profit they would have gotten if they were under a traditional arrangements?
Investment Director Cole: Yeah. So, first of all, importantly, that in the 20 side of 2 and 20, that we expect — not expect — we will insist, we will demand that the costs that are necessary to operate the business that I just described would need to be fully offset or effectively reimbursed before the first dollar of incentive is paid. So whatever that number might be, that all of it is — is — comes back to CalPERS before the calculation of the incentive, the carry, kicks in. That’s one.
Two, is that what we — there are some very important concepts that we’re embedding in looking at carry. Most important of all in my estimation is the concept of pooling or netting. What those terms mean is that when you have — are doing deals in a fund, in a commingled fund environment, let’s say you do — have five transactions, two of those transactions work out really well, one of them’s okay and — or maybe two are okay and one doesn’t work out very well. Often, and I’ll say most of the time, that the way the incentives are structured, there is a — it is paid for the benefit — on the benefit of those things that had done very well and there’s no penalty in the event that it doesn’t.
The idea of pooling or netting is to say that we look in aggregate. We think of it as an entire portfolio. And therefore, those things that underperformed on the one side of the portfolio are fully a part of calculating the overall success and netted against those things on the other side is the key concept and one that’s not —
Acting Member Juarez: And would you argue that differs from the current carry provisions that we experience?
Investment Director Cole: Yes.
Before we get to the more complicated question of “where does the carry equivalent come from” which was, in the context of the interaction, the “what bands does this phone transmit on,” question, let’s first dispense with the part that is the equivalent to the claim that “the phones all have the unique features of speakerphones and can SMS.” These were Cole’s two claims that
1. “We [CalPERS] will insist, we will demand that the costs that are necessary to operate the business that I just described would need to be fully offset or effectively reimbursed before the first dollar of incentive is paid.”
2. Two, is that what we — there are some very important concepts that we’re embedding in looking at carry. Most important of all in my estimation is the concept of pooling or netting.
Both of these features are absolutely standard provisions of private equity fund investing, and have been so for decades. It is trivially easy to demonstrate the truth of this statement simply by quoting from a treatise on standard private equity fund terms published by Debevoise and Plimpton, which has one of the largest U.S. practices representing private equity firms (and is chaired by Mary Jo White, former chairwoman of the SEC).
On page 28, the treatise refutes Cole’s first claim, his self-righteous assertion that it is necessary for CalPERS to stomp its feet, “insist,” and “demand” that carried interest be computed on the net profitability of the contemplated vehicle, after accounting for the expenses paid in by CalPERS. According to Debevoise:
Carried Interest typically is computed net of expenses, including Management Fees.
Likewise Debevoise contradicts Cole’s strong claim that “pooling or netting” is an atypical accommodation by a private equity manager to its investors (note that Juarez asks Cole specifically at the end of the exchange whether pooling or netting “differs from the current carry provisions that we experience” with other managers, and Cole answers definitively “Yes.”). On page 27 of the treatise it says:
When computing the Carried Interest, the netting of a Fund’s gains and losses across all investments is almost universal.
The concept of “pooling or netting” refers simply to the idea that the percentage of profits that a private equity manager takes as its “carried interest” must be based on the overall profitability of the vehicle, not the profitability of each investment in isolation. Otherwise, a fund could lose money overall while some individual investments were profitable, which in the absence of pooling or netting would allow the fund manager to take carry on those profitable investments even though the manager performed poorly overall.
In the early days of private equity, in the 1980s and early 1990s, it was relatively common for funds to lack a pooling or netting feature. Ironically, CalPERS played a major role in forcing the pooling and netting feature into funds as a standard feature. In the mid-1990s, CalPERS issued a report arguing for the flawed nature of funds that didn’t provide for pooling and announced that it wouldn’t invest in new funds that lacked that feature. Now we have Cole, 25 years later, stumbling onto the ruins of an ancient temple, missing the intellect or imagination to grasp the glory that was Rome.
This brings us to Juarez’s original question that set off Cole’s display of ignorance and/or misdirection. It appears that what Juarez wanted to know was how the private equity manager would receive carried interest in the long-lived, so called “Warren Buffett” strategy fund, where assets might not be sold for 15 years. Private equity fund managers typically sell assets after a four to seven year holding period, which allows them to start collecting carry, assuming that the fund is profitable overall. So the long holding period is a major negative for the fund manager, and that raises the question of whether it would seek novel carry fee provisions that could have hidden or obvious negatives for CalPERS.
With the much longer expected holding period, there are two main alternatives. One is for the manager has to accept waiting MUCH longer to be paid carry when the company is sold. The other is for CalPERS to agree to let the manager treat accounting gains as if they were realized profits, and take carry out of cash flow that would not normally be used to pay carry, such as dividends to CalPERS.
This second alternative presents multiple problems for CalPERS. First, the carry payment would have to be computed on appraised values of the assets, as opposed to the actual values at which the assets are sold in the traditional model. This presents a lot of opportunity for manipulating values, especially since the private equity managers traditionally assign values to the portfolio and do not obtain independent valuations. The other main problem is that taking carry out of cash flow would produce inferior economics for CalPERS relative to the traditional private equity structure, where cash flows like management fees are not inflated by having to pay carry.
Another way of generating cash in the “Warren Buffet” strategy to pay carry would be for the manager to aggressively add debt to the companies over time and take out equity. This is the equivalent of a “cash-out refi” of your house. You can be sure that if this is the only way that the manager can receive carry, they will do it, despite the dramatic increase in risk that it would entail and that CalPERS certainly did not intend.
You can see how Juarez’s question about how carry would be paid was probing at a critical issue and deserved a substantive response. All Juarez got was a load of nonsense from Cole that demonstrated Cole’s own ignorance and unwillingness to give good faith answers.