For carrying on an undertaking of great advantage; but nobody to know what it is.
Notorious fraudulent company business proposal from the South Sea bubble
CalPERS’ efforts to launch its private equity scheme has been a hot mess. It’s not clear what problem the giant fund is trying to solve, save further reducing transparency, which is not a valid reason. CalPERS has clear legal obligations to put the needs of beneficiaries above all else, as opposed to sparing its executives what often turns out to be well-deserved embarrassment. Even worse, CalPERS has effectively admitted that its new private equity scheme will hurt beneficiaries and California taxpayers by lowering returns as well as increasing costs (which would further erode returns).
The shortcomings with CalPERS’ process for developing its new program include:
Research that consisted mainly of talking to big name business people too removed from the investing action to be of much use (and with conflicts when they did know something)
Obvious plans to hand the business over to preferred vendors (first BlackRock, which backfired when they submitted an overly-high bid for a fund-of-funds that CalPERS has quietly abandoned; more recently, alumni of Silver Lake who seem awfully close to a key adviser who was one of the CalPERS plan architects, Silicon Valley fixer and Lyft attorney Larry Sonsini)
Not having any CalPERS employees with private equity expertise involved, troublingly compounded by CalPERS keeping its private equity consultant, Meketa, largely out of the loop
CalPERS CEO Marcie Frost is determined to persist in “Fire, Aim, Ready,” another sign of a poorly managed initiative, via teeing up a vote to approve the newfangled private equity plan at the March board meeting.1 And as we’ll see, Frost’s arguments for sticking to her timetable actually make the case for delaying the vote or scuttling the plan altogether.
Frost’s latest public remarks on the private equity plans came last Thursday, February 28, at a California State Retirees Board meeting. CalPERS asked for Frost and new Chief Investment Officer Ben Meng to be given the opportunity to speak mere days before the session. From a transcript prepared from an audio recording, when the discussion turned to private equity:
Chief Investment Officer Ben Meng: We do not have a specific timeline [for approval]. We do not have a specific outcome.
California State Retirees President Tim Behrens: So it won’t be March then?
Meng: I cannot comment on that.
[after objections from Behrens and others that Meng should be able to comment on plans for public actions that are just a couple of weeks away]
CalPERS CEO Marcie Frost: Let me see if I can take this one. So we, Larry have been working with the board for a few months now on answering and addressing questions and outside perspectives coming in. We’ve had a due diligence report, we’ve had outside legal expertise come in and help to address some of the questions from the board. And, as we are preparing for agenda items, like we do for the board each month, there is direction to bring back consideration of action in March that would approve the concept.
And so what Ben has been talking about on the execution side is, we don’t know how long it is going to take to move beyond the concept. So what we’ve been trying to do is separate “concept” from the ability to execute on that concept. Ben’s said now a couple of times that we don’t know that we can successfully find a team of talent, and if we do find a team of talent, can we actually negotiate a term-sheet that’s favorable to CalPERS. We don’t know the answers to those questions. And that’s the timetable issue he’s talking about. So we’re not going to push this through. If there isn’t an alignment of interest, including financial, then we’re not sitting down and having a term-sheet.
If we are able to find a team, sit down at the table, get to a term-sheet, then there is what is called a prudent person opinion that would come in. And then there would be a board action at that point in time to say “yes” we want to move forward. And I don’t know what that would look like–it could be a delegation of authority–we’re not sure what that would look like. But what we need to do is signal the financial markets that CalPERS is interested in exploring this concept more, to see if we can actually execute it. That’s what we need to send out to the financial markets because the way that we make this successful is being able to find the right team to work with us and then talk about, right now, we are a little captive to this market, we need them more than they need us. That’s today’s market cycle, that doesn’t mean that will be the market cycle two years, five years, ten years out.
And we want to have these tools ready that, depending on the deal, depending on the opportunity, they’re available for us to access that opportunity quickly… So what we think is going to happen in March–I’m working with the committee chair [Bill Slaton] right now, taking some direction, that we bring in March an action that would approve the concept and then direct the team to go out and see if we can actually recruit.
And the reason that signaling the financial markets is important is that when we’re out looking for teams or looking for talent, we have to be serious about execution. And the way that we do that is that we have to have the board make a prudent public comment or take an action that says, “Yes, we want to see if we can be successful.” Because it’s innovation, we want to be really clear–we don’t know that we can execute on this in six months, twelve months, two years. But in five years, or two years, we might be able to, the conditions have to be perfect for CalPERS. And if they’re imperfect, we will not execute on it. We have other…And there will be consequences to that. That’s a question of a little bit earlier, you know, having Ben here is critically important. We have an investor as the chief investment officer at CalPERS, who is really mindful to the mission that we serve. It’s really important. My own motivation is completely about protecting defined benefit plans and protecting your benefit. His alignment of interest is exactly in the same place. And he has the investor knowledge to make sure that we can do it. So that’s kind of the landscape as I understand, as I feel it is today. But that will evolve over the next week as we’re putting the agenda item together.
A signal to the financial markets? As if CalPERS were a stock and Frost has to make nice to Wall Street analysts? Help me. This is laughable. If Frost actually believes this nonsense, she’s totally out of her depth.
It’s not hard to discern that Frost is trying to get the board to commit to the project even as more and more routine business stories contain evidence that shows that CalPERS’ private equity plan is off base. For instance, by happenstance, the Wall Street Journal recently confirmed our observation that CalPERS is proposing to pay double the market rate in fees for its “Warren Buffett” style vehicle, when Buffett himself has consistently stressed how critically important it is for investors to minimize fees and costs.
And Frost’s “we’re not trying to push this through” is contradicted by her actions. She admits all she has is an empty bag, yet she is doggedly sticking to the schedule she presented months ago of having the board vote on the scheme in February or March.
Let’s look at why what Frost said should alarm CalPERS beneficiaries and California taxpayers:
Frost admits she has no idea what CalPERS is doing, yet she wants the board to give a go ahead. This project has been underway for nearly two years, all under Frost’s watch. Yet as she admits, all CalPERS has is a “concept” but actually not: “CalPERS is interested in exploring this concept more.” Substantively, this is actually worse than our repeatedly describing the CalPERS plan as a mere napkin doodle.
Frost even admits to CalPERS changing its newfangled program on the fly: “…but that will evolve over the next week as we’re putting the agenda item together.” What???? For asking for board approval for a new initiative with a large commitment and significant financial risk when things are so incomplete that she has to admit publicly that she’s making changes?
Frost says she doesn’t even know how to get from A to B with her private equity scheme. Having spent nearly two years faffing about, even with only a fuzzy idea, Frost repeatedly says “We don’t know” what the execution plan is, what the process would be for the board making later sign offs, or even if they can get a deal done. So what is the point of having engaged Larry Sonsini and other advisers if CalPERS admits it has no idea if it can get anywhere?
Frost effectively admits that she is asking the board for approval when no normal vetting has taken place. Anyone managing funds knows, or ought to know, that the name of the game is avoiding liability. Among other things, that means getting experts to bless what you plan to do.
Yet Frost plans to hang the board out to dry by her insistence on moving forward with none of the normal protections completed. One would assume that if CalPERS’ fiduciary counsel had issued a favorable opinion letter, Frost would have mentioned that to show meaningful progress. She admits that there’s no prudent person opinion with her bafflegab that maybe this will come later. Why the board tolerates a CEO putting them at so much unnecessary risk is beyond me.
What Frost does say contradicts what CalPERS has said regarding why it needs this scheme. Frost is now trying to depict the two new funds of $5 billion plus each as opportunistic. She wants to rush to try to negotiate but wants the conditions to be “perfect” for CalPERS:
Because it’s innovation, we want to be really clear–we don’t know that we can execute on this in six months, twelve months, two years. But in five years, or two years, we might be able to, the conditions have to be perfect for CalPERS.
Frost seems to think that invoking the word “innovation” is a magic “get out of making sense” card. I’m old enough to remember the innovations of the dot-com era, like valuing companies such as boo.com that would clearly never make a dime on “eyeballs”. We know how that movie ended.
And Frost, a lover of surveys, retreated from her “innovation” branding because it turned out CalPERS beneficiaries are smart enough to recognize that “innovation” in financial services usually means “better means for picking customers’ pockets.” In one of its many wild shifts over the course of trying to sell this scheme, CalPERS briefly abandoned its “innovation” positioning and attempted depicting this still-not-ready-for-prime-time program as “tried and true”. But it appears “innovation” is again useful as an excuse for Frost’s team not being able to get out of its own underwear.
Amusingly, in other contexts during the past month, Frost has told people to entirely stop calling the two private equity initiatives “Innovation” and “Horizon” and instead to return to their original designations of “Pillar Three” and “Pillar Four.” This is of course a tried and true principle of bureaucracy: when all else fails, keep changing the name of programs.
The balance of Frost’s comment would seem to suggest that she feels the need to acknowledge that prices for companies continue to be at nosebleed levels. But if catching the market at the right time is now important to CalPERS, that contradicts what the giant fund has said repeatedly before. Ted Eliopoulos and John Cole both stressed the peculiar assertion that CalPERS needed to set up two general partners that it would not control so as to invest “in size”. New Chief Investment Officer Ben Meng discussed the supposed advantages of CalPERS having a 16% allocation to private equity as opposed to its current 8%.
But as we’ve pointed repeatedly, the obsession with trying to put more money to work in private equity is now at odds with earning a decent return. CalPERS supposed role model Warren Buffett has not made any large acquisitions in the last few years. In his just-released shareholders’ letter, Buffett warned he was not likely to make a big buy this year due to high prices.
And even if we accepted CalPERS’ premise, there’s the wee problem that a newbie player with two teams, CalPERS is at a big disadvantage compared to large and even mid-sized private equity firms.
And if CalPERS now thinks it wants to be opportunistic in private equity, setting up two new general partners and spending roughly $100 million in management fees on each is the wrong way to go about it. First, CalPERS plans to be passive, so they won’t have any say. The fund managers will feel compelled to make investments on an ongoing basis, if nothing else for resume reasons. Second, there is no justification to pay this much to be in the market only when prices are favorable. Oxford professor Ludovic Phalippou devised an opportunistic strategy for Norway’s sovereign wealth fund. It was to buy stakes in private equity funds in the secondary market in times of distress. That does not take a ton of people and could be done by an up-skilled in house team.
But this posture of cluelessness may have a purpose:
Instead of figuring out what to do in adequate detail, Frost instead plans to hand the driver’s wheel over to Wall Street. The big justification for CalPERS to go out and recruit teams is that Frost presents that as a necessary next step. But given that she says CalPERS only has a vague idea of what it wants to do, this is the equivalent of saying only: “Here’s the land I bought, I want two houses, one needs to be Tudor style, the other sleek and contemporary, and my budget is $100 million for each house. And when you submit plans, I’ll tell you if I like them.”
This approach is wildly imprudent. Not only does it hand way too much control over the end result to the architect and building contractors, all of whom may have their own agendas, but any competent professional would be leery of taking on a client that so clearly signals its flakiness.
Frost is trying to cover up for having failed once on implementation. Remember that in January, Bloomberg reported that CalPERS had two former Silver Lake executives under consideration for running its private equity program:
David J. Roux, who co-founded the private equity firm in 1999, and Adam Grosser, who headed Silver Lake’s Kraftwerk fund, are among “a fair number” of candidates to manage direct-investing strategies for the largest U.S. pension fund, John Cole, who is overseeing the initiative for Calpers, said in a telephone interview.
So what happened? Why did this first round of discussions with candidates fail? As we pointed out, CalPERS is planning to pay fees that are double the market rate. That’s awfully enticing. CalPERS needs to tell the board what happened. The most charitable explanation is that the Bloomberg leak backfired by turning candidates off.2 But it may be that even with the considerable advantages of having CalPERS let the private equity pros design many critical elements of the program, it became a time waster to deal with an institution that hadn’t sorted out what it wanted. And that hasn’t changed.
All this talk of “We have to show the market we are serious” simply provides more evidence that CalPERS is going about this all wrong. Frost claims that making a public commitment to the concept is necessary to communicate to the marketplace. You know what else would be helpful to communicate to the marketplace? Putting out a solicitation document describing CalPERS’ goals and asking for proposals. Why isn’t Frost proposing an obvious, concrete next step?
Frost’s show of desperation may be to make sure she has cinched control from the board before the new members get up to speed. CalPERS’ thirteen member board has four newbies: the Treasurer, Fiona Ma, the CalHR member, Adria Jenkins-Jones, the State Personnel board member, Mona Pasquil Rogers, and the public agency representative, Jason Perez. Frost has good reason to be worried that they might not buy what she is trying to sell.
But by getting the board to make what Frost pretends is a minimal show of support for her scheme, with no outline as to when staff will deign to let the board weigh in again, they are at risk of falling prey to a trick CalPERS employs regularly with the board: of telling them later that they’ve committed to a policy, and they are therefore duty-bound to sign off on specific later measures, since the staff “merely” implements the policy the board authorized.
Here are a couple of specific examples of the problems that Frost’s ruse creates for the board:
Is John Cole’s claim of a 2% management fee on $5 billion per fund part of the “concept” that the board is being asked to sign off on? This is utterly indefensible, yet may be precisely what Frost intends to tell the board later was implicit in agreeing to the “concept”.
Frost has made clear that the prudent person opinion would only apply to particular proposed transactions. As a result, no consultant appears to be on the hook for recommending in favor of the “concept,” which the prudent person opinion will take as a given. That leaves the board legally exposed.
Note that we aren’t the only ones to see Frost as desperate. Frost and Meng are out selling this half baked scheme and even admitting it could end badly for CalPERS. One prominent stakeholder e-mailed this comment on a new piece at a CalPERS-friendly venue, Calpensions:
I’m concerned that Ben Meng is quoted as being in “We have to do something even if it has no hope of success” mode. This is just a face-saving exercise for Marcie Frost.
CalPERS does not have to “do something”. It’s not being fired by private equity managers. It has lots of routes for getting private equity-like returns, which is its real objective, including ones it keeps refusing to admit even exist, like public market replication (several studies have given this a thumb’s up), setting up separate accounts, or leveraging the entire portfolio. CalPERS also keeps asserting that building an in-house team is impossible. Yet private equity expert Dr. Ashby Monk recommend that broadly for public pension funds. CalPERS’ admission that its newfangled scheme may not be in a position to take advantage of good opportunities for years means there’s every reason to consider building up its ability to do its own private equity deals
In fact, doing nothing is often the wisest course in investing. By contrast, CalPERS saying loudly that it must, must go ahead even when it can’t even convince its own senior executives that it’s a good idea is a prescription for being fleeced. And as former board member JJ Jelincic stressed, organizations do things for a reason. So we need to repeat his question: What’s the payoff?
1 If you read the remarks carefully, formally it was presumably the committee chair, Bill Slaton, who asked for the item to be put on the agenda, but don’t kid yourself. Slaton is an eager tool of CalPERS’ executives. This item would not be up for consideration if Frost didn’t want that.
It is also noteworthy that the idea of putting the private equity scheme on the March agenda was not mentioned in the February open session, which means it must have been a closed session item. This tidbit is part of a pattern we’ve noticed before: it’s OK for staff and its dogged allies on the board to violate state law by making closed session items public, but if any skeptic does that, calls for “off with their head” start pronto.
2 We had surmised the “leak” of the Silver Lake names came from staff members, so as to bolster the credibility of CalPERS’ floundering efforts by showing that serious grown-ups were interested. It was way too convenient that the only names in the story were those of people not at risk of being fired.