By JJ Jelincic, a former board member of CalPERS
The new CalPERS Private Equity Business Model (which used to be “CalPERS Direct” even if it never was) is in trouble.
It simply makes no sense. Both Marcie Frost, CalPERS CEO, and Ben Meng have acknowledged that they don’t know if the model will work and even if the model works they are not sure CalPERS can execute it. For instance:
Staff has offered no explanation how small startup companies can find opportunities the major players with many more employees cannot find.
Staff has offered no explanation how these startups, whose goal is to acquire assets i.e. get more private equity exposure, will show any price discipline.
Staff has said Pillar IV (“Warren Buffett style investing”) will have higher costs and lower returns than traditional private equity. (Staff has said very little about Pillar III, “late state venture capital”. Does that reflect even greater ignorance about venture capital?) How does that lead to greater returns?
If you can’t even offer a basis for expecting the model to accomplish its goals, why do it? Where is the payoff and who gets it?
The focus of Pillar Ill will be late stage venture capital in technology, life sciences and healthcare.. It is interesting to note that staff has not even claimed that Pillar III would have above market returns. This actually does make sense since the real gains in venture capital go to the early investors who take the risk. The staff has offered no theory why a developed company that is private only to avoid the exposure and scrutiny of the market is likely to have above market returns.
The agenda item now posted on the CalPERS website under Benefits and Risks, states:
Risks relate to the ability to identify partners that will ultimately be successful executing the strategies, the ability of partners to build adequate teams, reaching adequate scale to reduce the operating budgets below the typical management fee costs associated with typical partnerships and the potential capital concentration in the eventual investments.
It is worth noting that staff has found a venture capital plan and a private equity plan that have no risk that the underlying investment may fail. Or at least that the odds are so low they are not worth mentioning. Truly a miraculous development.
However, Attachment 1 does identify some risks and mitigation strategies.
Reliance on Key Partners
- Dependent on top-tier Partners who can further define and execute strategies
- Must be able to build new teams from the ground up while having a successful track record (in some other venture someplace else?)
- Careful selection and diligence is essential
- Must act quickly so CalPERS doesn’t lose its future billionaires in waiting
Investment timelines vs Partner Commitments
- Initial commitments will have fixed terms that are likely to be shorter than the time to realize returns on investment.
- Create permanent structural commitment to strategy
- Align incentive with Partners to focus on long term performance
- Longer hold periods may ditute the high annual returns seen in short-hold gravitate equity
- Consider potential dilution in benchmark setting
- Utilize longer-term metrics to supplement performance metrics
The attachment also notes that realized drawdowns and volatility are lower than the capital market assumptions. Staff has acknowledged, since at least the Private Equity Workshop in 2015, that these outcomes result from favorable accounting treatment. If you only mark to market quarterly and the marks are set by a manager getting paid, in part, based on assets under management one should expect lower write downs and volatility. On several occasions staff has acknowledged that “observed volatility” is a measurement problem. No rational investor believes that leveraged small cap equity is less volatile than a large cap index.
So look at what they are putting forward? A program based on misleading accounting. CalPERS needs to act NOW or the potential billionaires will go away. (I guess the staff forgot about Meng’s presentation on stock pickers). CalPERS needs to make a structural commitment. (So much for a “conceptual” approval.) The CalPERS “long term holds” will not be long enough to realize returns so it must align incentives to focus beyond the investment period. (Neat trick. I wonder how?). Because of lower returns CalPERS will need to cut the benchmarks even further. How does any of this make sense?
At the February 28, 2019 California State Retirees Board meeting, Frost disclosed that she had been directed by Bill Slaton to bring the pending CalPERS Private Equity Model to the March Investment Committee for “conceptual approval.” That instruction appears to have been given in closed session.1
Over the last two years staff has repeatedly and publicly claimed that the Board had “approved” the new Private Equity model. When pushed by the Board, the press and/or constituents, the “approval” amounted to “Well, they didn’t tell us to stop.”
Now not rejecting is no longer enough. Now the Board needs to give a blank check to staff and approve the model “in concept.” This is interesting since John Cole has already said staff could implement the new model within its current authority. The next time this issue comes before the Board, staff will rely on “as you approved in March.”
Why does Frost need this blank check? She says it is to convince the market that CalPERS is serious. As Frost said:
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….
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.
As Dr. Ashby Monk, the executive and research director of the Stanford Global Projects Center, who was invited by staff to speak twice to the Board, said (my emphasis):
Because most people in the world today don’t grasp the sheer sale – scale of the compensation we’ve paid to these external managers. It’s often hidden in footnotes. It’s often buried in NAVs. And that lack of transparency has limited the amount of innovation that we’ve had. That transparency project of you all have realized and has start here a few years ago when the true cost came forward, drove this Board to say is there another way? And that is the best thing we could have had happen. Because the fastest path to becoming a billionaire in America today is not starting a tech company, it’s starting as asset management firm, okay, by a factor of two.
So given that CalPERS is trying to create billionaires by setting up their companies for them, why does CalPERS need to signal the markets? It’s because the market doesn’t believe CalPERS. Every time this so called Private Equity Model is exposed to sunlight it changes. The result is neither the beneficiaries nor the market are sure what CalPERS wants them to believe.
It is possible that the market does not believe any fiduciary who has his or her personal net worth at risk would even consider:
- creating a startup asset manager and giving it away,
- agreeing to pay all expenses of the new firm,
- setting up a non-owned LLC2to invest with that manager,
- giving billions to the new manager while retaining no ownership of the assets,
- not knowing when any cash may come back to the system, and
- having no control of the assets.
Yet that is exactly the concept staff is asking the Board to approve. Have you ever wondered by public pension plans are often seen as “dumb money”?
If I asked to manage your money on those terms how long would it take you to throw me out? Yet the Board members are legally required to act as prudent experts – a very high standard.
The Law? What Law?
Don’t forget what the California State Law which created and defined the trust says.
California Government Code § 20120:
The management and control of this system is vested in the board
California Government Code § 20170:
The Public Employees’ Retirement Fund in the State Treasury is continued in existence.
The Public Employees’ Retirement Fund is a trust fund created, and administered in accordance with this part, solely for the benefit of the members and retired members of this system and their survivors and beneficiaries.
California Government Code § 20171:
The board has the exclusive control of the administration and investment of the retirement fund.
California Government Code § 20190:
The Board has exclusive control of the investment of the retirement fund.
The Board may lack the legal authority to give away the assets of the fund.
Governance? What Governance?
Both Dr. Ashby Monk and Frost talked about the importance of governance.
Dr. Monk said:
I’m encouraged that if you can get the governance right, if you can evolve this into a platform that can recruit the right talent, you can succeed over time.
Marcie Frost had also said:
Governance. Governance very important. And I know that we’ve been looking at governance structures for a bit of time and will continue to do so.
While the issue of governance is still undecided, it seems that given the law it is unlikely that proper governance is achieved by placing assets beyond the reach and control of the Board. Abdication is not governance. Yet this is what is being proposed.
When board member Margaret Brown asked about increasing the transparency of the plan to the Board and the beneficiaries, her answer came from Matt Jacobs, CalPERS General Counsel:
Well, at a high level, I suppose we could. I think that would defeat the entire purpose of the endeavor that the Investment Office is undertaking, which is that these are private investments, and they’re private for a reason, which is that the – the financial information needs to be private. And the people running them have these types of preferences.
Why should the trust beneficiaries care? It is only their money.
So staff is seeking approval “in concept” for a model that is still in the process of being defined.
Staff has asserted but offered no reasonable basis to claim the model will actually achieve the goals being set out. The “model” has still undefined controls and governance.
The model has not been submitted to a prudent person opinion which makes sense since it is impossible to opine on an undefined program.
The costs remain undefined. It may be a reasonable experiment if it costs $100,000 a year. It does not make sense if it costs $10 billion a year.
Staff has not refused to answer Board questions; it has simply found it easier to ignore the questions. After all the staff has already given the Board their marching orders.
Three months ago, I described how CalPERS staff was unable to present any payoff to beneficiaries from the proposed private equity plan, that, for instance, there was no clear payoff from higher net return and no clear payoff from putting the trust assets beyond the control of the Board. Today, we are still wondering who benefits. Given the continued failure to explain why this plan could rationally be expected to help CalPERS’ beneficiaries, staff should not be surprised that independent parties are wondering about bad motives, particularly in light of the Al Villalobos/Fred Buenrostro bribery scandal.
At best, it is way too early to approve this so-called model even in concept.
1 I must assume that Slaton will be pursuing discipline against the CEO. After all, he once sought to have me disciplined for a passing mention of a SEC investigation of CalPERS insider trading. He claimed it was attorney-client and closed-session privileged even though the Sacramento Bee had written about it three years earlier.
2 John Cole has said that CalPERS would be the “sole member” of the LLC it uses for these funds but will not own it. That makes no sense. The members of LLCs are all owners. In addition, an LLC must have a manager who may or may not be a member. According to LegalZoom:
Not all LLCs have a managing member; in a manager-managed LLC, the members own the company and the manager is a non-member employee who runs the company. A managing member of an LLC is an individual who holds an ownership interest in the company, participates in its day-to day management and has authority to contract on behalf of the company.
Cayman Islands law on LLCs is modeled on Delaware law, so there’s not much reason to think there is a Caymans angle that would change this picture.
So it appears that CalPERS doesn’t know what it is talking about even on this basic issue and is hiding important information, like who would manage the LLC(s).