JJ Jelincic: CalPERS New Private Equity Model – What’s the Payoff?

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By JJ Jelincic, a former CalPERS board member

“CalPERS Direct” is a misleading working title for a new company with its own independent board that will create two other new companies with their own board and allocate trust money to them. The plan does NOT envision California Public Employees’ Retirement System (CalPERS or System) doing any direct private equity investing. These two subsidiary companies will act as private equity general partners. Staff has even admitted that what it presented as a new model is just like the way it invests in private equity now…..except it will be paying the costs and risks of putting new firms in business with no additional upside and less transparency to beneficiaries and the public.

The CalPERS staff is hell-bent on a path to create a new entity, beyond the control of the Board of Administration to manage private equity investments. Staff has stated a need to move quickly before the opportunity disappears. Perhaps private equity as an asset class will go away.

People and institutions do things for a reason. They do not act irrationally. That is not to say they do not make mistakes or act on bad information or bad assumptions. If conduct appears to be inconsistent with the explanation(s) offered it would suggest a hidden motive.

The explanations vary. The purpose, depending on the presentation is: to cut costs; to increase returns; to get more invested in private equity; remove the program beyond the control of the trustees; remove disclosure requirements. Other times it is that the CalPERS staff is incompetent and cannot analyze individual companies.

Top1000 Funds.comhas reported that the CalPERS staff has spent 3 years of intensive review an analysis to develop a new approach to private equity. It can only assume that reporter Sarah Rundell got that information from CalPERS. Clearly staff did extensive travel while developing this plan. If it did any analysis it has not shared that information publicly and there is no indication that any such analysis has been shared with the CalPERS Board. Assertion yes; analysis no.

Costs

Investing in private equity is a very expensive. The industry likes to focus on the management fees and carry, the proverbial 2 and 20. Charging 2% of the investment as an annual fee and then taking a fifth of the profits is a very heavy thumb on the scale, and that’s before you get to hidden fees and costs that the private equity funds take directly from the companies that they’ve invested in. These include “monitoring” fees, transaction fees, acquisition and disposition costs, broken deal fees, finder fees, indemnification costs, litigation costs, partner meeting expenses, consultants charged to the portfolio companies, and travel expenses (typically private planes). And there are hidden fees charged to the overall fund: custodian costs, administrative fees, legal and other costs of creating the fund, fund raising costs, accounting fees, office expenses for the general partner.

The academic community thinks the real total cost for private equity is about 7% per year and CalPERS confirmed that as a reasonable estimate in a 2015 workshop.

There is no available information on what the new company will charge for management fees. However, since a general partner’s largest expense is compensation and there is a stated intent to pay full market compensation, there seems to be little reason to expect significantly lower fees. So even if CalPERS claims it has lowered or even eliminated the management fee, the general partners are likely to make sure they get the same overall income they would otherwise, and will simply charge higher fees directly to the companies and/or the funds that they control.

The CalPERS staff has acknowledged that it doesn’t know what the real CalPERS costs are. They have also publicly acknowledged that the General Partners can charge anything that is not forbidden and can be bill at an inflated rate. It is hard to explain how you are going to save costs if you don’t know what your current costs are. CalPERS has not explained how any of these costs disappear. Presumably fund raising expenses would be eliminated but that is fairly minor. If you have the same essential costs of doing business it is unclear where the alleged savings comes from.

The California Public Employees’ Retirement Fund (PERF) exists to pay pension benefits. There are only four ways cash comes into the fund: employee contributions, employer contributions, investment income and investment realizations. There are four ways cash leaves the system: pension benefits, system costs, investment purchases and external fees. “CalPERS Direct” does not change those facts.

“CalPERS Direct” does not eliminate the middle man. It offers no clear plan for cutting costs. Where is the payoff coming from? ? Where is the payoff going?

Returns

Clearly returns are important. Modern Portfolio Theory is based on the fact that in the short run the possible range of expected outcomes (volatility) is very wide. In the long run, which is what a pension plan needs to be concerned about, higher returns require higher risks. Improved net returns that are derived from cost savings have the advantage of being both repeatable and guaranteed. There is nothing in the proposal that explains how increased returns will be generated. Yes it has been asserted but it has not been explained. Since there have been no identified cost reductions the clear implication is that the higher returns will come from more risk.

This begs the question “is the System being rewarded for the risks it is taking?” The answer is unknown. While the industry (and the CalPERS staff) keeps pointing to high reported returns they never claim higherrisk adjusted returns. If you do not know what risks you are taking you cannot risk adjust your returns. The CalPERS experience is that the program fails to match the benchmark of expected returns. The response has been to set a lower benchmark. That doesn’t really solve the risk/return problem. The majority of academic work, not sponsored by the industry, suggests that private equity investors are not getting well compensated on a risk adjusted basis.

No clear payoff for the System from higher net returns.

Trustee Control

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 members of Board of Administration are the named fiduciaries for the system. They have the responsibility for the administration of the system and the investment of the PERF. They can and have delegated the authority to staff. They have also given staff the authority to further delegate that authority to others. While the Board can delegate its authority it cannot delegate its responsibility.

It has been said that private equity deals come together too fast for the Board to be involved. Staff already has the authority to make a $1 billion commitment (recently reduced from $3.3 billion at staff’s request) and only inform the Board after the fact. While funds are larger than that few actual deals exceed $1 billion equity commitments. It is inconceivable that a reasonable deal larger than would come together in less than a month. It should be noted that the Board can meet on ten days notice, three in an emergency.

It was not until October 2, 2018 when Priya Mathur, speaking at the Top1000funds.com Fiduciary Investor Symposium, disclosed the previously confidential information that  the new company “would not necessarily be owned by us” that the extent of the intended fiduciary abdication became clear.

There is no clear payoff to the beneficiaries from putting the trust assets beyond the control of the Board. Who gains?

Disclosure

The private equity industry is not a big fan of transparency. One can only guess why it fears public disclosure of its actions. It could have something to do with Andrew J. Bowden’s, Director, Office of Compliance Inspections and Examinations, May 2014 speech in which he said:

When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.

When John Chiang, the California State Treasurer, was sponsoring AB 2833 to increase the transparency of private equity fees, the CalPERS staff was working in the background to weaken the bill. It wanted the bill to reflect the then current practices. It was that low level of transparency that created the need for the bill. It is interesting to note that the industry did not lobby on the bill at all. Clearly they felt that their message and concerns were being transmitted to the legislature by others.

When it was suggested that CalPERS adopt a policy that it would not enter into any new private equity agreements unless the general partner agree to disclose all the types of fee it would charge. the CalPERS staff argued against it. They claimed that if the System insisted on knowing, not even the amount, but the types of fees it would be charged the industry would refuse to accept the billions CalPERS had and wanted to invest. Staff was persuasive enough that the proposal died for lack of a second.

It is unclear how the beneficiaries are well served by dealing with firms that will not even let the System know the types of fees it would be charged.

It is not clear what role the CalPERS Board will have with the ”CalPERS Direct” other than creating it and sending it money. Who will appoint the board of this wholly owned company? Who will select the staff? What will the compensation look like? There seems to be no need for the beneficiaries or the Trustees to worry about where the trust fund assets are going.

By setting up a separate non-governmental company beyond the control of the trustees a lot of disclosure might disappear. CalPERS would still have to disclose what it paid directly to the firm “CalPERS Direct” but it would no longer need to report any of the underlying costs. There has been nopublic discussion that this is a scheme to avoid disclosure. It could avoid pesky disclosures like conflicts of interest, Form 700s, fees, salary and bonus disclosures. Is the move away from transparency even legal? It should be noted that Centerpoint Properties is wholly owned by CalPERS. Yet Bob Chapman, CEO, and Jim Clewlow, Chief Investment Officer, do not file Statements of Economic Interest. Does this structure avoid revolving door problems? If not, how would it be monitored and enforced without reporting? Could that be the goal?

There may be value in not disclosing anticipated specific investments but there is no value in hiding from the beneficiaries costs already incurred and investments already made. No one can “front run” an investment after it has been made.

Are shadows and secrecy the payoff? Who gains? Where is the payoff for the trust fund and the beneficiaries?

Getting More Invested

The CalPERS staff has asserted that unless the system adopts the new model it will not be able to get enough invested in private equity to meet its allocation targets. If the system is not being rewarded for the risk it is taking then that is be a good thing. Moreover, look at the current situation. CalPERS holds about $27 billion in private equity. CalPERS has over $14 billion in unfunded commitments, $6 billion of which is committed to the system’s largest managers. There is simply too much money chasing too few good opportunities. The industry is currently paying historical high acquisition prices and accepting the lower returns. Even then it cannot invest the currently available funds. If our largest managers cannot find opportunities why should we expect the new startup to do so?

If the goal is to get more invested then the way to do that is outbid others and to pay up even more. If our current managers will not do so, presumably because of the impact on their riskless profit participation, why should the system?

No clear risk adjusted payoff from getting more invested.

Staff

Another argument for creating a new firm is that state employees lack the ability to do the work. At the June 2018 Investment Committee Ted Eliopoulos, the CalPERS Chief Investment Officer said of his staff:

And as has been mentioned a few times now, the capabilities to undertake a co-investment and secondary investment program at scale requires a different underwriting capability than selecting general partners. The ability to underwrite and invest in an individual portfolio company, or a whole portfolio of portfolio companies is quite different skill set experience set than underwriting the capabilities of a general partner. So accessing some new talent and expertise in that area is really necessary for us to put billions of dollars into these categories going forward.

While I will not question Eliopoulos’ lack of ability, I would point out that most CFAs and MBAs on the investment staff can analyze a company. The fixed income staff runs a successful program that calls for just that skill. Even if Mr. Eliopoulos is right about his current staff (although there is no proof of the point) the state can clearly hire the skill set. It may require higher salaries but the whole proposal assumes that the new venture will pay market salaries. I would also point out that the System already pays for those skill sets in the form of fees paid to external managers and general partners. This proposal is just less transparent and controllable.

There is no disagreement that if you hire the needed skill sets and bring the investment process in house you can both increase the alignment of interest and reduce costs. Both of which would lead to increased performance. Yet that option is being rejected out of hand. “It just can’t be done. We can’t hire the skills.  We can’t pay the salaries.” The System currently pays the salaries just on a cost plus basis through the back non-transparent door. They are buried in the fees.

Six months ago it was impossible to pay an employee a million dollars. Now it is. What changed? CalPERS looked at the cost of not paying competitively. Alternatively, CalPERS could simply call the position(s) Head Coach (Investments) and then it could pay whatever compensation was needed and no one would complain. After all, successful coaches are paid more than doctors.

Conclusion

This is not ready for prime time. The proffered reasons do not support taking the action. So what is driving it and keeping it alive? What is the payoff and who collects? Is putting trust money down a black hole reasonable? The Board may know a lot more than it is letting on but is this the action of a prudent person knowledgeable about such matters? 

Waist deep (or deeper) in the Big Muddy. The big old fool says to push on.

  • Can’t offer any rationale but push on.
  • No Board approval but push on.
  • The Attorney General won’t declare the scheme legal but push on.
  • Board consultant kept away from details but push on.
  • Fiduciary Counsel kept in the dark but push on.
  • Contract out permanent state work but push on.
  • Scheme makes outsourcing permanent but push on.
  • Interview future billionaires and push on.
  • Silence is consent as the staff pushes on.

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