CalPERS seems to think it can brazen its way through a misleading presentation of management performance it made at last week’s board meeting.
After being challenged by an email from board candidate Margaret Brown, Chief Operating Investment Officer Wylie Tollette effectively admitted that a key slide was inconsistent and therefore misleading. Yet just minutes after recanting orally before the board, Tollette made a video presentation that doubled down on that misrepresentation and made an impressive three additional ones in 25 seconds. The Orwellianly named Office of Stakeholder Relations then encapsulated the core misrepresentations in a press release.
Note in our companion story that the Wall Street Journal has embarrassed CalPERS into backing down on the press release, but the Tollette video is still up.
There is no way to depict these mis-statements as innocent mistakes. Readers may recall that CalPERS board candidate Margaret Brown e-mailed CalPERS’ board to highlight that $75 million in expenses had been excluded from a investment cost comparison. As a result, these costs were presented on an apples and oranges basis and created a false impression that staff effort, and not an accounting fudge, was responsible for a large proportion of the cost decline that CalPERS touted. The ones she flagged, such as legal and accounting costs, were excluded from the latest year but included in prior years, making any comparison of this year to past years misleading.
For a public company, the misrepresentaion is as egregious as showing a table with a line item, “Profits” and having it be the more stringent “Net Profits After Taxes” for earlier years, changing to the much looser Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) for the current period, noting the switcheroo only in a footnote, and then putting out a press release claiming that profits had increased.
This sleight of hand matters because investment costs are a factor used in determining the bonuses for Tollette, Chief Investment Officer Ted Eliopoulos, and perhaps other members of the investment office.
As we described, Brown was being charitable, since the footnote that identified the missing $75 included another $46 million item, funds of funds costs, that CalPERS excluded. That brings the total airbrushed out to $121 million.
How CalPERS Doubled Down on Lying
By way of background, here is chart that CalPERS seems so desperate to defend, which you can also view on page 4 here. Despite having two board candidates with substantial investment experience challenge the presentation, CalPERS’ staff persisted in amplifying the bold header at the top of the slide, when the responsible course of action would have been to issue a corrected version of the chart at the Investment Committee meeting and retune the PR campaign accordingly.
If you look at the first footnote, it refers to the second row in the slide, “External Management Fees – Base (Private)”. Here is the key detail in the footnote: “Does not include PE Partnership Expenses (approx. $75 million) or Mgmt Fees paid by the underlying Funds in the Fund of Fund (approx. $46 million).” Margaret Brown’s e-mail to the board over the weekend prior to Investment Committee meeting, when this presentation was presented formally to the board, appears to have been forwarded to members of staff, since Tollette went to some pains to try to depict the footnote as on the up-and-up.
From 58:20 in this video, which you can also view here:
Wylie Tollette, Chief Operating Investment Officer: Now, we believe this treatment of partnership expenses is appropriate and maintains the proper distinction between…and consistency and the treatment of those expenses between our various asset classes, as well as in the degree of influence that CalPERS can wield regarding our negotiating ability as well as who bears those costs and who has privy of contract. If we were to re-comingle the $75 million in partnership expenses back in to external management fees, that number, that $500 million number up there in the current fiscal year, that would jump obviously to 575. Now, if we were to re-comingle the underlying fees on fund to funds, that number would jump to 621.
This attempt at porcine maquillage is pretty transparent. With this statement, Tollette admits that for the expenses to be consistent, you need to add back in the items buried in microtype in the first footnote.
On top of that (and we’ll discuss this at greater length), both Margaret Brown (at 1:17:20 in the video above) and former CalPERS board member and private equity expert Michael Flaherman (at 1:20:36) described how the cost presentation was incomplete and therefore inaccurate. Flaherman also punctures Tollette’s excuse that it was just too hard historically to go digging around in K-1s (partnership tax documents) to separate out these expenses. The fund expenses are a separate item in private equity capital calls and funds like CalPERS pay for them separately.
Contrast Tollette’s statement above with this video, which was posted after the Investment Committee meeting:
Tollette: The Investment Office and the different teams we have within the office here have done a great job in-sourcing investment management to teams here in Sacramento. It’s been a very economical activity for the state. Overall, we’ve saved $404 million in external fees over the last seven years. Very impressive performance and CalPERS continues to be a leader in this area.
As the former co-head of McKinsey’s organization practice and leadership expert Doug Smith noted:
Numbers don’t lie. But those like Wylie Tollette who operate within a culture of no governance predictably use numbers to lie. And, based on CalPERS sorry history, do so with impunity. Case in point: As Yves notes, Tollette admits having lying numbers one minute, then proclaims the same numbers just a few moments later.
Here are Tolette’s four lies:
1. That the time period at issue is seven years. You can see from the chart that it’s six years. Normally, one would give Tolette a pass, but he’s supposed to be a numbers guy and this was a prepared statement, not an off the cuff response to an unexpected question.
2. That the cost reduction was $404 million. Tollette is presumably referring to the first bold row in the table, “Total External Mgmt Fees – Base”. The difference between the 2010-2011 year, $904 million and the latest year, 2015-2016, of $500 million, is $404 million. But as Tollette acknowledged, the past years don’t include the $121 million we flagged. Add that back in and you get $621 million for the latest year and a decline of $283 million.
3. That the fall in costs was the result of CalPERS’ actions, specifically bringing activities in house. This is not accurate. The first line in table shows that only $3 million of the cost reduction came from public equities, which fell from $103 to $100 million. Virtually all of the decline in costs took place in private equity. And recall that in CalPERS’ own private equity workshop, in November 2015, staff stressed how little power CalPERS had, that it was essentially a terms-taker.
Now in fairness, Tollette does not attempt to attribute the fall in costs to CalPERS’ negotiating better deals. Nevertheless, the expense delince was due significantly and perhaps mainly to market factors, not CalPERS initiatives. As we’ll explain, using generous assumptions, the private equity cost reductions from 2010-2011 to the latest year attributable to “bringing activities in house” are probably not much more than $120 million. Mind you, that is not nothing, but it sure isn’t $404 million.
First, private equity fees decline over the life of a fund. Management fees are a prototypical 2% of committed capital, but that applies only during the “investment period,” the first five years of a fund. After that, it falls to a typical 0.5% of the assets under management.
2007 was the year when CalPERS made its biggest commitments ever to private equity funds. 2008 was another big year, although not as big as 2007. Commitments dropped like a stone in 2008 and and have continued to be lower than in the peak years.
The big year fee rabbit was moving through the anaconda as of the 2010-2011 year. You’d expect that to be the peak, since 2006 vintage funds would be rolling off their peak management fee levels in 2010. The decline was due to the global financial crisis. Is Tollette trying to give CalPERS for creating that to the benefit of staff bean counting?
Second, Tollette is giving himself an credit for a second effect of the financial crisis: low private equity transaction volume through 2012. That means few companies were available to buy, which meant that lower fees charged to portfolio companies.
Why does it matter that portfolio company fees declined for a period of years after the financial crisis? We need to refresh our memories about what JJ Jelencic refers to as the “left pocket” and the “right pocket” of private equity fees.
The private equity management fee line in the chart above shows management fees (the “left pocket”) after management fee offsets (the “right pocket”). CalPERS does not count as a cost the total amount of management fees it bears, the prototypical 2%. Instead, CalPERS counts only the portion of the management fee as a cost that it pays directly out of its left pocket. However, private equity firms collect a portion of the total management fees via various specifically enumerated fees, the right pocket, like transaction fees and the “money for nothing” monitoring fees that they charge directly to the portfolio companies they control but that are actually owned by investors like CalPERS. So those portfolio company fees are also borne by the limited partners. Ultimately, the effect of these fee machinations is to shift a portion of the management fee from being billed directly to funds (the left pocket), and instead extracted from the portfolio companies (the right pocket). It does not reduce the actual charges limited partners ultimately pay or make them go “poof”.
As regular readers may recall, CalPERS sticks fiercely to this head-in-the-sand position even though its own consultant, CEM Benchmarking, has cited this ignoring of the right pocket as one of the many reasons pension fund like CalPERS are underreporting roughly half their total costs. And gimmicks like excluding $121 million in 2015-2016 mean that CalPERS is moving in the direction of less, not more, accuracy and transparency.
So now we get back to the point of our left-and-right-pocket digression. Right pocket portfolio company fees are lower when private equity funds are doing fewer deals, as in buying and selling companies. That would result in lower transaction fees at the portfolio company level, which means lower fee offsets against management fees, which means that more of the management fee is paid from the left pocket that CalPERS tracks. The result would again be relatively high management fees according to the way CalPERS counted them in that table. As transaction levels rose in more recent years, all other things being equal, left pocket management fees would fall because they are being paid by the invisible right pocket.
And let us stress again: these factors were entirely outside CalPERS’ control
So what did CalPERS control? “Bringing private equity in house” simply means exercising contractual co-investment rights. Those provisions allow limited partner to invest more in particular deals in a fund, side-by-side with the general partner. In most cases, that means they do not pay management of carry fees.
What that might mean in hard dollar terms?
This is a crude computation but it should give a general sense of how much CalPERS might be saving in management fees by doing more co-investing, as many of its peers are also doing. Co-investments occur when limited partners take advantage of the right that general partners may allow, that of investing more money in particular deals in a fund than they would get through their position as as general partner. This has can have an expense impact since most general partners allow co-investments to be made without paying management or carry fees.
There may be some savings associated with that, but it is likely to be small relative to the huge number presented. Moreover, it’s not clear what real effort these co-investments took or who, if anyone should get credit for them. Moreover, the cost benefit is falling. Buyouts Magazine reported in 2016 that the year before, fewer than one in four of general partners charged fees on co-investments, but that had increased to one-third saying they were or planned to levy fees.
4. That CalPERS is reporting costs completely and as accurately as it can. This is implicit in Tollette’s presentation and more explicit in the press release. It is false because, as Michael Flaherman pointed out in public comments, CalPERS does not capture the cost of management fee waivers anywhere, even though CalPERS makes hard dollar payments for them. “Management fee waivers” are a tax abuse that the IRS has targeted yet perversely CalPERS and other limited partners enable (see here for a long-form treatment). We’ll unpack this immediately below, since the press release makes more explicit claims than Tollette’s short statement does.
Why This Matters
CalPERS board is failing to meet its fiduciary duty. One of the basic obligations of a fiduciary is to look at investment returns of a particular investment strategy in light of the costs. The board cannot make that assessment unless it knows the full costs of private equity, far and away its most expensive investment strategy. Yet despite making regular motherhood and apple pie statements about the importance of efforts to force more transparency in private equity, CalPERS continues to playing “hide the ball” games like reporting net rather than gross management fees (the “left pocket” only rather than both pockets), getting rid of the $121 million in costs, and reporting management fee waivers nowhere.
CalPERS can and should make a separate report on fees and costs that isolates those elements that are under management control. But that again would mean reporting gross, not net, management fees and also clearly identifying cyclical factors, like the breakdown of fees that are attributable to funds in the investment period versus mature funds so that the board can adjust for cyclical factors.
CalPERS board is actively enabling a culture of pervasive, institutionalized lying and of digging in even when caught out. As we describe in our related post today, it took the Wall Street Journal to get CalPERS to relent on its inconsistent reporting of private equity expenses. Where was the board? No one grilled Tollette or followed up on Brown’s or Flaherman’s public comments. Indeed, board members Henry Jones and Priya Mathur were all too happy to defend CalPERS’ charade to Buyouts Magazine’s reporter Sam Sutton. And in the board meeting last week, Richard Costigan on two separate days backed how staff cooked the numbers.
As Doug Smith summed up this sorry situation:
For a few decades now, we’ve reaped the evil harvest of out-of-control financial institutions. CalPERS is among the longest running example. Indeed, as Cfdtrade’s running account shows, it’s been years since any governance has come from any quarter. Other than JJ Jelincic and the occasional other exception to the rule, the board has not governed the giant pension fund. The risk division is embedded in the investment office: no governance there. It’s brutally difficult to mount an election campaign: no governance there. State officials, again with a few exceptions, don’t seem to care: no governance there. And the General Counsel routinely fits the law to the facts instead of the reverse: no governance there. From decades of observation, I’d say it’s too late. Sacromento ought to scrap the whole thing and start over.