CalPERS yet again shows itself to be the gang that is incapable of shooting straight.
The giant California pension fund is apparently so desperate to shout down any challenges to its completely misguided private equity outsourcing scheme that it tried to throw a punch against Sacramento’s most prominent political commentator, Dan Walters. Apparently having someone of Walters’ prominence (one reader called him the David Broder of Sacramento) pour cold water on CalPERS private equity plans was seen as a threat that had to be beaten back.
But CalPERS swing was so badly aimed that it did the journalistic equivalent of punching the wall and breaking its hand instead. Not only did the article come off as a shrill and desperate, but it contained assertions about how the new program would work that make CalPERS look incompetent.
Even though Walters retired from the Sacramento Bee late last year, he continues to publish at a new site, CalMatters, and his columns are regularly syndicated to California newspapers. His June 2 piece, Dan Walters: CalPERS’ new investment plan – wise or risky?, described the severity of CalPERS’ underfunding and mentioned that CalPERS’ own staff see its return assumptions over the next decade as too optimistic. And as anyone who has done financial modeling will tell you, the early year growth rates have a disproportionate impact on total results.
Walters then turns to the new private equity outsourcing model. Even though he lacks the space and the finance expertise to go into detail, his political nose tells him things don’t smell right.
Walters points to two issues: private equity having been a source of corruption at CalPERS in the pay-to-play scandal that resulted in its former CEO Fred Buenrostro being sentenced to four and a half years in Federal prison, and private equity investors routinely taking actions that hurt local communities (and therefore their tax bases), like shuttering operations and firing workers. Here are Walters’ major concerns:
As an independent investor, would CalPERS really emulate Buffett and invest for the long run, or would it feel the need to maximize short-term earnings by emulating the corporate raiders? Would it meddle in management of its companies for other purposes, such as political correctness? And if it entered the high-flying venture capital field, would those seeking start-up funds pressure politicians to pull strings for access?
Achieving more and more stable investment earnings are worthy goals, if done the right way. Unfortunately, CalPERS’ track record is spotty at best and those making its investment decisions don’t have skin in the game themselves, as do Warren Buffett and Silicon Valley investment houses.
CalPERS’ head of Communications & Stakeholder Relations, Brad Pacheco, wrote a letter to the editor about the Walters column which the Napa Valley Register published: Walters column bungled key facts.
The headline claim, and therefore much of the letter is false, and you can see that by reading Pacheco’s screechy piece yourself. The fact that the dissent came from the in-house flack separately raise doubts about credibility.
Pacheco fails to cite a single “fact” that Walters got wrong. The closest he comes, and it isn’t very close, is to complain that CalPERS private equity corruption scandal is old news and people like Walters should stop talking about it.
As we’ve written, CalPERS has not put the Buenrostro era behind it. We described at length how its investigation of the scandal was in fact a cover up. For instance, unlike Federal agencies, who will put companies that engage in corrupt practices in a penalty box and not do new business with them for a period of time, CalPERS never distanced itself from Apollo, the firm that paid an eye-popping nearly $50 million in placement agent fees.
Rather than engage in soul-searching and implement internal reforms, CalPERS has pretended to embrace transparency while becoming more secretive and embracing a culture of casual lying. Even worse, its response to a CEO who took cash in paper bags was to weaken rather than strengthen oversight, when any institution that was committed to staying on the straight and narrow path would have increased its checks and balances. The captured, cronyistic CalPERS board is the most visible symptom of the failure to take corrective measures.
Moreover, there is substantial corruption in private equity. Staff members at investee firms deem it to be necessary to participates in general partner meetings that pretend to convey information but are in fact a combination of relationship-building (as in selling) and a junket to a nice destination like New York or London, with fancy food and wine and top tier entertainment (see How Your State and Local Tax Dollars Paid for Private Equity Firm TPG’s Elton John Appearance for an example). Needless to say, those perks are particularly juicy for modestly paid government workers.
And mind you, these pricey meetings, including the lavish wining and dining and entertainment, are paid for by the fund, meaning the pensioners.
One private equity expert stressed that these sessions are counterproductive in terms of the private equity staff at investors like CalPERS actually learning what is going on. The investors flatter themselves that they can discern the social dynamic at various general partners by seeing the key players in the flesh, when the fund managers are consummate salesmen and their events are heavily staged.
But not only that, being on the road means the private equity staff aren’t at their desks, reading fund documents and SEC Form ADVs to see if the fund managers are living up to their commitments. But that sort of thing is apparently too much like work. And yet the failure to do adequate supervision continues even after the SEC told investors that more than half the private equity fund managers it had examined had engaged in abuses, including ones that in most walks of life would be called embezzlement.
Here are other things that are tolerated by private equity investors that no investor, much the less a fiduciary, should permit:
Routine, widely acknowledged false valuations
De facto waivers of fiduciary duty
Sweeping indemnifications, including in some cases (Bain is an example) of criminal acts
If you think I am exaggerating about “ongoing cheating,” the new tactic employed by many general partners is to describe behavior that amounts to a violation of their limited partnership agreement in their annual SEC Form ADVs. But investing-land is not the Catholic Church. Admission to sin, even if the clueless limited partners fail to act on the confession, does not amount to a waiver of a violation of a contract.
The “facts” that Walters did get wrong were when he unwittingly parroted CalPERS’ misrepresentations and cluelessness. Walters incorrectly assumed that CalPERS was being truthful when it claimed that it was going to be doing private equity on its own.
In fact, as we’ve described at length, CalPERS is continuing to do “indirect” investing, as in relying on costly third parties, as opposed to bringing private equity in house (see CalPERS CIO Ted Eliopoulos Tells 5 Big Lies in Presenting Super Indirect Private Equity Scheme).
Moreover, Walters quotes board member Dana Holliger claiming that CalPERS would be “forefront of creating a new business model”. Help me.
What CalPERS is trying to do is very old hat. And the fact that it is seldom done should be seen as a huge red flag that structures like this don’t work very well.
Hollinger must have been asleep during the July board offsite last year, when the panelists discussed that a potential model for CalPERS was that of Cadillac Fairview, a real estate investment manager acquired and still owned by a Canadian pension fund, the Ontario Teachers’ Pension Plan. Earth to Hollinger: this idea is decades old.
A big reason Cadillac Fariview worked out well is that it had a solid track record before it was purchased and Ontario Teachers itself has a strong presence on its board.
By contrast, CalPERS is planning to set up de novo operations, the riskiest way to do things, with two layers of boards between the funds and the CalPERS board, an arrangement that appears designed to assure that the inmates will be running the asylum and CalPERS’ board will be even less well informed as to what is going on.
It is Pacheco who makes flagrant misrepresentations. In a classic case of projection, Pacheco, who can’t lay an informational glove on Walters, tells some whoppers of his own. He straw mans Walters (a form of dishonesty right there) by trying to claim that Walters said something inaccurate about CalPERS’ private equity returns, when Walters said nothing whatsoever about them.
And then Pacheco doubles down:
Private equity has been the single largest source of income for CalPERS since the program began in the 1990s, contributing more than $30 billion to the fund after fees.
This is flat out false, and you don’t need to know much to see that. Private equity was less than 5% of CalPERS total asset allocation for most of the 1990s, and it has been 15% at its highest. Moreover, as staff regularly complains, the lumpiness of private equity investing, as in when CalPERS gets capital calls and distributions, means the fund is often shy of its PE target.
By contrast, CalPERS had a nearly 50% allocation to public stocks as of the mid-1990s, which it was planning to increase to 63% by 1998. CalPERS current public stock allocation of 46% is low by historical standards.
So how credible is it to think that private equity, which has probably averaged at best 10% of the total portfolio, could have delivered more in returns to CalPERS than public stocks, which have averaged at least 45%, meaning more than four times as much in terms of invested capital. The only way that could be true is if private equity delivered more than four times the returns of public stocks. And it hasn’t.
Pacheco’s use of the ambiguous word “income” doesn’t get him out of this hole; in fact, it makes matters worse. Stocks do deliver some income, in the form of dividends. Private equity only on an exceptional basis provide dividend, most often in the form of widely-criticized leveraged dividend recapitalizations. When a fund provides a distribution other than via the sale of an entire portfolio company, it is usually the result of a restructuring, such as the sale of real estate owned by the portfolio company and then leased back to it (which is referred to as an “op co/prop co” deal, for “operating company/property company”). In other words, virtually all gains from private equity investments result from the sales or leveraging of assets, and not income generated by the owned businesses. And comparing that to the capital gains over time from CalPERS public stocks would still put them ahead on an aggregate basis.
But it gets worse. More from Pacheco:
The new program, called CalPERS Direct, would operate as a separate entity, with its own oversight board, management team, and staff. CalPERS would be its only client, and the CalPERS Board would retain authority to shut it down at any time.
Apparently Pacheco does not read his own press releases. “CalPERS Direct” is a mere misleading brand name. CalPERS is seeking to set up at least three entities to be run by outside parties, and not its own employees. They are to be a fund of funds (although more recent comments indicate that idea might be dead), a late-stage venture capital operation, and a “Warren Buffett” style investing operation.
In other words, there won’t be one staff overseen by one board. There will be at least three staffs, with boards over each of those entities, and then another board over all of them. And had Walters focused on that, it would almost certainly have confirmed his concerns about corruption. These are a lot of patronage positions, um board seats, to hand out.
On top of that, the fund of fund would be run by a firm like Blackrock which runs other funds of funds, so the idea that CalPERS would be its only client is legally accurate but misleading as far as the way most Napa Valley Register readers would take it.
But the real howler is in Pacheco’s second obviously false claim, that CalPERS’ board could “shut it down at any time.”
What about “illiquid investments” don’t you understand?
First, you can’t get out of investments in companies quickly. Pacheco comes off like a fool to try claiming that. Moreover, selling companies in haste is a fast track to getting fire sale prices and wrecking returns.
Second, CalPERS has been claiming publicly that it wants these funds to be “permanent” and “evergreen”. A quick trigger exit provision is the polar opposite of that objective
More important, if CalPERS were to include that right in its arrangements with supposedly newly constituted management teams, two things are pretty much guaranteed:
Any exit provision would be made punitively costly to exercise. CalPERS would have to pay the fund managers a really big divorce settlement to get out
The fund managers would make it a top priority to raise other capital so as to reduce their exposure to potentially fickle CalPERS. Their first course of action would probably be, a few years in, to try to persuade CalPERS that it would be a sign of success would somehow benefit CalPERS in nebulous ways to open up the CalPERS vehicles to other investors. The next approach would be to set up other funds that were awfully similar to the CalPERS funds.
The next false claim from Pacheco:
This structure would help reduce fees by eliminating the middle man of the traditional fund structure.
Huh? This isn’t a departure from traditional fund structures. CalPERS is setting up an old-fashioned dedicated fund with more layers of boards and trying to pretend it will somehow be cheaper. This does not cut out any middlemen, at best it creates different middlmen.
Chief Investment Officer Ted Eliopoulos, who presumably knows the score better than Pacheco by virtue of being the architect of this scheme, rejected the notion that it would lower fees in an interview with Bloomberg reporter Erik Schatzker:
Schatzker: [sounding skeptical] Because of the fees?
Eliopoulos: Just the, just the size and the amount of capital that is pouring into these relationships. We’re not able to build a $50, $60 billion portfolio solely through the traditional general partnerships. That’s number one. Number two, there are real advantages to CalPERS to designing alternative business models in private equity, namely we have a very long term investment horizon. We have liabilities over a very long time horizon that we’re looking to pay 40, 50, 60, 70 years. Many of the traditional vehicles that we invest in have much shorter horizons. And these alternate vehicles that we are announcing today have evergreen, indefinite investment horizons, and that will allow us to match our liability stream much more directly.1
In other words, Eliopoulos won’t pitch his new gimmick as cheaper because it won’t be. We discussed at length how the funds of funds component would clearly cost more.
But in yet another demonstration of CalPERS’ culture of casual lying, Pacheco contradicts what CalPERS has said because he thinks he can get away with it. And that is precisely why Walters is absolutely correct to worry about corruption. CalPERS demonstrates it flagrantly on a daily basis out of sheer laziness. Why should we not expect it to operate when there is real money at stake?
Addendum: Assuming that Pacheco is factually accurate, the deal points that CalPERS would try to have the not-very-enforceable right to shut down its new funds at any time and that they’s accept money only from CalPERS would have to be closed session material. CalPERS has used the supposed sanctity of closed session information to sanction former board member JJ Jelincic….when in fact, the asset allocation information that he was accused of impermissibly making public had already been presented in a document CalPERS made public. So when can we expect for Pacheco to be disciplined? I’m not holding my breath. But this sort of hypocrisy is yet another demonstration of the hypocrisy of CalPERS’ leadership, most of all of CEO Marcie Frost and General Counsel Matt Jacobs, who led the bogus censure effort against Jelincic.2
1In a May 21 post, we dismissed this claim as one of five Big Lies Eliopoulos was peddling about the new scheme:
Big Lie #3: That CalPERS is having trouble deploying funds in private equity due to not enough general partners who can spend its money. The idea that it is hard to deploy funds in private equity is silly. As the head of one private equity firm said, “It’s not hard to find investments. I could close a fund at breakfast and be fully invested by noon.” So to advance this as a serious argument without a great deal of additional explanation is highly misleading.
According to Preqin, CalPERS ranked number four in 2017 among all international limited partners in terms of total private equity investments. The CPP Investment Board, at $44.4 billion, and the Abu Dhabi Investment Authority, at $39.6 billion, aren’t whinging about the difficulties of deploying funds.
One in fact could argue that CalPERS’ staff being stringent at a time of nosebleed valuations is entirely prudent, even if the effect is to have CalPERS with a lower allocation to private equity than it might otherwise prefer.
2 Don’t try excusing Frost. This kangaroo court took place on her watch and she gets paid big bucks because she is supposedly in charge. She could have called it off at any time and failed to intervene.