Wednesday, December 5, 2012

Crusade Against External Fees?

Gregory Zuckerman of the WSJ reports, Calpers Crusader Takes Aim at Fees:
At its annual investor meeting earlier this year, buyout firm Leonard Green & Partners LP played a video that parodied Réal Desrochers of Calpers as a spear-carrying sentry fending off a team of Leonard Green executives, portrayed as Knights of the Round Table, trying to raise money for a new buyout fund.

Mr. Desrochers's likeness hurled insults at Leonard Green executives and dumped garbage on them while defending a castle, people at the meeting said.

The Monty Python-like video was meant to be lighthearted, and parodied others, the people said. But it also is a sign of how Mr. Desrochers is picking fights with heavyweights of the private-equity business.

Mr. Desrochers, a 65-year-old native of Canada who last year became head of private-equity investing for the California Public Employees' Retirement System, has told buyout funds to reduce fees if they want cash from the $241 billion pension goliath, one of the nation's largest private-equity investors.

Much could be at stake for Calpers and its 1.6 million active and retired members. Lower fees could save the public pension money.

But Calpers could lose out if it snubs funds that deliver strong returns it needs to meet annual investment goals. Calpers saw returns of 1% for the fiscal year that ended June 30, below its 7.5% goal. Calpers's returns matter because they fund 65% of the pension fund's benefits; the rest comes from employers and members.

Private-equity investors are watching Mr. Desrochers's efforts. While few pension funds can command the bargaining power of Calpers, the largest public pension fund in the U.S., with $49 billion of private-equity investments, inroads by Calpers on fee cuts could create a precedent for others.

Some pension funds have received favorable fees from private-equity and other investment firms through special arrangements. The Teachers Retirement System of Texas this year received reduced fees to invest several billion dollars in special private accounts with KKR & Co. and Apollo Global Management LLC. In May, Calpers committed to invest $500 million in a managed account run by Blackstone Group LP  targeting investments that don't fit into its regular funds; Calpers receives lower fees in return.

But such deals usually aren't direct investments in traditional, buyout funds, something Mr. Desrochers has focused on. Two years ago, Apollo cut fees for Calpers, but only for accounts in which Calpers was the sole investor and not for Apollo's private-equity funds.

So far, Mr. Desrochers, who previously worked for the government-owned Saudi Arabian Investment Co. and the California State Teachers' Retirement System, has had mixed success. Calpers received lower fees from Cerberus Capital Management LP to invest $400 million in one of its latest funds, said people familiar with the investment.

"We are pleased that Calpers has selected the Cerberus platform for such a significant commitment and we look forward to continuing to build our long-term relationship with Calpers and all of our investors," said Mark Neporent, Cerberus's chief operating officer.

But Leonard Green and Ares Management LLC recently told Mr. Desrochers they wouldn't cut their fees, according to people familiar with the discussions. As a result, Calpers wasn't an investor in recent funds raised by both firms, both of which have had top-returning funds in recent years.

One Leonard Green fund that Calpers in the past invested in, the GCP CA Fund, scored an internal rate of return, a measure of annualized returns after fees, of over 90% between its launch in 2003 and close in 2010, a performance Calpers itself called "extraordinary" in an August report whose lead writer was Mr. Desrochers.

And Calpers has agreed to pay standard fees to invest in a new fund run by Advent International, according to people familiar with the investment, potentially signaling some flexibility by Mr. Desrochers.

Calpers's chief investment officer, Joseph Dear. said getting funds to change their fees can be a hard task, and deciding whether to take or leave a fund that won't budge on fees also isn't easy. "It's a tough slog," he acknowledges. "There are certain circumstances where we have to swallow hard" and invest without getting fees lowered.

Mr. Dear defends Mr. Desrochers's approach. "We're not doing our job if we're not doing our best to reduce what at times are exorbitant fees," he says. "We won't be successful in every instance, but if we don't try there never will be change."

One concern for buyout funds faced with Calpers's requests: Some have agreements with investors preventing the funds from reducing fees for one investor without doing so for others. That makes these funds reluctant to cut deals.

"Management and performance fees are pretty sacrosanct, you haven't really seen them breached," says Kevin Albert, head of business development at Pantheon, a New York firm that invests $25 billion in private-equity investments.

But some say it is an ideal time to levy pressure because many funds are struggling to raise money.

"The industry is in need of some fee rationalization, especially for large firms, as the fee structure has essentially been the same since the 1970s when funds were" below $30 million in size, says Maria Boyazny, who runs MB Global Partners, which invests in distressed-debt and other funds.
I also think it's the ideal time for large and small institutional investors to gather at their next ILPA meeting and have a comprehensive discussion on fees for alternative investments.

And I can think of no one better to spearhead these discussions than Réal Desrochers, a trendsetter in private equity investments. Réal reads my blog regularly, knows all about the changing of the old private equity guard and is keenly aware that we're entering a long period of deleveraging/ low growth which is placing downward pressure on returns.

Simply put, institutional investors are realizing that it's indefensible paying 2 & 20 management and performance fees when these alternative funds are struggling to deliver decent absolute returns. 2 & 20 when funds are delivering double-digit returns is much more palatable than when they are delivering single-digit returns.

But the discussion on fees runs much deeper than this, exposing serious governance flaws at US public pension funds. Beth Healey of the Boston Globe reports, Pension board OK’s contentious bonus pay plan:
In a narrow 5-to-4 vote, the board of the Massachusetts state pension fund approved a compensation plan Tuesday that will increase bonuses for investment staff and introduce new hurdles for earning them, while rejecting others proposed by Treasurer Steve Grossman.

Michael Trotsky, the $50 billion fund’s executive director, said the new plan would give him the tools to compete for top hires — something the pension fund has long struggled with, and which contributed to a slew of vacancies this year. He also vowed to cut expenses elsewhere in his $300 million budget.

“I want to save $100 million,” Trotsky said, noting that the “real money” is in fees paid to consultants and Wall Street firms, including hedge funds. By contrast, only 1.5 percent of the budget, or about $4.5 million, is devoted to staff compensation.

“I need talented people to be able to replace Wall Street salaries,’’ Trotsky said.

But the vote, which followed more than a year of debate, was not without controversy.

Some meetings were heated, and politics were often at play. Grossman and Governor Deval Patrick’s board representatives worried about the public’s reaction to raises at the Pension Reserves Investment Trust at a time when the state could be facing budget cuts.

Theresa McGoldrick, a director who represents 3,500 unionized employees in the executive branch and the Trial Court, voted against the new pay plan, rejecting the idea of bonuses outright. “Performance-based incentive compensation does not have a place in state government,’’ she said at the meeting.

The new plan, slated to take effect Jan. 1, would expand the number of top investment jobs eligible for 40 percent bonuses, while cutting bonuses for 16 out of 24 staffers who aren’t involved in managing money. The latter would get raises to make up part of the difference.

In addition, the new plan introduced an individual performance component to bonuses and established a peer group against which to measure pay, based on other similarly sized funds.

Grossman, who is chairman of the pension board, voted against the plan because it lacked three provisions he supported.

He had pushed for bonuses to be linked to the fund’s long-term 8 percent annual return goal, because, over time, a failure to deliver that will mean taxpayers have to cover the shortfall.

Grossman also had wanted to defer bonuses in years when the fund loses money, even if the staff outperforms the market and their benchmarks.

“I’m not comfortable paying bonuses after a down year,” he said. The board instead reserved the right to hold the bonuses, but didn’t make the deferral mandatory.

Currently, the fund must beat its benchmark return by 0.75 percentage points for staff to earn bonuses. Grossman wanted to keep that level, but the committee recommended 0.60 points, closer to the industry average, and the board agreed.

The fund’s return was essentially flat last fiscal year, falling 0.1 percent. It’s up 10.5 percent so far in this calendar year, 0.5 points ahead of the benchmark.
Grossman is right, pension bonuses should be linked the fund's long-term performance but that 8% bogey is based on rosy investment projections which are unrealistic. Also, beating the policy portfolio (benchmark portfolio) by 60 basis points might be industry average but I know of one Ontario fund that has to beat it by 100 basis points (other Canadian funds only have to beat it by 50 basis points).

Moreover, Grossman makes a good point on doling out bonuses when the fund loses money. I've long argued that it's politically stupid and insensitive to dole out bonuses when pension funds experience a disastrous year. Senior managers at CPPIB and PSPIB are still irked at me for railing against their ridiculous bonuses after their dismal performance in FY 2009 (only the Caisse wisely decided against doling out bonuses after their $40 billion train wreck).

Senior managers at Canada's large public pension funds, which are compensated considerably better than their US counterparts, will argue that bonuses are tied to overall results based on a four-year rolling returns and that a contract must be honored no matter what. Moreover, they will rightly argue that politics shouldn't be a factor in compensation packages.

But this doesn't change the fact that it's politically stupid to dole out huge bonuses when pension funds experience serious losses on any given year, leaving the impression that senior managers are greedy pension pigs only looking to line their pockets in good and bad years.

Having said this, I completely disagree with Theresa McGoldrick, the director representing unionized employees who voted against the new pay plan, rejecting the idea of bonuses outright because “performance-based incentive compensation does not have a place in state government.’’

The problem with most US public pension funds is they pay peanuts and get monkey results. Union representatives who argue against performance-based incentives are out to lunch. Worse still, they're not fulfilling their fiduciary duties by making sure incentives are aligned with the best long-term interests of all stakeholders, including taxpayers.

Michael Trotsky is absolutely right, the "real money" is in fees. Ask Leo de Bever the flack he got after cutting AIMCo's $174 million in external fees. The media harped on internal compensation, totally ignoring the significant cost savings that came from managing these assets internally.

I highly suggest the board of the Massachusetts state pension fund publicly discloses the fees paid out to all their external investment managers over the last 10 years and the IRR net of fees of all these external investments. Think Massachusetts taxpayers will be shocked after seeing these figures and the results they've produced, making the case for bringing assets internally and properly compensating their internal managers much more credible.

As far as alternative investments, the euphoria continues. Running out of alternatives to realize their ridiculous 8% bogey, US public pension funds are embracing the new asset allocation tipping point, paying high fees for low profits. Some pensions are squeezing GPs on fees, but by and large, it's an alternatives party for GPs.

That's why I wish Réal, CalPERS and other public pension funds looking to lower fees on direct fund investments best of luck. There will always be investors looking to pay Steve Cohen, the perfect hedge fund predator, and other alternatives "superstars" hefty fees for managing assets regardless of what CalPERS says or does with its program. The hunt for yield is intense, which is why so many pension funds keep getting bamboozled by alternatives managers running their version of 'MCM' Capital Management.

Below, Bloomberg's Cristina Alesci reports that Cerberus Capital Management’s pursuit of grocery chain Supervalu has stalled because the private-equity firm has had trouble obtaining the funds for a leveraged buyout. She refers to the mania in private equity recapitalizations as one possible factor as to why financing hasn't been secured in this deal.