Tuesday, December 1, 2015

CalPERS' Partial Disclosure of PE Fees?

Dan Starkman of the Los Angeles Times reports, CalPERS fee disclosure raises question of whether private equity returns are worth it:
The nation's largest public pension fund peeled back a layer of secrecy to reveal that it has paid private equity managers $3.4 billion in bonuses since 1990, a hefty figure sure to heighten arguments over whether the controversial sector is worth its high risk and expense.

The California Public Employees' Retirement System said Tuesday that it paid $700 million in so-called performance fees just for the last fiscal year that ended June 30. The disclosure comes as critics increasingly question the wisdom of pension funds investing in such complicated corporate deals as start-ups and leveraged buyouts.

CalPERS officials emphasized that private equity generated $24.2 billion in net profit for the state's retirees over the 25-year period, a strong performance that they said more than makes up for the sector's added risk, complexity and cost.

Like many public pension funds, CalPERS has relied on the potentially large returns on private equity investments to help finance benefits for its 1.7 million current and future retirees — and to avoid turning to taxpayers to make up shortfalls.

“Returns from those sorts of investments need to be much higher than returns on assets not bearing similar risks and especially to justify such huge fees,” said David Crane, a Stanford University lecturer in public policy. “From what I read today about CalPERS' returns on private equity, it's hard to see that being the case.”

CalPERS' disclosure, although not the first of its kind, is considered a landmark because of the system's size and influence in the market. It's expected to lead major pension funds to demand similar, or even more, disclosures from a multitrillion-dollar industry that has been insulated from calls for reform by the relatively rich returns it generates.

The California State Teachers' Retirement System, for instance, plans to take up the issue of private equity disclosure at the system's February board meeting.

“The CalSTRS Investment Committee has asked [its staff] for a greater degree of reporting and cost accounting information, which will require additional resources,” said Ricardo Duran, a spokesman for the nation's second-largest public pension fund.

The bonuses, known in the industry as carried interest, don't include annual management fees. Typically, bonuses amount to 20% of profits over a certain target on top of a 2% management fee, a formula known as 2-and-20.

Because of its size, now at about $295 billion in assets, CalPERS has been able to command a somewhat lower bonus rate of about 12%. Still, private equity's outsized compensation system remains baffling to many.

California State Treasurer John Chiang is sponsoring legislation requiring even more extensive fee disclosure for private equity firms doing business with the state's pension funds.

“Too much compensation information remains missing, and no amount of profit-sharing returns should cause us to turn a blind eye to demanding full transparency and accountability from firms which call themselves our partners,” Chiang said Tuesday.

“With any other investment class, it would be a no-brainer to demand full disclosure of all fees and costs.”

CalPERS officials, who ordered the review after acknowledging a need to get a better handle on private equity fees, believe they have reaped the benefits of private equity and are satisfied with the performance of the $27.5-billion portfolio, which represents 9% of the total fund.

“We have been rewarded appropriately for the risks that we took,” said Ted Eliopoulos, CalPERS' chief investment officer.

Crane isn't so sure. The difficulty in getting out of private equity deals and the high debt loads the sector usually carries raise questions about whether the investments are worth the inherent dangers, he said.

“If the returns were worth the leverage and liquidity risks, then such levels of fees might be worth it,” said Crane, who was an advisor to former Gov. Arnold Schwarzenegger.

The high-stakes business of buying and selling whole companies, dominated by massive global players such as Carlyle Group, Blackstone Group and Kohlberg, Kravis & Roberts, has struggled to shed a swashbuckling image that dates to its roots in the go-go leveraged-buyout boom of the 1980s.

Last week, its board agreed to cut the fund's expected rate of return to 6.5%, from 7.5%, though in incremental steps that could take 20 years. The move drew criticism from Gov. Jerry Brown, who urged the system to cut the expected return to 6.5% over five years to curb its reliance on higher-risk investments.

Caught in the middle are taxpayers, who must make up for investment shortfalls — a challenge for communities struggling with retirement costs they said are already unsustainable.

In a recent report, CalPERS' main consultant strongly endorsed the private equity sector, noting that it had an annualized rate of return of 11.9% over the last 10 years, compared with 6.6% for CalPERS' stock portfolio, and that it performed better than CalPERS' public stocks over all relevant periods.

Last year, for instance, the private equity portfolio's 8.9% return blew away the public stock portfolio, which returned an anemic 1%.

But Eileen Appelbaum, senior economist at the Center for Economic and Policy Research, a Washington think tank, countered that CalPERS' private equity portfolio has failed to meet its own benchmarks over the last one, three, five and 10 years, important measures that seek to account for the added risk that comes with complicated and cumbersome assets.

“Comparing CalPERS' private equity returns with the overall returns of the pension fund and/or their target return for the pension fund is meaningless,” she said.

Steven N. Kaplan, a finance professor at the University of Chicago, cautioned that although CalPERS' private equity portfolio has indeed beaten alternatives in the past, even after fees, studies show the rate of outperformance has slowed more recently.

“You should watch it very carefully going forward,” he said.
No doubt about it, the outperformance in private equity has slowed for all pensions investing in big funds and the reason is simple. As more and more pension money chases a rate-of-return fantasy, the returns of these funds are being diluted. Worse still, this is a brutal environment for private equity which is why all these historic returns are meaningless.

The good news is CalPERS is finally dropping its 7.5% expected rate of return to 6.5% but the bad news is that it's doing it in incremental steps that could take 20 years. They should pass state and federal laws in the United States forcing all U.S. public pensions to slash their expected rate of return immediately to reflect reality of today's markets.

As far as CalPERS' private equity, Yves Smith of the naked capitalism blog ripped into their sleight of hand and accounting tricks where they claimed there are no alternatives to PE. Take the time to read Yves' comment as she raises many excellent points about how the investment staff presented their findings in a way which makes their private equity portfolio look much better than it really is.

For example, apart from plotting private equity returns relative to CalPERS’ overall returns which was mentioned in the article above, Yves notes the following:
In addition, anyone who watches financial markets will notice that the returns from CalPERS’ “global equity” portfolio, which is the “Public Equity” shown in its slides, look peculiarly anemic. That’s because CalPERS has a 50% allocation to foreign stocks. Thus CalPERS’ global equity results are lousy due to CalPERS having a currency bet that turned out badly hidden in it. That in turn is used, misleadingly, to bolster the case for private equity. The fact that CalPERS is underperforming in public equities is a problem it needs to address directly and not use as a trumped-up excuse for not asking tough questions about private equity. 
I couldn't agree more and I actually had a chat with Réal Desrochers, CalPERS' Head of Private Equity, long before last year when they were mulling over a new PE benchmark. I agreed with him that their PE benchmark was too hard to beat on good years but I told him that any private market benchmark should reflect the opportunity cost of investing in public markets plus a spread for illiquidity and leverage. Period. [no idea if CalPERS adopted a new PE benchmark]

Yves also raises excellent points on volatility. Basically, the volatility in private equity, real estate and infrastructure appears lower than it really is because of stale pricing due to the illiquid nature of these investments. So, anyone who buys these volatility figures on private equity or other private assets needs to get their head examined.

Where I disagree with Yves and her other experts who raise well-known critiques on private equity is that they downplay the significance of this asset class and why there are intrinsic opportunities in private markets which are not readily available in public markets.

Mark Wiseman, President and CEO of CPPIB, told me that he fully expects private markets to underperform public markets when the latter are roaring but in a bear market, he expects the opposite and over the very long-run this is where CPPIB sees most of the added-value coming from.

The key difference between big Canadian and U.S. public pensions is governance and the ability of the former to go above and beyond fund investments and co-investments in private equity and invest directly in this space, saving a ton on fees. Of course, to do so, you need to pay pension fund managers properly and get the governance right.

By the way, Yves Smith had another scathing comment on CalPERS' board where she rightly defended board member JJ Jelincic:
The starkest proof of how CalPERS’ board is willing go to extreme, and in this case, illegal steps to defend staff rather than oversee it came in its Governance Committee meeting last month. We’ve chronicled how the board fell in line with recommendation by staff and its new, tainted fiduciary counsel, Robert Klausner, for fewer board meetings, even though CEO Anne Stausboll offered no factual support for of her assertion that her subordinates are overworked or that she has considered, much less exhausted, alternatives for streamlining the process or increasing staffing. Moreover, to the extent that board meeting take a lot of employee time, Stausboll’s stage management of the monthly board meetings via illegal private briefings is a major contributor.

In the next section of this board meeting, Klausner and most of the board participated in what one observer called a “hating on JJ Jelincic” session. Board member JJ Jelincic has engaged in what is an unpardonable sin: he asks too many questions at board meeting and occasionally requests documents from staff. If you’ve looked at board videos (as we have) the alleged “too many questions” are few in number save when staff obfuscates and Jelincic tries to get to the bottom of things.

This section of the Governance Committee meeting clearly shows that the board, aided and abetted by Klausner, is in the process of establishing a procedure for implementing trumped-up sanctions against Jelincic, presumably so as to facilitate an opponent unseating him in his next election. But Jelincic’s term isn’t up until 2018, so from their perspective they are stuck with an apostate in their ranks for an uncomfortably long amount of time. Part of their strategy appears to harass him into compliance with the posture the rest of the board, that of ceding authority to staff and conducting board meetings that are largely ceremonial. We strongly urge you to watch the pertinent portion in full, and have provide a link and annotations at the end of this post.*

And what are Jelincic’s supposed cardinal sins, aside from being too inquisitive? That of using the California Public Records Act (California’s version of FOIA) to request documents that staff refused to produce. Mind you, Jelincic has used the PRA all of three times, in #2029 on June 8, 2015, #2077 on July 14, 2015 and #2084 (a duplicate of #2077, so it is not really a separate request, as far as staff effort is concerned) on July 16, 2015. And these requests were for a small number of recent, readily accessible records. By contrast, virtually all of our Public Records Act requests have been far more difficult to fulfill, so it is hard to depict Jelincic’s modest submissions as burdensome.

And as to the other bone of contention, that Jelincic making these queries is an embarrassment to staff? Yes, as we’ll discuss in detail, staff ought to be embarrassed, since their refusal to provide information is rank insubordination and a further sign of an out-of-control organization that should trouble every CalPERS beneficiary. But if the board weren’t making a stink about Jelincic (almost certainly at the instigation of staff), it’s a virtual certainty that no one would have noticed, since the monthly PRA logs are read by hardly anyone, and certainly not reported on by the media.

So substantively, submitting a mere two Public Record Acts in response to staff intransigence has resulted in the board attacking Jelincic, when any properly-functioning board would be all over staff for their high-handedness in refusing a request for documents by a board member.

Every legal expert we’ve consulted in this matter has been appalled by the refusal of CalPERS’ staff to supply records to a board member when asked. For instance, we contacted two law professors, each at top law schools, both with considerable expertise in trustee matters. Each took a dim view of the notion that staff was trying to duck board member requests for information.
I will let you read the rest of Yves' comment here but I contacted JJ Jelincic who sent me this reply on CalPERS' disclosure of private equity fees and naked capitalism's stinging comments:
The disclosure was a long time coming. It is a step in the right direction. However, it is not complete. It provides 17 years of data but only for the funds that we still have active positions in. It ignores closed funds which is where you see only realized values, not manager estimates.

It also fails to reflect the $1.2 billion in accrued carry. It ignores the $1.3 billion in net management fees CalPERS has paid in just the last 3 years. Portfolio company fees, discounts and waivers remain a black hole but the flash light will come.

I have been told it is a breach of my fiduciary duty to disparage staff so I will not comment on the Naked Capitalism story. I think there is some merit to Dan Primack's comments on the timing.
The timing JJ is referring to was that CalPERS disclosed PE fees last week during U.S. Thanksgiving when most people aren't paying attention. In his comment, Fortune's Dan Primack notes the following:
The pension system, which is the nation’s largest with $295 billion in assets under management, reports that its active private equity fund managers have realized $3.4 billion in profit-sharing between 1990 and June 30, 2015. That is compared to $24.2 billion in realized net gains, which works out to an effective carried interest rate of just 12.3%. For the 2014-2015 fiscal year, the shared profit totaled $700 million on $4.1 billion in realized net gains, or a 14.6% effective carried interest rate.

For context, the industry standard for carried interest is 20%. That would suggest that CalPERS has been a savvy negotiator, but it’s also worth noting what today’s data dump is missing:

1. CalPERS only released data for active funds, as opposed to all of the private equity funds in which it has invested since 1990. Excluded are any fund positions that have been sold or liquidated. A CalPERS spokesman says: “We have limited recourse to seek the data from exited, inactive, sold, liquidated, etc. funds. We felt the best use of our time and resources was to focus on active funds – 98% of cash adjusted asset value is represented. And moving forward we will be consistent in that approach.”

2. We do not know actual carried interest structures for any of the funds, many of which might include preferred returns (i.e., hurdle rates). In other words, certain private equity funds only begin generating carry once they have returned the entire fund plus something like 8%. As such, the realized profit-sharing may be artificially low. Even without a hurdle rate, carry is rarely made effective until a fund repays its principle, meaning carried interest can be artificially low in a fund’s early years (something exacerbated by the pension system’s decision to only report active funds). This could be partially rectified if CalPERS also released data on accrued carried interest — something it requested from its fund managers earlier this year — but it is unclear if such figures will be forthcoming.
I doubt CalPERS will release data on accrued carried interest but Primack is right to point out that this disclosure is only partial and not a full disclosure of all fees paid out to active and closed funds (JJ Jelincic's comment above highlight the same points and provides figures). He's also right to point out the realized carry is artificially low.

To conclude, CalPERS big PE disclosure is a step in the right direction but it's not enough. The senior investment staff need to respect their fiduciary duties and provide full disclosure on all fees and expenses paid out to active and closed private equity funds on their books. I expect the same thing from others who might follow CalPERS' lead, including CalSTRS and even Canada's large public pensions which typically keep this information hush and never break it down by fund and vintage year.

Below, I embedded two clips from the investment committee from CalPERS' November 16th board meeting (see agenda here). You should read the CalPERS Private Equity Program Review here which Réal Desrochers and his staff discuss at the beginning of the second clip.

This slide on the PE benchmark caught my attention (click on image):

I love this part: "The benchmark creates unintended active risk for the Program, as well as for the Total Fund." In other words, they prefer a benchmark which is much easier to beat so they can look better in bull and bear markets and get their full bonus (this is actually a good PE benchmark; they can drop the spread by 100 or 150 basis points but even that is debatable).

Anyways, take the time to watch CalPERS' latest investment committee and ask yourselves why Canada's large public pensions which pride themselves on "world class governance" are not providing the public with the exact same transparency (this is a rhetorical question but I'm serious).

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