‘Alpha Wolves in the Henhouse’: California’s Multibillion-Dollar Private-Equity Boondoggle


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The $340 billion California Public Employees’ Retirement System, or CalPERS, has been laboring mightily recently to launch a “new private equity business model” — four new initiatives ostensibly designed to improve on the fund’s return — just as private equity reporters, in a departure from their usual form, have taken to ridiculing the nation’s biggest and once highly-esteemed public pension fund. Sam Sutton and Chris Witkowsky of PE Hub burst out laughing on a 2017 podcast. Dan Primack of Axios compared CalPERS’ private equity machinations to how “a toddler treats a Netflix queue.” The Wall Street Journal even trolled CalPERS over its ostensible trouble with understanding investment fees and presented the giant fund as in need of gee-whiz algos to do its basic bean counting.

But these reporters may have been missing the real story. Even months after presenting a supposedly final version of its new model, which has since been revised considerably, the giant fund has yet to offer a coherent justification of why it is making radical changes, particularly since most of the elements of this new scheme would further enrich already egregiously well-compensated private equity industry professionals. Giving more to investment middlemen is inconsistent with the principles of improving returns and with CalPERS’ long-standing efforts to minimize investment costs. Even the normally deferential Pensions & Investments devoted much of a lengthy story published last month to puzzling over the contradictions and inconsistencies of the plan.

In other words, this plan is so criminally incompetent that insiders are wondering about actual criminality. Former board member J.J. Jelincic, who was present at the private equity initiative’s inception, says:

In all my years of working with the system, I’ve never seen anything that makes my hair stand up on the back of my neck like this. Even though I can’t point to anything specific, my gut says someone will go to jail if this gets done. And my gut has a good track record.

The original plan, which was announced with great fanfare in May, was based around four “pillar” initiatives. One was to turn most and perhaps all of CalPERS current investment over to a “fund of funds” manager. The second was to commit more money to “emerging managers,” as in younger and smaller funds, even though this is the worst-performing of CalPERS’ current strategies. The third and fourth pillars had the same structure but different strategies. As originally described, CalPERS would commit roughly $5 billion each to two newly created private equity firms that would have CalPERS as their only client. Each would pursue a fad: “late-stage venture capital” and “Warren Buffett investing,” meaning ownership of investee companies for longer than the usual four to five years and a focus on the “core economy,” whatever that means.

If you don’t know the private equity industry, you are unlikely to detect defects that are obvious to incumbents. This plan would send CalPERS in the opposite direction of its peers in their own attempts to improve private equity returns, which involve building up their skills and bringing more of their private equity investing in-house to cut fees and reduce costs. CalPERS has estimated its annual private equity fees and costs at a mind-boggling 7 percent per year. Cutting that to 2 or 3 percent by relying on CalPERS’ own staff would add directly to returns. CalPERS can pay new hires market rates as long as it can substantiate the compensation level. Canadian pension funds are already well down this path and some American pension funds are following them.

But CalPERS is perversely determined to launch a “new business model” which has no realistic prospect of bettering returns, and worse, three of its four initiatives would almost certainly increase its costs. For instance, the two newly created funds would have CalPERS paying for start-up expenses on top of everything else, when first-time managers underperform established players. And two $5 billion commitments would reduce CalPERS’ diversification, another negative for expected returns.

Why should shenanigans in provincial Sacramento matter? CalPERS’ conduct provides a peek into the tight, seldom-examined interrelationships between state and local government pension systems and private equity fund managers. And that includes more unsavory activity than the public is aware of, including criminal conduct. A former CalPERS CEO is now in federal prison serving a four-and-a-half-year sentence for bribery and fraud, and a former board member killed himself before his prosecution began. And CalPERS is far from alone. Alan Hevesi, the former comptroller of New York State and sole trustee for the state’s pension fund, went to jail, in part, for accepting bribes from a private equity firm. The former treasurer of Connecticut, Paul Silvester, landed in prison thanks to a bribery scandal involving a D.C.-based private equity firm, Carlyle.

Similarly, investigative journalist David Sirota has been unearthing dirty dealings between public pension officials and private equity firms for the past four years, exposing how politically connected financial firms have secured high-fee deals in states such as New Jersey, North Carolina, and New Mexico — all while donors connected to those firms have funneled campaign cash to politicians overseeing the deals.

On top of these glaring incidents, smaller-scale chicanery is also common in private equity. Recall that the SEC started to audit private equity firms following the Dodd-Frank reform. After reviewing a large sample, the agency said that more than half of the firms were engaged in serious lawbreaking or other regulatory infractions. Later enforcement actions resulted in penalties and disgorgements for some of the most celebrated firms in the industry, including Apollo, KKR, Blackstone, Carlyle, and TPG. In other words, finding honest players in private equity is an uphill battle.

The reason for overt and soft corruption is that private equity is government-sponsored, and in the U.S., these public-sector investors have weak and deficient oversight. People like Mitt Romney, who made his fortune at Bain Capital, like to wrap themselves in the mantle of free enterprise, when nearly half of their fund commitments come from government investors — overwhelmingly, state and local pension systems like CalPERS.

But public pension funds are governance disasters waiting to happen. Their staffs have day-to-day control over huge amounts of money, with their boards as the only theoretical checks on their decision-making. Unfortunately, all around the U.S., including at CalPERS, public pension fund board seats are usually elected or patronage positions and they too often go to people with no expertise — or worse, to people with expertise as well as major conflicts of interest. This stands in contrast to other countries, like the Netherlands, where public pension fund board members are selected from public workers who must pass investment competency tests.

CalPERS, unfortunately, has become a vantage point for viewing the too-often-corrosive relationship between private equity firms and public pension fund investors. CalPERS has suffered permanent institutional damage from its failure to take adequate remedial steps in the wake of its bribery scandal.

Beginning in the late 1980s, CalPERS used its dominant size to operate in the public interest across a huge number of financial domains in a sophisticated, effective manner. CalPERS helped force the SEC to require companies to disclose CEO employment contracts. CalPERS was instrumental in reforming so-called “soft dollar” kickbacks from brokers to investment managers. CalPERS published a report publicly challenging the then-prevailing terms and conditions of private equity funds, and in so doing, put great pressure on the fund managers. CalPERS was among the first institutional investors to take on the role of lead plaintiff in securities litigations, alleging that public companies had defrauded investors.

By 2000, the organization was such a power center that California Democratic party icon Willie Brown pulled strings to be appointed to its board, despite already having a full-time job as the mayor of San Francisco. Its chief investment officer then, Mark Anson, had a Ph.D. in economics, a law degree, a CPA, a CFA, and wrote academic finance articles for fun.

At the peak of its prestige, in 2002, the CalPERS board made the disastrous decision to elevate an insider widely seen as a political hack, Fred Buenrostro, to the position of CEO. Buenrostro is now in federal prison for fraud and bribery, having taken kickbacks such as cash in paper bags from former CalPERS board member Al Villalobos. Buenrostro steered a mind-boggling $58 million in payments to Villalobos, who was acting as a middleman for Apollo and four smaller private equity firms. Villalobos killed himself before his trial began, and three trustees who were implicated left CalPERS’ board.

CalPERS has never recovered from this scandal and the impact of the financial crisis that unfolded around the same time. CalPERS was only 71 percent funded before the recent market wobbles, and that was after a $6 billion mini-bailout by the state of California via a pre-funding. In addition to some poor investment calls, CalPERS, similarly to many other public pension funds, did not assess high enough employer contributions due to overly-optimistic assumptions about investment returns during the dot-com era and since the 2008 financial crisis.

CalPERS’ response to the Buenrostro/Villalobos scandal was a management power grab that perversely made the California giant more vulnerable to misrule and corruption.

As a result, the CalPERS board has shifted over the past ten years from hyperengagement to a credible imitation of potted plants. It has ceded virtually all its power to staff, allowing as much as $1.9 billion in individual private equity commitments and $10 billion over a year without board approval. Management and outside lawyers have pushed restriction after restriction on the board, demanding that they not dissent publicly, refrain from requesting documents that any member of the public can see under California law, and until a new board member made a ruckus about it, even intercepting, reading, and answering their mail without board members’ knowledge.

CalPERS’ downward-spiraling reputation has hurt the organization’s ability to hire people with needed expertise. In selecting a new CEO two years ago, CalPERS settled for Marcie Frost, who has only a high-school education, no finance training, and no experience managing investments. She is now embroiled in a scandal for having made misrepresentations about her education before and after her hiring, with the state treasurer and past board members calling for an investigation. Similarly, the position of head of private equity investing has been vacant for more than 18 months — the entire duration of CalPERS’ private equity restructuring process.

Even in its diminished state, CalPERS receives probably more than 80 percent of the national press on pension issues, and substantial general business coverage as well. The giant fund is still a standard-setter. For instance, when CalPERS announced at the end of 2014 that it would not longer invest in hedge funds, it sent shock waves and gave other investors cover to start dumping hedge funds. That became widespread in early 2016 as the typical hedge fund continued to deliver lower returns than plain old stock-index funds.

So, having seen CalPERS finally act on its 2006 admission that it wasn’t getting high enough returns in hedge funds, CalPERS’ failure to make the same sort of sober assessment for private equity is puzzling. CalPERS is desperate to earn high returns and reduce its underfunding. CalPERS doggedly maintains that private equity its its only way to beat its overall investment target. Yet returns for the last decade have fallen below CalPERS’ benchmarks thanks to too much money chasing too few deals. Not meeting the benchmarks means CalPERS is not earning enough for the risks it is taking. Similarly, in August, Oxford professor Ludovic Phalippou determined that since 2006, the average private equity fund has failed to beat the S&P 500 index. Despite CalPERS’ enthusiasm for private equity, there’s no reason to think returns will improve any time soon. CalPERS’ fix was to lower its private equity benchmarks to make its flagging results look better.

Other pension systems are further along in the process of decline that CalPERS now confronts. For example, the Kentucky state pension system has gone from being more than 100 percent to only 13 percent funded since 2000, amid the too-familiar allegations of self-dealing staff and asleep-at-the-controls board members chronicled by a former board member, Chris Tobe, in a book with the tragicomic title Kentucky Fried Pensions. The publicity has led to a path-breaking lawsuit which has named two major private equity firms, KKR and Blackstone, as well as their executives, Henry Kravis, George Roberts, Steve Schwarzman, and J. Tomilson Hill, as defendants, alleging that they participated in looting the pension system by selling it high-fee hedge funds that were misrepresented as low-risk. At the end of November, a judge ruled that the case could proceed. The new private equity scheme that CalPERS is hell-bent on implementing has disturbing parallels to the case in Kentucky.

CalPERS’ changes to its plans and even its messaging have had a bumbling, Keystone Kops quality. But that hasn’t been enough to hide dodgy conduct. In a “fire, aim, ready” process, CalPERS tried to get its “fund of funds” program underway before it had announced the entire scheme. This also happened to be the element of the scheme that was the most obviously wrongheaded.

Fund of funds managers are typically for small fries who aren’t big enough to put together a diversified portfolio. The managers levy significant fees for performing this service on top of what the managers they select charge. For a huge player like CalPERS — which is so large it runs its stock index funds internally to save money — to throw away an estimated, unnecessary $50 million a year was obviously suspect. As one longstanding fund of funds professional said, “Clearly someone is getting a new Mercedes.”

A Bloomberg story revealed that CalPERS was in discussions with the giant fund manager Blackrock, behind its own board’s back. CalPERS then launched a bidding process that had the hallmarks of being rigged, being on an invitation-only basis and conducted around the Christmas and New Year’s holidays last year, allowing only a handful of work days for responses. The good news is that CalPERS abandoned the “fund of funds” plan; the scuttlebutt is that Blackrock submitted a bid so much higher than the others as to make it well-nigh impossible for CalPERS to hand the business to them.

CalPERS has also retreated on its “emerging manager” program, and is now saying it will keep it at its current size rather than throwing more money at it.

But CalPERS is still pushing hard for board approval of the two new private equity funds, even though the idea now makes even less sense than it did at first.

Early on, CalPERS touted that it would own these firms outright and be their sole client. But CalPERS has recently reneged on these points. It’s ‘fessed up that it expects to receive no equity or profit participation in the firms, even with CalPERS putting them in business by committing massive amounts of investment capital and paying their startup costs. On top of that, CalPERS admits that the firms will solicit other investors. Successful mid-career private equity executives are flush enough to stake their own funds. Why are state and municipal employees giving the already-rich handouts?

On top of that, CalPERS has a poor record with new private equity firms, even when they bring it sweeteners that had been missing from its plan. For instance, it unwound a strategic partnership with Health Evolution Partners, in which it had backed an industry executive with no private equity experience.

And the fund strategies are also questionable. Warren Buffett investing with no Warren Buffett? Just as troubling is that CalPERS’ main advisor on the entire program is Larry Sonsini, the managing partner of the top Silicon Valley law firm Wilson Sonsini. Sonsini has glaring conflicts of interest by virtue of the fact that his firm represents venture capitalists and entrepreneurs who will benefit by having CalPERS money come their way thanks to the “late-stage venture capital” component. Not only has Sonsini promoted venture capital with CalPERS, he’s also been speaking to private equity professionals about how to win CalPERS’ business. As Bill Lerach, a formidable but now disbarred plaintiffs’ attorney who is a consultant to the attorneys leading the Kentucky case, said regarding Sonsini’s role with CalPERS:

Are you kidding me? That guy’s not a fox in the henhouse. He’s an alpha wolf, whose law firm has been involved in more dubious financial companies and their practices and transactions in Silicon Valley than any other firm. Of course he’ll be great for his financial clients while he works inside CalPERS to direct billions of dollars to them. Will someone please call the cops?

While CalPERS has given Sonsini a prime role, it has also kept experts who’d be predisposed to protect the giant fund well away. CalPERS’ private equity staff, current private equity consultants, and the board’s fiduciary counsel have been largely frozen out from the plan’s development. And as Primack pointed out, “The mastermind here is CalPERS chief investment officer Ted Eliopoulos, who resigned just in time to not oversee its execution.”

Private equity has been central to CalPERS’ decline, yet CalPERS is staying on its course. Its downward spiral evokes Detective Pembleton’s line on Homicide: “Crime makes you stupid.” Are we about to see more of the same?