CalPERS: Stockholm Syndrome and Cowardice on Private Equity Fee Disclosure

I have wanted to leave CalPERS alone. Really. Truly.

But they keep doing things that are so absurd, misguided, or disingenuous as to almost cry out for comment. And after initially wondering why I found CalPERS noteworthy, a significant cohort of readers are now following the CalPERS saga as a high finance soap opera.

CalPERS’ board and staff should be concerned about the reactions of Naked Capitalism readers to what they can discern about how the pension fund operates. The site has a sophisticated and not-easily-scandalized audience. The members of the commentariat, when they see how CalPERS’ officers and Investment Committee members rush to defend the private equity industry and are clearly loath to do anything that they think will upset their “relationship” with private equity firms, conclude corruption is at work. Comments from different individuals on CalPERS posts regularly say that CalERS staff and board members have to be on the private equity meal ticket somehow to be behaving this way, be it revolving door, political contributions, payoffs, or other forms of palm-greasing.

And they reach these conclusions despite CalPERS’ efforts to make its board meetings sessions as dull and unrevealing as possible via active stage management through illegal (under Califonia’s open meeting laws) pre-board meeting briefings, and having successfully indoctrinated the board to be passive. Even with those measures, the agency keeps providing juicy material despite itself on the private equity front.

And let us not forget that CalPERS’ conduct is revealing, not just for itself, but as illustrative of the behavior of a lot of public pension funds. If CalPERS, the biggest, most powerful, and most sophisticated, behaves this way, just imagine what the others are like.

Two recent vignettes may help readers better understand CalPERS’ pathologies, at least as far as private equity is concerned. The first was an op-ed in the Sacramento Bee that attempted yet again to defend CalPERS’ private equity returns. The second was the scrambling by board members to squash a proposed amendment to a private equity policy document that would require full disclosure of the types of fees that private equity firms. As you will see when we get to that section of the post that the language was pretty mild. Yet the other board members were unusually vocal, by the standards of CalPERS’ board meetings, in opposing it.

What is Wrong With CalPERS?

If CalPERS’ capture isn’t the result of corruption, pray tell what is at work?

CalPERS carries itself with a self-righteous conviction that its conduct is correct, when any fair-minded reading of the evidence would say that is very much in doubt. It’s reminiscent of a borderline alcoholic insisting far too often that he can handle his liquor, or an abused spouse defending her husband, even when her friends notice she wears eyeglasses way too often.

But CalPERS and other limited partners really are afraid of the general partners, as bizarre as that may seem. They continue to tell themselves, and in their private equity workshop in November, the public, that There Is No Alternative to private equity, even as they are told by the SEC and top reporters that general partners are cheating them, when their own data says PE isn’t providing adequate returns relative to the risks, and when academics have identified multiple alternatives to private equity that CalPERS does not appear to have assessed in a good-faith manner.

In other word, CalPERS and other limited partners look a lot like the poster child of the Stockholm Syndrome, heiress Patty Hearst, who called herself “Tania” when she was acting as spokesperson for the Symbionese Liberation Army. In case you are too young to remember the story, History.com gives a decent synopsis:

Patricia Hearst, the 19-year-old daughter of publishing billionaire William Randolph Hearst, is kidnapped from her Berkeley, California, apartment…Soon, a ransom demand came from the Symbionese Liberation Army (SLA), a radical activist group…

The SLA instructed William Hearst to distribute $70 in food for ever poor person from Santa Rosa to Los Angeles. Hearst agreed to give away $2 million to the poor in Oakland to have Patty released….Afterwards, the SLA demanded an additional $6 million giveaway. Hearst refused and they did not release Patty.

The Hearst story took a strange and unexpected turn two months after the abduction, when the SLA robbed the Hibernia Bank in San Francisco. The surveillance cameras clearly showed that Patty Hearst was one of the machine gun-toting robbers. Soon after followed a taped message from the SLA in which Hearst claimed that she had voluntarily joined the SLA and was now to be known as “Tania.”…

Patty Hearst was put on trial for armed robbery and convicted, despite her claim that she had been coerced, through repeated rape, isolation, and brainwashing, into joining the SLA. Prosecutors believed that she actually orchestrated her own kidnapping because of her prior involvement with one of the SLA members. Despite any real proof of this theory, she was convicted and sent to prison.

Hearst was no mere decoration for her SLA unit; she also hijacked cars, was involved in other robberies, and helped make bombs. She was also one of the few survivors of her SLA unit, and not by virtue of efforts to protect her (she was believed to have been killed in a gunfight at the SLA base).

Now brainwashing, um, Stockholm Syndrome isn’t the full picture with CalPERS. Another part of the problem is that CalPERS overestimates its capabilities. General partners routinely tell investors how clever they are in order to make them believe that they really have done a meaningful job of negotiating, when they’ve actually missed the significance of the many tricky features in limited partnership agreements. And there is also a large contingent of advisors who’d also like to feed off the CalPERS’ meal ticket, and they too find flattery to be an effective sales tool.

The result is a textbook case of the Dunning-Krueger effect, which per Wikipedia, “…is a cognitive bias in which relatively unskilled individuals suffer from illusory superiority, mistakenly assessing their ability to be much higher than it really is.” One manifestation is how the giant pension fund respond to criticism in the news. The tone of the rebuttals is often tart and condescending, which is not an institutional voice and backfires when savvy people are on the receiving end.

CalPERS Acts Like a Sore Loser in Sacramento Bee Op-Ed

Last week, CalPERS, though an article nominally written by Investment Committee Chairman Henry Jones, attacked an op ed published at the beginning of the week by Eileen Appelbaum and Rosemary Batt criticizing changes to private equity policy language that would strike the requirement that CalPERS seek to maximize risk-adjusted returns in private equity. Apparently the finance version of an apple pie and motherhood statement was too embarrassing in light of CalPERS’ abject failure over the previous ten years to meet its benchmarks.

But what did CalPERS try to pass off in the SacBee? Here is the opening section:

The California Public Employees’ Retirement System’s investments in privately held companies have come under recent scrutiny. This week, economist Eileen Appelbaum and Cornell University professor Rosemary Batt made much ado about nothing by offering up false claims that CalPERS was changing its private equity strategy and benchmark to help validate its decision to invest in the asset class (“Private equity funds are a bad deal for retired state workers,” Viewpoints, Dec. 14).

Nothing could be further from the truth. No changes to the benchmarks were proposed, and none were made. The private equity policy in question was approved, and the CalPERS board voted Monday to retain language to ensure that these investments maximize risk-adjusted returns.

Did you get that? Let’s remind readers of what happened: CalPERS staff was proposing changes to its private equity policy language which would then tee up a later change in the actual benchmark. The Los Angeles Times story on the board vote tell you what really happened: CalPERS shelves controversial private equity policy.

In other words, what Jones is trying to pass off is that because the board voted down the proposed policy change (as a result of both the Appelbaum/Batt op ed and a Los Angeles Times story that morning) they never wanted to make the change. Do you seriously imagine the Administration would try to claim it hadn’t really wanted a bill to become law after it lost a vote in Congress?

If you read the rest of the article, it’s a compilation of private equity shibboleths that this site and even CalPERS’ own experts at points have refuted. For instance, Jones depicts the Institutional Limited Partners Association as a force for reform when we’ve shown it can never be, because over 75% of its revenues come from general partners. Jones also touts private equity returns via the misleading historical comparison to other CalPERS investments, which by virtue of being lower risk, you would naturally expect to show lower returns.

But the real howler is Jones asserting that CalPERS is pro-transparency, when it dragged into its biggest pro-transparency moves in private equity under duress. Its publication of private equity return data came about via a settlement with the San Jose Mercury News in 2002; its carry fee disclosures came about as a result of the media picking up on the story we broke, that CalPERS admitted it has no idea what it was paying in carry fees.

You can see how pro-transparency CalPERS really is in this section of December Investment Committee meeting that took place prior to the publication of the Jones op-ed. David Sirota and Andrew Perez of the International Business Times reported on this telling incident in a story yesterday: California Pension Won’t Force Wall Street To Disclose All Fees Charged To Retirees. We’d seen it live on the day of the board meeting.

JJ Jelincic proposed an amendment:

Board Member JJ Jelincic: I would like to move that we add a provision that says, “CalPERS will not sign any new limited partnership agreements that does not require the general partner to disclose as part of the agreement any and all types of fees, carry, discounts, rebates, and any other forms of economic rent related parties may charge”.

A short discussion of procedural matters ensues, followed by this discussion of the amendment:

Board Member Bill Slaton: So I don’t think there’s anyone on this board that is not in favor of full fee disclosure. If we had our druthers, that’s exactly what we’d want, every fee, the way Mr. Jelincic described it. And maybe there’s a few other ways to describe it, because people who do financial deals are pretty good at getting creative to say, well, this doesn’t fall in those categories that were enumerated in your policy.

But that being said, I’ve come to the conclusion that we do not control the private equity market. It would be nice if we did, but we don’t. So I think that staff’s approach, kind of measured approach to this, to work with other partners, to work on the regulatory scene, to arrive at the same point that we’re trying to arrive at I think serves us better, because I’m concerned that there may be some partners that we would like to do business with irrespective of this fee issue, and that we would preclude those transactions from taking place in the short-term.

So I think just, I think we as a fund are better served by continuing to work on the issue, but not for this Committee to prescribe it at this moment in time, because I think it ultimately would be respective. So I’ll be voting against the amendment.

Jones: Mr. Costigan.

Board Member Richard Costigan: Thank you, Mr. Jones. So, Mr. Jelincic, I agree with you on transparency and disclosure. I guess the question I really have, Mr. Jones, is Mr. Jelincic you made a large motion on a number of items. It’s whether or not we could go item by item, because I think Mr. Slaton raises some excellent points. But I do believe, or I’d like more staff direction, is which of the items in your large motion could we, in fact, do to move towards the goals, because I’d hate to almost see this go down in defeat, because I do think more information is important.

And I think, do think from the standpoint that among our private equity partners, more disclosure. Even if you read among the placement agent items, I sometimes find the calculations to be rather amusing as I may raise in one coming up, that they seem to minimize the number of hours that they’re working to make sure that they’re disclosing as little as possible, and I would be more for transparency. But I am concerned that the way you made your motion it’s kind of an all or nothing.

Thank you, Mr. Jones.

Jones: OK. Thank you. Ms. Hollinger.

Board Member Dana Hollinger: Yes. I also agree with full transparency, but one of my concerns is, as Mr. Slaton and Mr. Costigan suggested, that I don’t want to price us out, make it so restrictive to deal with us that we lose this asset class in our portfolio, because I recognize that the outsize returns that we’ve seen over the years goes to our ability to pay benefits.

So similar to Mr. Costigan, I’d like to see what staff feels they could do, because I also think the industry is getting pressure also on transparency, and I recognize this is evolution, not revolution. So as to what you feel you, um, would be workable and wouldn’t actually throw us out of the marketplace for this asset class.

Jones: OK. Mrs. Taylor.

Board Member Theresa Taylor: So I also want to echo my co-board members. I do support very much transparency on these fees. And I also want to remind everyone that we’re sort of in the forefront talking about this, and getting it out in the public. As Mr. Costigan and Mr. Slaton said, I’m concerned that we don’t have control over the private equity. And I’m concerned that we would not be able to continue relationships with those folks. And I understand you want to wait until some of the legislation passes before we take a stance.

Maybe there is a way that we can word this differently so that we could include some sort of education or investigation into how we put this in our policy at a later date maybe. That would be my suggestion.

But again, I couldn’t agree more, we need transparency on those fees. So I would be voting no on this particular, the way it’s worded. So maybe we can come up with something else.

Jones: OK. Mr. Jelincic, you wanted another…Push your button.

Jelincic: I actually want to speak to my amendment. This amendment does not limit the GPs from charging us whatever they want. This does not limit staff’s ability to negotiate what kind of fees we’re going to pay. All this amendment does is say before we enter an agreement, you have to tell us what kinds of fees you’re going to charge us. It doesn’t limit how much you charge us. It doesn’t limit how we negotiate fee sharing. It only says you have to tell us what kind of fees you are charging.

Now, there may be some GPs who don’t want to tell us what they’re going to charge, and I have to question why we would want to enter into any agreement with somebody who says I’m reserving the right to charge you fees that I’m not going to tell you about.

Now notice that there could be some legitimate grounds for questioning Jelnicic’s amendment, for instance, that the language needed some adjustment given that it was in a broad policy document. But the objections from the board members are all of the same form: “Oh we are all in favor of more transparency, unless it will annoy some general partners.*” David Sirota and Andrew Perez read the board move the same way we did:

That momentum toward transparency at the California Public Employees’ Retirement System (CalPERS), however, appeared to abruptly halt last week when pension overseers quietly rejected a measure that would have required Wall Street firms to disclose all possible levies before they get their hands on the retirement savings of the system’s 1.7 million members. Some CalPERS board members said they were concerned the measure might alienate private equity firms, thereby denying pensioners the benefits of those investments.

And the unspoken rationale is that CalPERS would come out the loser by being denied access to funds is that it would do worse in terms of performance because “hot” managers would not let CalPERS into their club. But that issue was refuted by Rosemary Batt, in a public comment in the private equity workshop in November, when she pointed out that top quartile funds were less likely to be top quartile in their next fund that if you chose funds randomly. In other words, investing in top quartile funds (charitably assuming you can accurately identify them early in the fund life) produces worse results than throwing darts. CalPERS might be being done a favor by being exclude d from some of these funds.

Most important, staff and the board are ignoring that chipping away at the egregious fees that private equity charges will improve returns. Michael Flaherman, a former CalPERS investment committee chairman and private equity senior executive, now an academic at Berkeley, told the board right before Jelincic proposed his amendment that there was no sound reason to oppose transparency, to the degree that he signaled reservations about Chief Investment Officer Ted Eliopoulos’s preference for a “measured approach”:

Michael Flaherman: And then lastly, the fee transparency issue, I would voice support for the idea that, that requiring fee transparency is a good idea. I think it’s actually kind of hard to argue against it. I mean, I understand the idea of a measured approach. But as just sort of a commercial matter, it seems to that it’s sort of, it’s hard to argue that you’ll make more money over time by letting people charge you undisclosed then you’ll make by requiring them to disclose what they’re charging you.

In sum, the video shows the unattractive spectacle of board members rejecting the idea of requiring information merely about the types fees the all-might general partners might charge, lest supplicants like CalPERS offend them. This move puts these board members squarely in violation of their fiduciary duties, which require that they assess the reasonableness of fees. That means CalPERS staff and board are so deeply in thrall to private equity that they are choosing to perpetuate its secrecy regime, when they’ve been told they will do better financially by moving faster in the direction of greater disclosure, and when separately their legal duties also argue for a more aggressive push for information.

I hope CalPERS beneficiaries and California taxpayers will continue to tell their state representatives, as well as the elected officials John Chiang and Betty Yee, that the time has passed for complacency and caution on the private equity front. They need to press staff to take fee transparency and alternatives to private equity much more seriously than they do now. Patty Hearst, who was held hostage and threatened with execution, had a much better excuse for her support of a bad cause than CalPERS does.

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* After Jelincic explained what his language was intended to achieve, a CalPERS staffer took the opposite tack from the board members, effectively arguing that Jelincic’s change was trivial and could be satisfied by providing a long laundry list of possible fees. Since the board isn’t very savvy about private equity, that “Oh the GPs can easily satisfy Jelincic’s amendment” which was meant as an argument to dismiss it, should have instead been taken as a rejection of the board member concerns!

But the reality is different. The SEC has fined general partners for charging undisclosed fees. This is a live issue. And the board chooses to stick its head in the sand over this ripoff. Jelincic’s amendment or an improved version would force changes because disclosing the types of fees would then lead to the requirement that all those fees be offset against the management fee, as the limited partners had assumed was taking place.