CalPERS’ Private Equity Scandals and the Steptoe & Johnson Report Whitewash

Readers may recall that we published a letter that a beneficiary of the nation’s largest public pension fund, CalPERS, wrote in support of our effort to have CalPERS provide us with data that it has finally admitted it gave to Oxford academics in 2009.

In his letter, our advocate, Tony Butka, stated:

What is less commonly known…is that playing fast, loose and in secret with private equity folks got CalPERS into a significant scandal not that long ago. I refer to the 2009/2011 special review of placement-agent activity in the fund which culminated in a March 2011 Steptoe Report. That Report came at a cost to plan members of some $11 million, and ultimately CalPERS wound up in litigation, suffered millions of dollars in losses, and criminal charges ensued.

This bit of history is germane, particularly since, as Butka noted, CalPERS promised to become more transparent as a result of this scandal and in particular, to “improve the timeliness and responsiveness to Public Records Act requests” like mine. But if you understand what went on, CalPERS conduct should come as no surprise.

Overview of the “Pay to Play” Scandal at CalPERS

CalPERS’ investments have been controversy-ridden since the early 2000s, but the “pay to play” scandal that Butka alludes to directly implicated the CEO and some board members. The former CEO, Fred Buenrostro, as well as the placement agent, Alfred Villalobos, were indicted in 2011. This is how Matt Taibbi summarized the case:

In California, the Apollo private-equity firm paid a former CalPERS board member named Alfred Villalobos a staggering $48 million for help in securing investments from state pensions, and Villalobos delivered, helping Apollo receive $3 billion of CalPERS money. Villalobos got indicted in that affair, but only because he’d lied to Apollo about disclosing his fees to CalPERS. Otherwise, despite the fact that this is in every way basically a crude kickback scheme, there’s no law at all against a placement agent taking money from a finance firm.

$48 million wasn’t the total Villalobos got; it was $58 million because he was pushing deals to CalPERS on behalf of four additional clients: Relational, CIM Ares, and Aurora Capital. And the part that has been curiously airbrushed out of every media account of this scandal is Villalobos was engaged in improper conduct, even if he had managed to get the needed sign-offs from CalPERS. He wasn’t a registered broker-dealer, as he was required to be when marketing deals on a regular basis.

As we’ll explain in due course, this omission appears to be deliberate, to protect the hides of Apollo and the other fund managers (referred to in the trade as general partners or GPs) who hired a placement agent they knew, or should have known, shouldn’t be in that business at all. And it also obscures the fact that CalPERS had tremendous leverage in dealing with these GPs. One of the remedies available under the securities laws when party who is not licensed engages in securities transactions is rescission, as in demanding that the deal be unwound and the funds returned.

To make a very short story of how this process worked, as Taibbi does state correctly, placement agents had to get written acknowledgments from fiduciaries like CalPERS of the fees paid by general partners. Indeed, many GPs insist on having the documentation in hand before paying the fees.

Villalobos used his personal relationships with Buenrostro and a CalPERS board member, Charles Valdes, who got improper political donations from Villalobos’ firm, to get them to lean on the investment team on behalf of his clients. It was also Buenrostro who signed the waivers without notifying the board as required. In two cases, the waivers were on crudely doctored-up CalPERS letterhead and dated after Buenrostro was no longer with the giant pension fund. There were other sordid chapters, like improper gifts and flights on private jets, but the real juice was in the coverup of the massive fees paid to Villalobos.

Why the Choice of a Law Firm and Private-Equity Connected Partner Say that CalPERS Wanted a Cover Up

When the scandal broke in late 2009, CalPERS hired a Los Angeles law firm, Steptoe & Johnson, to investigate. This is absolutely standard practice, but the question whenever these “investigations” are launched is whether the firm really intends to turn over a new leaf or whether the “investigation” is an effort in damage control and perception management.

There are plenty of reasons for skepticism. First, CalPERS has such a well-established pattern of pay-to-play abuses that the legislature barred those payments in 1997. Astonishingly, a CalPERS board member got the law overturned.

But second is the decision to hire a law firm. Generally speaking, corporations will elect to pay the higher price tag of law firms for this sort of investigation precisely because they want to take advantage of attorney-client privilege; otherwise, you’d use a consultant or accounting firm for this sort of work. For instance, former Comptroller of the Currency Gene Ludwig built his reputation and top-level relationships by becoming the preferred provider of investigations on rogue trader scandals. Remember, when a bank has suffered billion dollar losses, they need to be seen to have done a credible investigation, to understand exactly how the fiasco happened and to be putting proper controls and other remedies in place. They have not merely their reputations but their stock prices, funding costs, and counterparty relationships at stake. I’m not overstatig the stakes: remember that Barings failed due to rogue trader Nick Leeson. So parties with economic exposure need to know the deficiencies are being remedied, pronto. And since most of them also run trading operations, they have a finely honed radar for bullshit.

The third reason to be skeptical is CalPERS is perfectly positioned to do accountability theater. Their beneficiaries have little ability to influence the organization. Seven of the thirteen member of the board are selected by the state government or are members of it:

Three appointed members:

Two appointed by the Governor – an elected official of a local government and an official of a life insurer
One public representative appointed jointly by the Speaker of the Assembly and the Senate Rules Committee

Four ex officio members:

The State Treasurer
The State Controller
The Director of the California Department of Human Resources
A designee of the State Personnel Board

So even more so than with a public company, the incentives of the board are to make problems go away rather than get to the bottom of them. The one possible source of real pressure on them is the state legislature, but they tend to be more sensitive to press coverage than occasional letters from upset CalPERS beneficiaries.

Now let us finally turn to the Steptoe & Johnson report proper and see if it bears out our concerns.

Our first step is to look at the choice of law firm and partner. Here CalPERS was likely to have been constrained in its options, since Apollo and the other firms use a large number of law firms, so most of the top candidates would be conflicted out. Philip Khinda was the Steptoe partner that ran the investigation and prepared the report. If you look at his bio at Steptoe, you can discern what the real priorities were. This is what he lists immediately after his work for CalPERS, and shows what his calling card was prior to that engagement:

Mr. Khinda also represents and defends public companies and institutions, their officers and directors, regulated entities, and others in matters before the Securities and Exchange Commission, the Department of Justice, state prosecutors and other regulatory authorities. He is well-known for the many government investigations and inquiries he has resolved for clients without any charges ever being filed, or any public disclosure of the government’s interest ever being made. Those clients have included a broad group of public companies, private equity firms, hedge funds, and investment advisers as well as corporate executives and public figures. While Mr. Khinda has served as successor and settlement counsel for a variety of institutional and individual clients, no corporation or individual that he has represented from the outset of an investigation has ever been sued by the SEC or indicted.

Notice how this description emphasizes that Khinda smoothes problems over and often succeeds in making them invisible to the public. Khinda also has important prior experience in investment fund kickback scandals.

But another critical element is that CalPERS hired someone who has worked heavily for the sell side of the financial services industry. This almost guaranteed that Khinda would at a minimum be sympathetic to their point of view. CalPERS appears either to have been insufficiently sensitive to this issue or have resigned itself to the fact that anyone with a big firm who had heavyweight investigation experience would have similar conflicts (and big companies feel the need to hire other big firms; it’s doubtful that CalPERS considered hiring a scrappy boutique like Boies Schiller).

The Peculiar “Steptoe Report”

Despite its length, the public version of the Steptoe report reads as thin and temporizing, particularly when you contrast it to other reports on questionable conduct, such as the so-called Ludwig report issued by Wachtell Lipton and Promontory Group on the Allied Irish Bank currency trading scandal, or the UBS report on its crisis-related losses. If you look at either one, you can see how dramatic the contrast is in the level of detail provided.

And here is why the lack of detail is troubling: the real reason for this sort of investigation is to look into whether anyone at CalPERS got kickbacks from Villalobos. That’s why Steptoe brought in Daylight Forensic & Advisory, which specializes in financial fraud and money-laundering investigations, so that they could examine transactions and activities and see if they looked to be payoffs for helping Villalobos.

And trust me, it’s a near certainty that kickbacks were offered. Why? There is absolutely no reason for Apollo to have hired a placement agent for CalPERS, much the less paid one so lavishly. Staff with CalPERS at the time in question confirm that the head of Apollo, Leon Black, could get the Chief Investment Officer and the head of alternative investments (known in CalPERS-speak as the SIO, or senior investment officer) on the phone or in a meeting in Sacramento at any time. So far and away the most plausible scenario is that Apollo and the other private equity firms were told that they had to hire Villalobos as a condition of doing business with CalPERS.

The report does provide evidence that Buenrostro got inducements from Villalobos: an offer of a Lake Tahoe condo, payment for wedding expenses, and his plan to go straight from CalPERS to Villalobos’ firm, which would have allowed him to have a cut of the CalPERS fees laundered to him via compensation for his then-current work.

But what about others at CalPERS? There’s reason to wonder about the conduct of certain board members, particularly given the discussion of Villolobos’ role in getting a pharmacy benefits contract awarded to Medco.

The brief version is that Villalobos convened a meeting at his house with the CEO of Medco and Buenrostro, which led to Villalobos being retained by Medco for $4 million. Shortly thereafter, Villalobos met with the Medco CEO, Buenrostro, and three other board members, Chuck Valdes, Kurato Shimada, and Bob Carlson. Various members of that group continued to meet. Medco mysteriously got its hands on useful CalPERS internal documents.

Medco came to the Health Committee meeting as the preferred candidate; Valdes moved to recommend that Medco be awarded the contract and Carlson, another committee member, voted for it. And apparently, to leave nothing to chance, Shimada, who was not a member of the committee, attended the meeting and asked questions.

And it gets even better: Shimada had taken a three year leave from CalPERS in 1999, and had worked as a placement agent with Villalobos. And remember, Valdes was head of the investment committee of the board, and thus well positioned to be useful to Villalobos.

Now the report does unearth a lot of penny-ante payoffs from Villalobos to Valdes (hundreds of dollars’ worth of casino chips, possible large advances for travel that were never repaid) and Shimada (help in paying for his trip to attend the Academy Awards). But the report simply finesses the question of whether this might have been the tip of the payoffs iceberg. And troubling, we see no discussion of the scope and limitations of Daylight Forensic & Advisory’s investigation. You would expect a report of this sort to be far more crisp on the matter of “Here is what we looked into. Here is what we found. These particular issues (stated specifically) remain open because the individuals were not cooperative and we lacked the authority to compel the production of documents.”

Given the failure to say in sufficient detail what was and was not done, the second striking element is the cost of the report, which the Los Angeles Times revealed to be $11 million. As Butka indicates, there was a great deal of consternation over the price tag, and experts were stunned too. From the Times:

The review found support for allegations of corruption, bribery and influence peddling at the country’s biggest public pension fund, but some lawyers and financial experts familiar with the scandal said they were surprised by the large legal fees.

They also suggested that the investigative work could have been done by the state attorney general’s office, which has sued two former CalPERS officials over fraud allegations.

“I’ve never heard of a pension fund paying that kind of money” on an internal investigation, said Ed Siedle, an expert who investigates pension fund portfolios.

Let’s do some back-of-the-envelope math. The article reports that Steptoe’s rates were capped at $400 an hour. Let’s charitably assume Steptoe had $500,000 in expenses. Take $10.5 million and divide it by the maximum rate, $400 an hour, for an 8 hour billable day (trust me, 8 billed hours is more like a 10 to 12 hour work day) and 250 working days a year. You get 13.125 man years. Divide that by the year and a half the study took. That says they had at a minimum of 8.75 very senior people working on this full time for the full 18 months, or a bigger team of some senior people and lower-rate attorneys and staff. This for a study where a total of 140 people were interviewed, some of them more than once, plus (as we will see) some pretty limp-wristed negotiations with four funds.*

You can see why eyebrows were raised.

Unfortunately, clients are hostage in situations like this, since the steps needed to dispute a bill run the risk of breaching attorney-client privilege, and we suspect having attorney-client privilege was one of the top objectives of this exercise.

A third striking element of the report is how deferential, indeed, fawning, it is to Apollo and three of the other four implicated funds: Relational, CIM, and Ares. CalPERS evidently decided that its interests were best served by making common cause with them.

It is critical to understand that there is no reason, ex ante, to assume these relationships should be preserved. However, CalPERS, like many other public pension funds, is cognitively captured and terrified of alienating private equity funds. And in this case, it’s not hard to imagine that Khinda advised them that they would only lose if they went to war with Apollo, so they’d be better off turing him into an ally.

Now let’s look at the report in more detail.

The writing style of the Steptoe report is patronizing, as if a parent has been forced to explain a hopefully past affair to his children. However, the report is up front about not being complete: two section headers contain the phrase “illustrative conduct”. Yet the report tries to assuage concerns by saying how cooperative everyone was, except, not surprisingly, Villalobos and Buenrostro.

Its very first paragraph tries to present the use of placement agents as common and by implication, not necessarily a cause for alarm. And we have an explicit “everyone is doing it” statement:

The experience of the California Public Employees’ Retirement Systems (“CalPERS”), the nation’s largest state pension funds, was apparently no different than that of other public pension funds.

Ahem, the whole point of hiring a placement agent is to try, first, to make sure your fund gets an audience, if you might not normally get access to the pension funds investors (known in the trade as “limited parters” or “LPs”), and second, to try to get a bigger share of the total pot than you’d get otherwise. But the fact is, as Khinda stresses, that Apollo already an well-established relationship (“one of CalPERS’ largest and most trusted private equity managers”). Yet the notion that Apollo and the other funds were seeking to get a large piece of the CalPERS pie, and presumably did, seems to have been completely neglected in the Steptoe analysis of harm.

In fact, the report acknowledged that this in fact probably happened in a back-handed way, in the recommendations section (as in while this presumably refers to Medco, one has to wonder if this was also an aim of the private equity payoffs):

Notice how this question ties into the scope of Steptoe’s assignment:

The purpose of the review was to examine whether the interests of the institution’s participants and beneficiaries had been harmed by the use of placement agents or related activities, to pursue remedial measures addressing any such harm, and to make recommendations to prevent future harm.

Yet the Special Report fails to contemplate the possibility that CalPERS was harmed by the five managers having received larger allocations than they would have otherwise. You’d expect a declaration that an analysis was performed and either no harm resulted or “It’s too soon to tell, given the long time frame of these commitments; we’ll give you an update in five years.”

Moreover, the only outside expert mentioned in the report is Daylight Forensic & Advisory. Daylight has a great deal of experience in fraud investigations, anti-money laundering and regulatory compliance, which would be helpful in pinning down the financial dealings and movements of the key figures under scrutiny. However, they do not appear to have expertise in the valuation of illiquid assets like private equity funds or leveraged loan participations. So it appears that CalPERS would rely, as it does generally, on the general partners’ valuations, even when the standards of an investigation would suggest that they should get an independent assessment.

There’s also the peculiar treatment of the senior investment officer, Leon Shahinian, who was in charge of private equity investments. The report goes to great lengths to stress how he resisted Buenrostro’s strong-arm tactics and even told Apollo that they didn’t need to use Villalobos. Yet it then sanctimoniously says Shahinain “seemed to lose his way” when he rode on Villalobos private jet to New York and stayed in his suite to attend a black tie event and meet with Apollo executives. A crisper statement of exactly how out of line the conduct was and why would be far more fitting. Instead, we get hand-wringing:

Now why does this matter? Shahinian was forced out. If he was merely guilty of taking some inappropriate gifts but his judgment really was not swayed, this punishment is excessive. Paying him no bonus and/or demoting him would have been sufficient. Either CalPERS really believes his judgement was biased but won’t admit it because it would create liability, or figured it needed to fire someone in the investment department in order to look serious, and he was a party who did have some dirty laundry, making him an easy scapegoat.

Now, of course, you might say that this discussion is making too much of less than stellar drafting in a highly politicized environment. But far more troubling than the inconsistent treatment of Shahinian is the unduly deferential treatment given to the Apollo.

One tell is the depiction of Apollo as “trusted”. When I described the report to a savvy real estate investor (Apollo is a big, brass knuckle player in that business) and asked him what he thought about a law firm who’d describe his client’s relationship with Apollo like that, his immediate response was, “I’d think they all were in cahoots”. If you don’t know private equity, Apollo is known as not being terribly nice (its head, Leon Black, comes out of Drexel), so to anyone in finance, to see them described as “trusted” is jarring, unless you are the sort that trusts scorpions.**

In fact, you don’t have to look very hard to find evidence of Khinda being far too accommodating to Apollo. For instance, Khinda insinuates that Villalobos defrauded Apollo because Buenrostro signed two dummied-up disclosure forms for dates after he left CalPERS, and Villalobos got paid $20 million in fees for two deals in which Buenrostro didn’t talk to the decision-makers in the alternative investment group at all. While Khidna has some air cover for taking that view, since Apollo tried to recover these fees in bankruptcy court, that position finesses the issue of whether Apollo got value by getting enough in the way of larger commitments than it would have otherwise. If so, even these extra fees could just be rounding error.

But the real indicator is the structure of the settlement with Apollo and the other three funds, which Khinda brags about in his bio:

His leadership of the CalPERS Special Review, its fee recovery of over $200 million for the nation’s largest state pension fund, and its March 2011 public report on pay-to-play and public corruption issues are recent representative efforts.

As we’ll demonstrate, we have absolutely no idea whether this fee recovery proved to be remotely worth its face amount. As readers of this blog know well from the junk credits in various mortgage settlements, anything other than cold, hard, cash payments are likely to have a lot of air in them. Moreover, CalPERS has never released a detailed agreement, which raises the possibility that this was never properly papered up.

Moreover, this deal assures that CalPERS will continue to do business with the very same firms that hired an clearly dubious placement agent, by virtue of not being properly licensed and supervised by the SEC. By contrast, when a Defense Department contractor is found to have engaged in abuses, they are put in a penalty box and barred from doing new business for a set period of time.

The report effectively admits that CalPERS had nothing to lose by denying the four funds that engaged Villalobos mandates for a period of time (note one of the five offenders was not allowed into the fee recovery deal, hence we are now discussing four of the original Villalobos five). The very fact that these funds felt they would benefit from hiring him is strong proof that CalPERS is oversolicited and has more attractive opportunities than it can fund. It has the high-class problem of needing to ration money among them.

But instead we get a sanctimonious description of the deal:

Recognizing the difficulties that arose from their use of placement agents, and consistent with their leadership in the financial industry, these firms – Apollo, Relational, Ares and CIM – agreed to a total of $215 million in fee reductions to CalPERS.

And then we have this confection, that it’s technically accurate but substantively misleading to say that the funds “agreed” to a deal when in fact the funds are depicted as having proposed it. This is the text of the letter with Apollo:

Calpers Apollo Fee Reduction Agreement

Notice how sycophantic Khinda is. This is not the posture you expect from someone dealing with an adversary. If you look at the letters to the other three funds (at the end of the report, which we have embedded below), you’ll see the language is parallel.

Now I imagine that any readers who have been involved in large financial transactions will be gobsmacked by this document. This letter is the legal equivalent of a doodle on a napkin. Yet it is signed by both sides (including, for three of the four GPs, by outside counsel as well) as if this was meant to be a final deal. Notice that the agreement contains no undertaking to come up a definitive agreement. That would include what you’d expect in a normal fee agreement: definitions (or references to existing definitions in the various limited partnership agreements), clear beginning and end dates, details on computation and reporting, and so on.

So we have one of two possibilities, neither of which is pretty. The first is that this is all that was ever negotiated and agreed to. That puts the general partners in the catbird seat. The utter vagueness of the agreement allows them to interpret what it means and present to CalPERS how they claim they’ve complied as a fait accompli. Of course, that scenario assumes they even bothered. Notice the lack of any penalties or remedies if the GPs fail to live up to their fuzzy obligations.

The second is that they did eventually draw up a proper agreement (notice that these letters were entered into in mid 2010, but the report was not presented to the public until March 2011), but that’s been hidden from the public, on the assumption that it would not hold up well to third-party scrutiny. In fact, it’s not impossible that the parties negotiated detailed terms and then agreed on the napkin-doodle document for public consumption.

Notice that the language of the negotiation-theater document is that the funds were proposing the settlement terms. If they also provided the draft detailed settlement language, Khinda allowed them to take the wheel. One of the oldest rules of negotiations is “he who controls the document controls the deal.” The party that proposes the text of an agreement has a tremendous advantage, because the other side is forced to start from that and push for any changes or additions they want.

And don’t kid yourself. It would not be hard for these funds to come out having made no real economic sacrifices to CalPERS. Here’s one way that Apollo could get away making no net fee concessions, and could conceivably even come out ahead.

Limited partners like CalPERS pay an annual management fee, which is typically 2% for smaller funds and scales down for mega-funds.*** They also pay transaction fees to the general partners for investment-banking-type transactions, such as the purchase or sale of companies. Over time, LPs have succeeded in getting the GPs to reduce the transaction fees so that they typically only get 20%. But that does not take place by the GP taking the “normal” fee and then applying an 80% discount. Instead, the GP charges the full transaction fee, but then reduces the management fee by 80% of the transaction fee amount.

So…if the fee reductions came in the form of waived management fees, Apollo and its confreres could easily make that up to a large degree, even in full, by being able to charge 100% of transaction fees. After all, there are no management fees to reduce. In this simple scenario, the recovered 80% of a few transaction fees in a year could even exceed the waived management fee, particularly on a large fund, where the fee management fee waived was less than 2% of the commitment amount.

Why do I think this is likely to be the case? Look at that buddy-buddy letter between Khinda and Leon Black again. Remember, the odds are high that either the deal was never formalized, or if it was, Khinda allowed Black and the other general partners to propose the language. And the latter would be sure to allow for the maximum amount possible of the gaming of the arrangement.

While there are other troubling elements of this report, we’ll finish with evidence that it is not being observed. As Butka points out, CalPERS promised to improve the timeliness and completeness of its Public Records Act requests. Our experience, both in CalPERS’ stonewalling, and even more important, its failure to inform the board of our request and lawsuit, show that if anything, CalPERS has become more hermetic. Confirmation comes via the fact that the most recently published version of CalPERS’ organization chart shows that no one is in charge of the PRA effort. That is not what you’d see from an entity that was serious about doing a better job. As a result, retirees like Butka have good reason to be concerned.
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* Yes, 70 million pages of documents were also reviewed, but that was likely handled primarily by Daylight and the screening of those documents into wheat and chaff is done by expert systems.
** It is likely that the investment staff is under no illusions about Apollo, but the public readers of the report are being treated like chumps.
*** The management fee also typically scales down after the investment period, which again works to the advantage of Apollo and its confreres in this scenario.

CalPERS Special Review by Steptoe & Johnson