If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:
Executive Summary
Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity Fees Work
CalPERS Chief Investment Officer Defends Tax Abuse as Investor Benefit
CalPERS, an Anatomy of Capture by Private Equity
CalPERS’ Chief Investment Officer Invokes False “Superior Returns” Excuse to Justify Fealty to Private Equity
In the last CalPERS Investment Committee meeting, one of the most revealing incidents took place when Investment Director Christine Gogan repeatedly refused to answer a simple, direct question about a widely-used private equity tax abuse, management fee waivers,* from board member JJ Jelincic. This was pure and simple insubordination and reveals serious governance problems at CalPERS. This is also not the first time we’ve seen staff show disrespect for a board member, but it is one of the most flagrant incidents.
Moreover, Gogan’s evasiveness suggests that she was not able to field a response, raising doubts about her ability to do her job. Finally, her misdirection served not simply to keep the board in the dark, but also conveyed inaccurate information to them.
Board Member JJ Jelincic: Okay. I won’t ask about offsets. Fee waivers. Can you explain to me what fee waivers are, how they’re used, and how the GP gets their money back?
Investment Director Christine Gogan: So by management fee waivers, just to make sure that we’re on the same page, what you’re talking about is the ability for a general partner to use a management fee waiver in place of a deemed contribution for their one to three percent…
Jelincic: Yes.
Gogan: …correct? And so your question is, to start with, you’re trying to get a sense of throughout our portfolio how common that arrangement is?
Jelincic: That’s a question that I had asked earlier. There’s some research apparently being done on it. But this question is just how does it work? What’s the process? What’s the economics of it? You know, quite frankly, I’m sure that the Wall Street hearts of private equity don’t say, you know, I overcharged you, I’m just not going to take the money.
Gogan: Well, I think, if I could, one thing that I would like to back up and offer up is that with respect to our entire portfolio, it’s important to note that the entire portfolio is audited. Everything is audited. Ninety-seven and a half percent of the portfolio is audited under standards that conform with U.S. GAAP. And so one of the questions without going into a lot of detail on how the management fee waiver mechanics work from partnership to partnership, and it depends to Réal’s earlier point on the waterfall computation, one thing that does give us comfort with respect to having assurance that the bottom line numbers that we’re relying upon are fairly stated, is that the majority of the portfolio, as I mentioned, the overwhelming majority is prepared in accordance with U.S. GAAP. And there are independent auditors typically, one of the top three, that provide a statement to us that provide information that we, as investors, are reasonable in relying on the fact that the financial presentation of the income statement, the balance sheet, and the capital accounts are materially accurate and fairly represent the financial position of the company.
Jelincic: And so how does the fee waiver function work?
Gogan: And so with respect to the fee waivers, to some degree, it’s going to depend on whether it is a European waterfall or whether it is a deal-by-deal waterfall. But my point in trying to go back to the audited financial statements is that in accordance with presenting the financial condition of the individual partnership, there are independent auditors that look every year to evaluate and assure that the computation of net income is consistent with the particular limited partnership agreement, and take into account each of the idiosyncratic conditions of the various waterfalls that exist for that particular partnership.
Jelincic: And the SEC would say they didn’t do a very good job of it.
As South Carolina Treasurer Curt Loftis wrote:
The staff responses are absurd.
Ms. Gogan failed a basic test of her fiduciary responsibilities. She is required to provide information in a timely and practical manner and she did neither. The Committee’s questions were direct and clearly stated and her replies were evasive, perhaps even obtuse.
Gogan’s repeated reliance on the audits for detail specificity is misplaced and is a “dodge.” GAAP audits are helpful but are not, as she implies, appropriate as the primary due diligence tool for PE fees, expenses and income. A sophisticated fund such as CalPERS has the ability and right to demand more stringent initial and on-going due diligence and the staff should be willing participants in that effort. Committee members should not be forced to “dance” with staff for information due them as a fiduciary.
As ugly as this picture is, it’s actually worse than Loftis indicates. If you watch the committee meeting in full, you’ll see again and again that if a staff member looks to be having difficulty answering a question, someone rides in quickly to their rescue. Here, no one more senior spoke up.
By contrast, recall our post last week where the CalPERS Chief Investment Officer, Ted Eliopoulos, described management fee waivers as beneficial to CalPERS when they are a tax dodge that does not benefit limited partners like CalPERS.** Eliopoulos had spoken up because the Managing Investment Director responsible for private equity, Réal Desrochers, was struggling to come up with the proper term of art, management fee waiver, in response to a question from board member Priya Mathur (and yes, the fact that Eliopoulos had to intervene was not a good sign). Similarly, when Jelincic was trying to get answers from Desrochers about another common provision in private equity limited partnership agreements, management fee offsets, Desrochers kept saying he’d be happy to answer the questions later, which almost certainly also meant out of the public eye. When Jelincic pressed onward, the chairman of the Investment Committee called Jelincic out of order, then reversed himself when Jelincic appealed the ruling and asked for a roll call vote.
Thus, as Gogan engaged in a heavy-handed form of obstructionism, no one intervened. By implication, her stonewalling of Jelincic had the full support of her boss, Réal Desrochers, and his superiors who were also present at the meeting, Eliopoulos and the Chief Operating Investment Officer, Wylie Tollette, as well as Mike Moy, CalPERS’ private equity consultant. In other words, staff and CalPERS’ outside advisors are apparently united in its position that the board is not entitled to honest and complete answers. As we discussed at length earlier this year, Tollette clearly and knowingly misdirected the board in trying tell them that it couldn’t get carried interest fees.
And most of the members of the Investment Committee seem to back staff’s apparently successful effort to tell board members as little as possible. You’ll notice that the chairman of the Investment Committee, Henry Jones, never once supported Jelincic’s efforts to pry information loose from the private equity team. Instead, he consistently weighed in on behalf of staff to uphold their apparent right to be less than forthcoming.
Gregg Polsky, former Professor in Residence in the IRS Office of Chief Counsel and now a professor of law at the University of North Carolina, surmised that the reason for Gogan’s slipperiness was that she could not answer Jelnicic’s question. That would be consistent with the performance of the rest of the senior staff. From Polsky via e-mail:
Gogan completely dodges the question, talking about financial statement audits and European versus deal-by-deal waterfalls. I can’t see any relevance at all of this to Jelincic’s questions.
There are two potential explanations for the dodging: she doesn’t actually know at all how fee waivers work or she’s defensive about where Jelincic is going with his questioning. I’d vote for the ignorance explanation for two reasons: (1) someone who knows the basics of fee waivers could have dodged whatever questions were coming without coming off as clueless (she could have fended off any criticism simply by noting that fee waivers can’t hurt CalPERS and she could have pointed out that, in any event, fee waivers are pervasive in the industry and the CalPERS lawyers thought fee waivers were fine at least until the recent guidance which requires them to take a fresh look); and (2) relatedly, there is no reason for someone well-versed in the basics of fee waivers to be all that defensive about them (at least from the LPs perspective). It’s a tax game between the GPs and the IRS; the LPs are really just bystanders.
Bottom line is that I think the exchange suggests that Gogan doesn’t know much about fee waivers. It’s like when I ask a law student in my class about something that he or she knows very little about even though they should know it. They change the topic to something they know about, even if it has little relevant to the topic at hand.
Actually, there could be a reason for Gogan to refer to waterfalls, but that would simply confirm that she indeed does not understand how management fee waivers work. The “distribution waterfall” determines how to divvy up the proceeds of the sale of a company between the general partner and the limited partners. By focusing on the distribution of funds in the event of a sale, Gogan is cementing the misinformation that Eliopoulos also conveyed to board members in the same meeting, namely, that the management fees that the general partners forego are put at risk on the same footing as the monies provided by the investors. Earth to board members: They aren’t. As we discussed at length in a post last week, the general partners have the ability to gin up profits for purposes of recovering their waived management fees, including creating them even when there have been no sales of assets in the fund at all.
So take your pick. Gogan is either trying to cover for the fact that she is out of her depth or is choosing to mislead the board by doubling down on the false story that management fee waivers are a plus for CalPERS because they aligning the interests of the general partners with those of the limited partners.
At another point in the Investment Committee meeting, Gogan fails to answers a simple, direct question and shades the truth so heavily as to be engaging in distortion:
Board Member Dana Hollinger: In the past have we seen the financials of those underlying companies or no?
Chief Investment Officer Ted Eliopoulos: Well, I’ll turn that question over to Christine.
Gogan: With respect to what’s been occurring in the industry is there’s definitely been an evolution that’s occurred over time. And I would say we are moving towards an environment where we are receiving the much more detailed information with respect to the underlying. But to make a broad statement that we have always had access to the underlying detailed information in the portfolio companies is a stretch. It’s definitely improving.
The truthful answer to Hollinger’s question is “No, and we don’t typically get them now either.” Yet Gogan tries to give Hollinger the misleading impression that the limited partners get a considerable amount of disclosure, although she throws in some baffle-speak (“we are moving towards an environment”) to try to make her claim sound like less of a stretch than it is. Curt Loftis concurs:
Ms. Gogan’s response was bureaucratic gobbledegook. She chose to ramble incoherently for several minutes rather that submit a truthful and straightforward “no.”
Public pension plans should not accept as gospel the paltry representations from the GP as to the condition of the underlying investments, valuations and their attendant risk. The failure to perform the required due diligence and adequate ongoing oversight are unforgivable errors that will cost the fund substantial sums of money.
And that’s before you get to the fact, as we discussed in depth in a 2013 post, Why You Should Not Trust the Financials of Private Equity Owned Companies, that many general partners use a portfolio company software package called iLevel Solutions that gives private equity general partners an unprecedented ability to cook the books of their portfolio companies while maintaining a facade of compliance. In other words, the portfolio company data that CalPERS does get is of questionable integrity.
Gogan’s stonewalling shows the true face of CalPERS’ private equity staff: They deem it to be acceptable to defy and mislead the board to protect private equity general partners. This warped sense of loyalties is proof of serious governance problems at CalPERS. But the sorry fact is that the board itself, save JJ Jelincic, has made clear by its failure to press for better answers that it fully supports this abject failure of governance and neglect of fiduciary duty.
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* A management fee waiver is a provision in the limited partnership agreement that allows the fund manager to forego management fees that it was going to receive for overseeing the fund, substituting a separate profits interest (often mislabeled “carried interest”).
As Lee Sheppard wrote in Tax Notes:
Fund governing documents usually allow the general partner to find profits to cover the waived fee wherever it can. The general partner often has a lot of discretion in accounting for profits. Some fund documents refer to undefined “available profits.” The general partner takes its profits to cover the waived fee out of the first profits in any future accounting period, regardless of losses in other periods.
So a fund could lose money over its lifetime yet have enough isolated successful quarterly or annual periods that the waived fee can be recouped. The point is that there are lots of machinations that the general partner can use to ensure that its waived management fee gets paid.*
As Sheppard concluded in a more recent Tax Notes article (emphasis ours):
There is no real intention to subject the management fee to the risks associated with the general partner’s profits interest.
** Former Professor in Residence in the IRS Office of Chief Counsel and now a professor of law at the University of North Carolina Gregg Polsky stresses that management fee waivers are designed to leave the economics of a private equity fund unchanged.
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This series continues to be fantastic.
What strikes me about that description is how broadly it applies to significant numbers of people in positions of power and responsibility all across our public institutions.
Earth to Jerry Brown: Might want to deal with this.
California needs to borrow South Carolina’s treasurer.
How about New York’s Attorney General?
‘Public pension plans should not accept as gospel the paltry representations from the GP as to the condition of the underlying investments, valuations and their attendant risk.’
Many of the underlying investments likely are saddled with heavy debt service on sub-investment grade debt. This works fine in an economic expansion.
But when revenues start to shrink (see today’s post ‘Corporate Revenue Recession’), cash flows can turn negative. Once that happens, access to fresh financing tends to get cut off, often at the most inconvenient moment.
Prudent managers probably would not take on the debt loads that many PE-held companies have. Thus, better to gloss over the dicey details rather than take board members on an unpleasant tour of the offal-littered floors of the sausage factory. That foul odor is the smell of money being made!
“Gogan’s stonewalling shows the true face of CalPERS’ private equity staff: that they deem it to be acceptable to defy and mislead the board to protect private equity general partners. ”
These posts are stunning. Where did Gogan and Eliopoulos come from? Who vetted and hired them? I can’t decide if CalPERS PE staff is deep into Dickens’ Uriah Heep territory acting for their own interests, or are captured useful idiots for the PE General Partners. Either case is ugly. Either case is costing CalPERS a bundle in lost income.
Thanks again for these posts.
The silence of the Board speaks for itself. Most Board members don’t want the answers to be discussed publicly, either. The senior management is doing exactly what they are paid to do. As far as the who, these are employees of the state of California. Very well compensated employees of the state of California, by the way.
P.S., you might like this link. Generally speaking, our leadership class is quite proud of their leadership bona fides to lead the rest of us.
Eliopoulos, for example, worked in the Treasurer’s office before moving to CalPERS. He actually represented the state Treasurer with CalPERS and other groups (the Treasurer serves ex-officio, meaning by default of having their elected office they are a Board member) before moving into a staff role at CalPERS. He’s an Ivy grad and a lawyer. You can’t make up this kind of stuff if you tried.
https://www.calpers.ca.gov/page/about/organization/executive-officers
Thanks. Particularly liked this bit in his job description:
“The CIO determines prudent, forward-thinking investment strategies in accordance with CalPERS fiduciary responsibilities,…. “
Forward, comrades…long live Prudent Equity.
Sorry, couldn’t resist.
Considering these 2 observations by Loftis and Yves,
Curt Loftis:
Yves:
What rights can LP such as CalPERS exercise to directly examine the books of the companies in which a PE fund is invested, and to directly examine the agreements made by the PE fund with individual companies in which they are investing? It seems that only by such examinations is it possible for CalPERS/LPs to do appropriate due diligence on the PE fund which they are about to “marry” for a lengthy investment period.
For example, the GP fund probably makes the companies sign an NDA on the terms of the agreement; would this prohibit CalPERS LP from seeing it? Presumably the GPs had rights to explore any secrecy-protected contracts the investment companies might have made, and so it seems that CalPERS/LPs should have similar rights. Otherwise no due diligence is possible and everything is on a “trust me” basis. GPs would never accept that from a company, why should CalPERS consider that adequate, particularly with what has come to light here & with SEC.
Level solutions? Based on the mechanix of the Panama Canal? No matter how heavy and water-logged your boat is, if it just barely floats you can still get it through the locks and home free. And foregoing management fees for profits and calling it an expense is classic. Makes Mitt look like an amateur with his personal capital gains status. Tho’ I’m sure he did all this stuff too. One aspect of all this that gives me the creeps is the underlying fact that pension funds are busy denying all responsibility, as merely limited partners who sign away their right to know in order to get a tax break, and so they actually choose to undermine the very tax base that supports their existence. Which is supported by current and future taxes. And etc.
hopefully, eventually this will lead to the fiduciary theater of phony losses at StuyTown/Peter Cooper where cali pensions were “told” they had losses of over 100 million and florida was “told” it had a 250 million dollar loss…but there was no actual foreclosure all this time…at least not until the “mystery” deed in lieu deal in june of 2014…nothing to see here folks…just keep sending in your pension contributions/gifts to the fund to protect americas private equity managers…operators are standing by…call 1-800-gift-2-us…hampton operators are available 24 hours a day, seven days a week…won’t you help keep the hamptons strong america…do your part…
1-800-gift-2-us
great stuff…
Yves, In your earlier post – “CalPERS, an Anatomy of Capture by Private Equity” – you quote Peter Morris:
“And, paradoxically, imperfect alignment of interests is more dangerous than none at all. That is because it gives a principal false confidence that she can afford to stop worrying about her agent’s conflict. ”
The CalPERS PE staff looks like a perfect example of this “more dangerous” alignment. Where are the PE staff interests really aligned? And does the CalPERS board understand – or even see – the conflict of interest?
And/or do they care? Doesn’t look like they do, does it?
Thanks again for the links to the meeting, plus excellent and educational and revealing commentary from Yves and others. Absolutely stunning stuff, but not in a good way.
Either CalPers is staffed by know-nothing idiots who should never have been hired for their jobs (and should get the sack immediately, if not sooner) and/or they are in collusion on the grift/dodge/whateveryouwanttocallit.
Thanks for the continuing updates, and I hope more light can be shed on this pathetic situation.
Again: Cui Bono? And how? Who is getting WHAT, exactly, out these PE investments, and what is it, exactly, that they don’t want the Board, the CA government, and citizens to know??
Plus most of the Board should be tossed out. Seems like most of them are captured, too.
Is choosing new CalPERS Board members the most that payers-in can do, in this case?
Though who’s to say–new Board members might be even less informed than most of the current ones.
Do the Board members get paid enough that they all want to play nice with the CalPERS executive staff? Unspoken rules of decorum?
So is she being fired? Isn’t that the usual result of refusing to answer your boss’s questions? Or is the board not in fact the boss?
“It is difficult to get a man to understand something, when his salary depends on his not understanding it.” — Upton Sinclair, I, Candidate for Governor: And How I Got Licked (1935).
Plus ça change, plus c’est la même chose…
Once again, this is fascinating. It’s almost like reading a novel, one in which the moral of the story seems obvious to everyone except the characters in it. Thank you for writing this. The people who put years and years of their work paying into their pension funds deserve much better than this.
This blog has become my first read each morning. Thanks for your fine work.
Those of us that have been “clued” into the public pension plan madness can now watch the chickens come home to roost. Please pardon me for being petty, but I am having some wonderful laughs.
DG
The weird part is that, as Polsky said, “there is no reason for someone well-versed in the basics of fee waivers to be all that defensive about them.” Her conclusion is that Gogan “doesn’t know much about fee-waivers” but, come on, how is that remotely possible? While the concept of management fee waivers is not at all complex, it’s also self-effing-explanatory! As opposed to being totally ignorant, I would say she’s just someone who’s been doing what she’s told, doesn’t ask questions, and was dumbfounded upon being pressed…
Which brings me to the intuitive conclusion that the CIO is the rat. Whereas the others just sound like morons, he’s the one knowingly and mendaciously parroting the same nonsense that the GP’s do about “aligned interests.”
Given the way her boss Réal Desrochers twice made it clear that he did not understand that private equity general partners still collect the full amount of the management fee when management fee offsets are in place, I would not discount the possibility that Gogan really does not know how management fee waivers work (particularly the issue we’ve raised, that the fees waived are not put at risk, while the limited partners’ funds are). However, she acted like a hostile witness on the stand, so she may simply be operating from the premise that any serious questions from the board need to be stymied.
With Gogan, probably some combination of the two, but either way she’s very transparently on tilt…
As I mentioned in this annotation, what makes Desrochers’ shiftiness particularly sketchy is how back in 2012 he was boasting about his negotiating savvy in reducing Calpers’ private equity fees (a feat which one must imagine is predicated on having the data on the fees in the first place). It’s yet another reason why, in my view, Occam’s Razor cuts at “ethical capture” more than at an intellectual one.
With Gogan, probably some combination of the two, but either way she’s very transparently on tilt…
As I mentioned in this annotation, what makes Desrochers’ shiftiness particularly sketchy is how back in 2012 he was boasting about his negotiating savvy in reducing Calpers’ private equity fees (a feat which one must imagine is predicated on having the data on the fees in the first place). It’s yet another reason why, in my view, Occam’s Razor cuts at “ethical capture” more than at an intellectual one.
Um. you discount the possibility that Desorchers (and much of the PE staff) exhibits the Dunning–Kruger effect. And I’ve seen way too often that senior people overestimate their negotiating abilities. CEO are classic in this regard. Unless they grew up in an industry where you negotiate all the time, like media, they are typically not very good but fancy themselves to be superstars.
And one of the ways GPs get their way is to flatter the LPs as to what great negotiators they are, so that the LPs can tell themselves they won a hard-fought battle when the GPs gave them bupkis. As Andrew Silton wrote:
Yves
I’ve been a long time follower of this blog, almost since its inception (I think either calculated risk or Mish drove me over here back in 2007) and I think the work you have done here over the years is nothing short of extraordinary and assuredly unique in the world. These PE pieces certainly fit your highest standard.
I think your premise that they are captured is really the germane point. Dunning-Kruger is a symptom of lving in their world. Desorchers and Grogan are average to poor managers / administrators. They have ‘staff’ or ‘teams’ that do all the detailed work. They get overly simplified status reports, likely ‘one-pagers’, of deals to review and approve. I would doubt they have ever been involved in a negotiation of any real depth or meaning. They don’t have the bandwidth.
They would have to read voluminous contracts, meet with lawyers to go through them line by line to get their interpretation, meet with finance people to build models and forecasts, develop detailed negotiation points and strategies to get there, build internal support to fight the political charge from the GP’s and ensure all of the risk and control policies are being complied with, not the least of which is an internal tax group that is really good describing all the things that can’t be done. This is weeks and weeks of hard work, long hours on top of the HR issues, budgets, committee meetings, briefings etc….
Instead they manage by metrics, which of course are meaningless because the information they really need can only come from the GP’s who won’t give it up. Instead they focus on the only numbers they do have and make decisions that are doomed from the start.
They won’t answer Jelencic because he IS a detailed guy who worked in operations and does in fact know how the processes work in detail. They know he is peeling back the onion and at some point they are exposed, so why go there if it can be avoided. They might even intuitively understand they are fighting a losing battle, but to admit it is to cut the portfolio and doom their livelihood in the process.
It really becomes a major governance issue and that board is ill equipped to deal with it. Jones is openly giving them air cover. Jelencic is the black sheep and the only one to confront it in open session. Whilst Mathur points out the obvious, it is striking that someone who has a Masters from Cal Berkley and has served on the board since 2003 is just now doing the 5th grade math on a 2/20 fee structure equating to 36% of the fund over 10 years. Some $40 billion in investments already made…..
The Governors appointees are playing nothing to see here, although one does suggest using some ‘influence’. Here’s a suggestion, stop spending $40B on PE. I’m guessing that would be pretty influential, but may not go down so well in the govs office.
Chiang and Lind seem to get it, but are happy for Jelencic to carry the water. 7 of them fly totally under the radar, who knows what politics are going on there.