California Treasurer Chiang’s Private Equity Transparency Three Card Monte

We held our fire on the progress of California Assembly bill AB 2833, a private equity fee transparency bill, in the hope that its sponsor, Treasurer John Chiang, who sits on the CalPERS and CalSTRS boards, was acting in good faith.

In fact, AB 2833 was amended on Wednesday so as to be so pointless that we oppose the bill and urge California readers to call and write their representatives to urge them to vote against it in its current form.

Worse, it’s obvious that Chiang and his staff merely used this bill as an opportunity for the Treasurer to pretend to be on the right side of the growing consternation over the ignorance of limited partners like CaLPERS of the full fees and costs of investing in private equity, which come at the expense of their beneficiaries.

This bill has the hallmarks of cynical ploy. Chiang was not only unwilling to challenge the private equity industry. He failed even to make a pretense of standing up to their stooges, the captured California public pension funds. Not only did he fail to put up a fight for having the bill deliver on its promise, he never took basic, pro-forma steps to advocate for it.

The initial bad sign was when the stewardship of the bill through the legislature was orchestrated to assure that only insiders, meaning captured public pension funds acting as stooges for the private equity industry, had input into the sausage-making.

But even worse, as we’ll show next week, at a recent CalPERS board meeting, Chiang’s staffer, Grant Boyken, flagrantly misrepresented the status of the bill as the board was debating what action to take with respect to AB 2833. As a result of this gamesmanship, the board gave blanket approval to the measure when it had been advised that amendments were pending but was kept in the dark as to what they might be. And in fact, Chiang and Boyken knew what was pending; a draft was circulating at that time that is virtually identical to the key changes that were just made.

Today, we will discuss the deficiencies of the bill as it stands. Next week, we will show how Chiang failed to make a serious go at implementing real reform.

What Chiang Promised Versus What the Bill Delivers

As regular readers know well, the reason a seemingly technical matter like private equity fees and costs has become controversial is that the private equity fund managers, who are also called “general partners,” not only have made an art from of extracting cash from the companies they buy on behalf of their “limited partners,” but they have also been called out by the SEC for wide-ranging abuses, including making unauthorized charges. In most walks of life, that would be called embezzlement. Moreover, the SEC depicted the limited partners as part of the problem by signing agreements that were vague on critical points and performing little in the way of oversight.

Chiang announced his intention to sponsor private equity transparency legislation last October. From Reuters:

….Chiang said the California Public Employees’ Retirement System and the California State Teachers’ Retirement System, along with other limited partners, “pay excessive fees to private equity firms and do not have sufficient visibility into the nature and amount of those fees.”…

Last month, the Institutional Limited Partners Association announced it would seek a better understanding of “all monies paid to the fund manager.” Calpers has said it will begin reporting the amount of carried interest paid to general partners later this year.

Chiang applauded these efforts, but noted “more needs to be done to ensure public pension funds and their trustees have the transparency they need to determine the value of private equity investments.”

Chiang proposed not to impair existing contracts with general partners. Instead, disclosure requirements would include gross management fees, management fee offsets, fund expenses and carried interest, as well as related party transactions.

In other words, Chiang was concerned that investors are paying unjustifiably high fees to private equity firms. He described his transparency bill as a means to achieve that end and stated that “more needs to be done” than the Institutional Limited Partners (ILPA) fee template. Bear in mind that while the final ILPA template was not released until January 2016, it was in an advanced form as of October.

Recall also that a few months earlier, Ching along with a dozen other prominent public pension fund trustees wrote the SEC to intervene on behalf of these investors. One of the ruses they flagged was the way that general partners circumvent disclosure is by having the companies they control make payments to them or to related parties. That means the monies do not flow through the investment fund and are not reported as costs in the investment fund’s audited financial statements.

Worse,some of these fees, like monitoring fees, are purely extractive; Oxford Professor Ludovic Phalippou has called them “money for nothing.” Others are set well above any defensible value for the service rendered. For example, many general partners charge “transaction fees” at the level that investment banks charge, when they also have engaged an investment bank to do the actual work. From the trustees’ letter:

Among the four types of private equity firm expenses—management fees, fund expenses, allocated incentive fees, and portfolio-company charges, a portion of which serve as offsets or contra-expenses to limited partners—only directly billed management fees are easily segregable and therefore regularly disclosed. Though private equity firms generally disclose information on all types of fees, it is often reported deep in annual financial statements and is not reported directly to limited partners on a quarterly basis. This lack of clear and frequent reporting has resulted in an uneven approach to fee disclosure from private equity general partners to limited partners.

One tangible example of inadequate expense reporting relates to portfolio company monitoring fees. Limited partners, such as state pension portfolios, are typically eligible for an allocation of fees that private equity managers collect from their portfolio companies. However, this limited partner share is usually not transferred to the limited partner, and instead it is maintained by the manager and used as an offset against payment of management fees. The calculation behind this offset is often opaque to the limited partner, making consistent disclosure of private equity expenses to the public extremely challenging.

Broadly, this opacity has also led to a culture in which management fees reported by state pension funds often do not reflect total management fees accrued by private equity firms.

Notice the concerns raised:

1. Most fees are not reported separately

2. The fees reported by state pension funds “often do not reflect total management fees accrued,” meaning incurred at the fund level or at the portfolio company level.

The letter hints at a third concern, that because various management fee offsets are opaque, limited partners cannot determine whether the charges are warranted, either in substance or how they are applied.

How does the current version of AB 2833, which is now set in its repeatedly-amended form to go though the California Senate (more on procedural fast ones soon) stack against up these promised and needs? Poorly.

In the interest of space, we’ll describe only three major shortcomings.

AB 2833 has gaping holes that will allow general partners to structure related party payments to escape reporting. The bill, which you can read here, has a very long and complicated definition of what constitutes a related party. It is inferior to shorter and more comprehensive definitions in earlier drafts.

Specifically, the focus of the related party definition is to force the reporting of transactions with individuals that are managers, owners or employees of the general partner entity, service providers to the general partner, and vehicles with as little as 10% ownership of a “related person or operational person”.

However, the restrictions on entities upstream from the general partner are not water-tight. Recall that “general partner” is used loosely and can be any one of: the legal entity established to serve as general partner of the fund; the firm hired to act as investment adviser to the private equity fund; and the natural persons who work for that investment adviser.

The definition of “related party” includes “any operational person” who are included only when their (emphasis ours) “primary activity for a relevant entity is to provide operational or back office support to any portfolio company of any alternative investment vehicle, account, or fund managed by a related person.”

An “operational person” could have his role structured so that his “primary activity” is not “operational or back office support” but a secondary activity.

And while we are at it, what is a “relevant entity”?

“Relevant entity” means the general partner, any separate carry vehicle, the investor advisor, any of the investment advisor’s parent or subsidiary entities, or any similar entity related to any other alternative investment vehicle, account, or fund advised or managed by any current or former related person.

This is not comprehensive in capturing entities upstream from the investment adviser, which can be structured legally to be an investment adviser for only that particular fund. The only upstream entity is “the parent”. If you put two legal entities over that investment adviser (a parent of the parent), the ultimate parent would not be included.

AB 2833’s definition of “portfolio company” allows payment to be routed through other entities. The definition of “portfolio company” is more obviously deficient than that of “related party” and again allows the bill to be circumvented:

“Portfolio companies” means individual portfolio investments made by the alternative investment vehicle.

Huh? What does “individual portfolio investments” mean? This language does not map onto legal entities or contractual relationships. But by saying “individual,” that would appear to set up the argument that the portfolio company is only “individual” meaning the senior-most legal entity that owns fund assets. But private equity funds seldom invest directly in a portfolio company. For tax and other reasons, there are often “blocker” legal vehicles and other legal entities that sit between the private equity fund and the investee business. It thus appears that general partners could launder the former portfolio company fees through legal vehicles that sit above the portfolio company. For instance, Portfolio Company contracts with Intermediate Co. which has a mirror contract with the general partner or a related party.

Reporting is at far too high a level of abstraction to allow for verification or cross-checks. Another major flaw in the bill is that it fails to report fees quarterly, as the unhappy 13 major trustees had called for, and is nowhere near granular enough to allow them to map the fees back to either portfolio company activities or limited partnership agreements. It simply calls for an aggregate of fees and costs, reported on a pro-rata basis for the fund and also by the portfolio companies.

Bear in mind that the previous version of the bill required that all related party transactions be reported. The current version calls only for providing each CA public fund with its pro rata share of those fees.

This example illustrates of how this newly proposed reporting structure would cause vast under-reporting of the total amount of fees that a portfolio company is paying to a private equity firm:

• PE firm “Deal Guys” makes a $100 million equity investment in “Widget, Inc.”

• Deal Guys Fund V, L.P., its current flagship buyout fund contributes $65 million of equity

• CalPERS has contributed 5% of the capital in Deal Guys Fund V, L.P.

• The of the remaining $35 million of equity, $20 million is contributed by a friends and family fund ($5 million), and an “offshore” fund ($15 million) that holds the capital of non-U.S. investors, both of which are required by the LPA of Deal Guys Fund V, L.P. to invest alongside it pro rata. The final $15 million is contributed by an LP co-investor (not CalPERS).

• Upon purchasing Widget, Inc., Deal Guys forces it to execute a monitoring agreement calling for an annual payment of $5 million to a Deal Guys affiliate.

What is CalPERS’ pro rata share of this $5 million? It is five percent (CalPERS’ interest in the fund) of 65 percent (the fund’s interest in the Widget, Inc. deal) =(5,000,000 X .05 X.65) = $162,500.

From this $162,500 number, CalPERS would either 1) erroneously infer that the total amount of money being taken by Deal Guys from Widget, Inc. annually is $3.25 million (162,500 X 20), a conclusion they might reach because they incorrectly think that the fund in which they are invested is the only vehicle invested in Widget; or, if they are more sophisticated, they would recognize that there is no conclusion they can reach about the total amount being sucked out of Widget by Deal Guys.

Further, because CalPERS has no visibility into the other Deal Guys entities in the transaction, it does not know that the $20 million contributed from the friends and family fund and the co-investor do not give rise to any management fee offsets, meaning that the Deal Guys affiliate just keeps the full $1 million annually (20 percent of the annual monitoring fee) attributable to this capital.

Please Call or E-mail and Oppose the Current Version of AB 2833

If you are in California, please call or write your state Assemblyman and Senator to let them know you oppose the bill in its current form because it offers the only the pretense of transparency. Tell them it is worthy of support only if it is restored to the original strong form of the bill or something very close to it. It is particularly important to contact your Senator promptly if he is on the Senate Committee on Public Employment and Retirement, since the bill is scheduled for a vote before that Committee on Monday. Note that a different version of the bill made it through the Assembly; the Public Employment and Retirement is its first stop in the Senate.

The members of that committee are:

Richard Pan
Mike Morrell
Jim Beall
Isadore Hall, III
John M. W. Moorlach

You can find the contact information for your Senator and Assemblyman here.

If you send an e-mail about AB 2833, please send a copy to Chiang and his deputy Grant Boyken. Since Chiang has made it clear that he intends to run for Governor, he should be concerned that voters recognize that his efforts to garner good PR will backfire if he does not deliver the goods:

john.chiang@treasurer.ca.gov
grant.boyken@treasurer.ca.gov

You can also contact Chiang via mail or telephone:

Mr. John Chiang
California State Treasurer
Post Office Box 942809
Sacramento, CA 94209-0001
(916) 653-2995

As always, thanks for your interest and support!