After 30 Years of Investing in Private Equity, Washington Decides That It Might Help if Its Board Knew What It Was Doing

A gobsmacked reader sent me a story from PEHub titled, Pension boards could use a tutor. Here’s one that hired.

The headline presupposes that pension funds are clueless when it comes to investing in private equity. While based on our extensive commentary of CalPERS, widely considered to be the best managed public pension fund, that happens to be true, it’s nevertheless revealing to see a major industry publication treat this as normal, as opposed to proof of a wide-spread pathology. First, pension funds trustees are fiduciaries. They are obligated to understand the risks that the funds they oversee are taking. If they do not understand an entire asset class, and one widely acknowledged to be one of the riskiest in these portfolios, they have no business investing in until they’ve become competent.

Instead, this obviously planted sales pitch for one of the providers of this sort of remedial education, Harvard Business School Professor Josh Lerner, makes clear how far behind the eight ball these boards are. The example served up is the State of Washington, which currently is the biggest public pension fund investor in private equity.

But even more important from the perspective of gross dereliction of duty is that Washington is the longest-standing investor in private equity of all public pension funds. It not only invested in KKR’s funds in the 1980s, but then proselytized on behalf of KKR to other public pension funds.

Yet the article, while trying to preserve appearances and make the training sound as if the board members are being given advanced coaching, reveals that it’s material they should already know cold:

Institutions looking to narrow that gap should take a cue from Lerner and Washington State Investment Board. Earlier this summer, the $106.9 billion retirement system brought in Lerner to give a presentation covering the nuances of private equity, including fee and fund structures. He also put board members through the paces of manager selection and return considerations, pairing his instructional programming with interactive scenarios.

Lordie. Board members should already know how fees and fund structures work. And if they are that far behind that they need tutelage on such basics, they need a lot more than one session to be deemed competent.

It’s also telling that nowhere does this chipper article mention that Lerner is badly conflicted. He makes far more consulting to the private equity industry than he does from his nominal day job as a Harvard Business School prof. When Lerner gave a presentation to CalPERS in 2015 (more on that shortly), David Soares, a member of the public, questioned the failure not just to disclose Lerner’s considerable conflicts of interest, but also the refusal of the committee chairman to allow this issue to be raised while Lerner was still on the video link:

But I know that also Professor Lerner is, and it just, this all came up on a simple Google search, he’s a [sic] advisor since 2009 for Grove Street Advisors, which is a major private equity firm. He’s listed also as an advisor at Caspian Private Equity as a strategic advisor, and I’m concerned that he may have a certain amount of conflict of interest, that is, I can’t ask him, but that his most of his income is coming from in fact the private equity industry. And I even look at his research institute and the tax filings for that research institute. His directors are essentially from the private equity industry and his funding comes from the private equity industry. And so I’m concerned that the presentation, obviously all the other presenters are investors in private equity and Professor Lerner is being sort of presented as independent, but he really isn’t. In fact, he’s the most conflicted presenter today.

Moreover, we made an extensive critique of Lerner’s lightweight and often misleading presentation to the board. Rosemary Batt, the co-author of the highly respected book Private Equity at Work spoke to take issue with how Lerner depicted private equity returns, including what he said about recent papers. As we concluded:

As one academic said to me, Lerner’s presentation was of the type he was advised to make when he started researching private equity: point to the importance of top quartile performance, suggest that there are ways to achieve it, and drop hints as to how to be helpful (he highlighted the Lerner slide that mentioned the importance of expertise on the board: One remedy if you don’t possess it is to rent it, as in engage a consultant… such as a top academic).

The notion that CalPERS may well have received a prototypical presentation from Josh Lerner, even if it was updated to incorporate recent research, is consistent with the fact that private equity spends so much in fees that is it difficult to get independent advice. But the fact that CalPERS is so deeply captured that it does not even appear to recognize this impediment is even more troubling.

While Lerner may have spent more time with Washington State and focused more on manager selection issues, any knowledge transfer would be limited, even before getting to the fact that Lerner’s past work shows that he regularly makes positive-sounding remarks when the data he presents often doesn’t support his claim. So he has a track record consistent with his apparent economic loyalties: to defend the industry even when the case for doing so is questionable at best. Yet this sort of thing is considered to be perfectly reasonable, as the approving PEHub stroy shows.

As we’ve said, public pension funds have already admitted they need to be protected from themselves. In 2015, a group of state treasurers plus the New York City controller, who would be among the most financially savvy members of their pension boards, wrote the SEC to ask for what amounted to help with doing their jobs. It’s time to admit that public pension funds lack the skills to invest in exotic products like hedge and private equity funds. The SEC should remove their accredited investor status and have them enjoy the benefit of retail disclosures, which unbeknownst to them, is the only way to satisfy the pleas of the frustrated state officials who had a sense of they didn’t know and asked the SEC to rescue them.