CalPERS Goes for Secrecy Over Returns; Exploring Paying Additional Layer of Private Equity Fees by Outsourcing to BlackRock

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Bloomberg broke the story that CalPERS is considering outsourcing its entire private equity program to BlackRock. This would be a desperate move and as we will discuss, is inconsistent with CalPERS’ objectives of obtaining the best returns and minimizing costs.

This scheme is also inconsistent with the idea that CalPERS broached at its offsite last July, that of setting up an independent vehicle (with the “independent” part looking like “inadequately supervised”) to cut out the middleman and make more private equity investments on a direct basis. Moreover, one of the panelists at that July offsite, Mark Wiseman, is the head of BlackRock’s private equity business. Yet staff presented him as an independent expert when in fact he had a glaring conflict of interest.

Moreover, this idea looks like yet another power grab by staff. The board has not been briefed. Board member JJ Jelincic said, “This is not something the board should learn about from a Google alert.” Moreover, staff’s delegated authority investment authority is well less than $26 billion, the size of CalPERS’ private equity program. Any significant shift of private equity funds to BlackRock would require board approval.

From Bloomberg:

The largest U.S. pension fund is talking to BlackRock Inc. about outsourcing its private equity business as it seeks to control fees and offset anemic returns, people familiar with the matter said.

The California Public Employees’ Retirement System is in discussions with New York-based BlackRock about managing some or all of its $26.2 billion in private equity investments…The discussions are preliminary…

Calpers is reckoning with criticism over its private equity investing and how it discloses and accounts for fees.

Why Hiring BlackRock to Manage Private Equity Would Hurt CalPERS Beneficiaries

The official story as to why CalPERS is talking to BlackRock is nonsensical on its face.

CalPERS will pay more in fees with BlackRock and there is no reason to expect improved performance. As the former Chief Investment Officer for North Carolina, Andrew Silton, stressed, CalPERS is such a large investor in private equity that is unlikely to achieve better than index-like returns. And it’s a no-brainer that introducing another intermediary means more fees and costs.

BlackRock would effectively be a dedicated fund of funds manager for CalPERS, an approach that is typically used only by small fry, like high net worth individuals and and smaller institutional investors, or for bigger players, to achieve adequate diversification for small, niche-y strategies (say if CalPERS decided to make an allocation to infrastructure in Latin America).

It is remarkable to see CalPERS consider outsourcing, since going in the direction of increasing its cost flies in the face of prudent investment management. It also contradicts the approach CalPERS takes in all other strategies in which it invests, where it has a strong focus on expense reduction and manages many of its investments in house because it is cheaper.

CalPERS board candidate and private equity expert Mike Flaherman explained why CalPERS would wind up paying more by turning to BlackRock:

BlackRock would be acting as a “middle man” standing between CalPERS and private equity managers, and this role doesn’t come cheaply in the marketplace. Even if CalPERS is able to negotiate heroically and ends up paying BlackRock 20 basis points (0.2%) in annual management fees, that would amount to more than $50 million a year. On top of that, BlackRock would typically receive a cut of profits.

These costs would be substantially larger than the approximately $5 million annual expense of the internal CalPERS private equity team that BlackRock would replace. In addition, it is likely that BlackRock’s compensation will rise over time, as CalPERS will likely pay a much lower fee for BlackRock to monitor legacy investments made by the CalPERS team compared to the compensation paid for new investments sourced by BlackRock. Over time, the CalPERS-sourced investments will be harvested and replaced by BlackRock-sourced ones, likely leading to large cost increases.

On top of that, despite having the veneer of a Big Finance Brand name, private equity is not an area where BlackRock is a top tier player. CalPERS’ $26.2 private equity program is a full 20% of the size of Blackrock’s entire alternative assets business, which includes real estate, hedge funds, and infrastructure along with private equity.

BlackRock’s substantial conflicts mean it would be a less vigorous advocate for CalPERS with private equity fund managers. Regular readers of this site know that the private equity industry is rife with dubious conduct. The SEC said in 2014 that more than half the firms it had examined had engaged in serious compliance violations, including what in other lines of work would be called stealing. Even after the SEC fined major firms including KKR, Blackstone, and Apollo, limited partners like CalPERS almost without exception took no meaningful steps on their own regarding these revelations.

One of the supposed checks on private equity fund manager misbehavior is that private equity funds have advisory committees that consist of the more important limited partners. Even though these advisory committees have very weak powers to being with, private equity fund managers take no chances. They make sure that they have a comfortable majority of limited partners will never vote against the fund manager.

And who are top candidates for that role? Fund of fund managers with Big Finance Brand names, like JP Morgan….and BlackRock.

Why are fund of funds managers such reliable allies of the private equity fund managers? Because the fund of funds business model depends on being able to sell investors on the idea that the fund of funds has great access to private equity funds. If a fund of funds manager were to make a stink about a private equity bad practice, the fund managers could do the fund of funds manager great harm simply by letting it be known that the fund of funds manager was difficult to work with.

As Mike Flaherman added:

There is a lot we don’t know based on this Bloomberg report, but based on the sketchy details, this appears to be a troubling development.

BlackRock already has a private equity business that competes on a daily basis with CalPERS for investment opportunities, so there are severe questions of how this conflict of interest could be managed.

CalPERS would have much less ability to get private equity fund managers to divest problematic holdings. CalPERS has a strong commitment to socially responsible investing. Even though it is tricky to figure out how to reconcile this goal with CalPERS’ objective of achieving sparkling investment returns, one important way to square this circle is to be able to exit particularly rancid investments. That’s already difficult with private equity given its long investment time horizons.

But even so, CalPERS’ Sacramento sister CalSTRS decided to ditch investments in the manufactures of firearms that were illegal to be sold in California. That included a stake in Remington Outdoor via a Cerberus fund. After a two-year effort by Cerberus to sell the company at a sufficiently attractive price, CalSTRS obtained an economic exit from its position.

CalPERS is regularly exposed to controversies like this. For instance, a campaign is underway to get CalPERS and other limited partners to stop funding Trump’s violation of the Emoluments Clause of the Constitution via its investment in CIM Fund III, a real estate fund. Among other things, CIM is an investor in Trump International Hotels Management, LLC which among other things manages Trump SoHo Millennium.

While this is a real estate investment and not a private equity investment, CIM was one of the firms involved in CalPERS pay-to-play scandal, which is an unduly polite word for bribery, that led to the prosecution of former CalPERS CEO Fred Bruenrostro, who was sentenced to four and a half years in prison. Even though this CIM fund is in CalPERS’ real estate portfolio, the beneficiary of the scheme was the private equity giant Apollo. Richard Ressler, the co-founder of CIM is the brother-in-law of Apollo’s CEO and founder Leon Black. CalPERS should have gotten clear of CIM a long time ago.

CalPERS has also been under pressure to divest from DAPL. The giant pension fund has resisted, arguing it can do more good by “having a seat at the table”. The legislature has proposed legislation to require CalPERS to get out of other investments.

The larger point is that whatever you think of the merits of CalPERS’ stance on particular investments, it has adopted a policy of supporting socially responsible investing in other parts of its portfolio. It is hypocritical to treat private equity as exempt, which appears to be its position. CalPERS will be even less able to exert pressure on private equity funds if it is investing via BlackRock.

What is Likely the Real Reason for CalPERS’ Seeking a Worse Deal in Private Equity?

CalPERS’ Chief Investment Officer Ted Eliopoulos stated clearly why he wanted to make big changes in private equity. In a June board presentation that one CalPERS insider called a “pity party,” Eliopoulos said he couldn’t handle the transparency demanded of CalPERS in private equity. From a transcript of a June board video:

Because it is vitally important to whether CalPERS can successfully meet our investment objectives over this next ten-year period. I mention it also because over the course of the past two years, and frequently in these monthly Investment Committee meetings, CalPERS’ staff is attacked and denigrated for our decision to invest in these funds and for the manner and transparency of our reporting of the fees, carried interest, and expenses attached to these funds.

As Andrew Silton wrote:

As CIO for North Carolina, I faced frontpage stories questioning the pension’s investment programs, as well as my decisions and motives. Without a doubt the stories were painful. As the leader of North Carolina’s investment effort, it was my job to ensure that the attacks didn’t distract staff. We simply continued to invest. Mr. Eliopolis’s statement to the investment committee only serves to reinforce my critique of CalPERS. The pension plan has a leadership problem.

We went through some of the recent incidents where CalPERS was deservedly lambasted by the press and concluded:

To put this more tersely: if Eliopoulos thinks his problem is that CalPERS’ reputation is taking a hit, he needs to stop shooting messengers and clean up the underlying conduct.

Instead, by engaging in innuendo and lashing out at critics, he’s made matters worse by refocusing media attention on CalPERS’ recent own goals. For instance, in a podcast by PEHub editors Chris Witkowsky and Sam Sutton, which was supposed to be about When PE Firms Sell Themselves, more than half wound up being about CalPERS’ fiascos, as you can hear starting at 11:06, that both writers were unable to refrain from laughing at CalPERS, for instance, about how it tries to “rationalize its private equity costs”. At 20:21, Chris Witkowsky described Eliopoulos complaint about the attention it gets as as “whining”.

But instead of fixing the real problem, which is weak skills in private equity, CalPERS appears to be trying to hide its private equity problems under a costly rug.

Is This Move a Hedge Against a Private Equity Reformer Mike Flaherman Winning a Board Seat?

The CalPERS board elections are underway. Two reform candidates are running for each of the two seats up to a vote this year: the aforementioned Mike Flaherman for an open seat, and Margaret Brown, who is contesting the incumbent Michael Bilbrey. You can watch Flaherman’s candidate statement here and Brown’s statement here.

Flaherman’s extensive research into private equity abuses has served as the foundation for major stories in the Wall Street Journal and the New York Times. He has also worked regularly with JJ Jelincic on private equity issues.

Even though CalPERS should welcome Flaherman because he could help improve their private equity program, its staff seems to regard him as a threat. Flaherman is vastly more knowledgeable than Eliopoulos or his deputy Wylie Tollette. Flaherman could also readily expose any dodgy ideas that more savvy private equity group members were trying to fob off on the board.

Thus it’s not inconceivable that one of the motivations for the idea of moving private equity over to BlackRock is that the spotlight that CalPERS has already found too hot to handle would get even brighter if Flaherman (and/or Brown, who is not as expert as Flaherman but has good general finance knowledge and won’t be rolled) were elected.

Eliopoulos was correct when he said last June that CalPERS might not have the governance structure to handle private equity. But he’s reached the wrong conclusion. It isn’t private equity that needs to be extracted from CalPERS. It’s him.