California Judiciary Committee Gives Blistering Assessment of CalPERS’ Fiduciary Duty Failings in Analysis of Fraud-Friendly Private Debt Secrecy Bill

It appears that at least some people in Sacramento are paying attention to what has been happening at CalPERS and don’t like what they see.

Below, we have embedded the California Assembly Judiciary Committee staff analysis for AB 386, a bill providing for secrecy of private debt investments. The analysis calls out some of CalPERS’ major fiduciary duty failings in remarkably blunt terms.

This matters because CalPERS claims it intends to set up an in-house unit to make direct debt investors, or as laypeople would put it, make loans. CalPERS further maintains that it wants to keep these debt investments until maturity. Yet it also insists that it needs to hide all the details about these loans, including their terms, whether there is any collateral, and who the borrower is!

It’s not hard to see how the utter lack of transparency can open the door wide open to fraud. What if CalPERS makes a $50 million loan to a company that no one else would every fund, at very favorable interest rates….and Marcie Frost’s son is a major owner? Or a more likely scenario in one-party California, that CalPERS winds up sometimes lending money to friends of powerful pols so its shenanigans continue to get a free pass? Or as happened with CalPERS former CEO Fred Buenrostro and former New York State Controller Alan Hevesi and his aides, they get kickbacks?

This is are the key sections of the staff analysis:

The analysis explains what CalPERS is, what it does, and what constitutional duties its Board of Administration has. It also mentions several incidents in the past 15 years in which CalPERS Board members or officers engaged in illegal and/or unethical behavior. The analysis also explains what “internally managed private loans” (a.k.a. private debt) are and why CalPERS wants to make them part of its investment portfolio. The analysis next discusses the California Public Records Act (CPRA) and its strong presumption that records in the possession of public agencies, including CalPERS, are open to the public. In that context, the CPRA was amended in 2006, as a result of SB 439, to exempt many CalPERS records related to “externally managed alternative investment vehicles” (investments in venture capital funds, hedge funds, etc.) were exempted from disclosure in response to a CPRA request because investors did not want their proprietary and personal information disclosed to the public. In response to litigation at the time—which resulted in CalPERS being ordered to release many records related to these investments, CalPERS was excluded from participation by some historically high performing investment funds. CalPERS fears the same outcome for internally managed private loans, so is sponsoring the bill…

While the public (especially those who are public employees and retirees) would like to think that the CalPERS Board abides by its fiduciary obligations, recent scandals have unfortunately shown that it has not always done so. Just last year, former CIO Yu Ben Meng suddenly departed after an anonymous ethics complaint to the Fair Political Practices Commission alleged he approved a $1 billion deal with the New York financial firm Blackstone Group while personally holding as much as $100,000 in the company’s stock. (Finch, “CalPERS ahead of earnings goal with absence at top. When will investment chief vacancy hurt?,” Sacramento Bee (April 19, 2021), available at https://www.sacbee.com/news/politics-government/the-state-worker/article250732564.html.) It was another embarrassing chapter for the agency. In 2018, a blogger revealed exaggerated claims on the resume of newly-hired chief financial officer Charles Asubonten, prompting him to resign. (Ibid.) Two years prior, former CEO Fred Buenrostro was sent to prison for taking bribes from former CalPERS board member Alfred Villalobos. (Ibid.)

This analysis was published right before CalPERS got another entry on its rap sheet, that of a reported $685,000 embezzlement, where the perp has been walking free for months. Why hasn’t she been arrested? She could easily have left the country with all her ill-gotten loot by now. The lack of anything approaching adequate disclosure to the board or beneficiaries is yet another reason to nix this rancid-smelling private debt initiative.

We remain The Blog That Must Not Be Named in California, despite having our posts repeatedly cited by mainstream media outlets, in Congressional reports, and by academics.

But even though it is gratifying to see this legislative analysis push back against CalPERS undeserved “trust me” position, the author of this analysis lacks the investment/pension fund contacts to appreciate that CalPERS claims of being frozen out of supposed high performing funds are fabrications. We explained this back in 2016:

The idea that private equity funds might refuse to deal with investors if forced to make more disclosures is a carefully cultivated urban legend. It rests on a widely misrepresented response when CalPERS, as a result of a 2002 settlement with the San Jose Mercury News, started publishing quarterly return data for all the private equity funds in its portfolio. Two fund managers, Sequoia and Kleiner Perkins, huffily said they’d never do business with anyone that published their returns.

Why is that less meaningful than it sounds? It was only public pension funds that might be required to emulate CalPERS’ move. Sequoia and Kleiner Perkins are venture capitalists. While that technically makes them private equity funds, the fact is even the large venture capital funds are too small for a large majority of public pension funds to invest in them. It’s also an open secret in the industry that the reason for Sequoia wanting to hide its results was that it had India and China funds that had done badly and didn’t want that exposed.

Industry stalwarts might nevertheless contend, “But Sequoia is a top performer! If you did want to invest in Sequoia, you’d have suffered.” That is also inaccurate. It is true that Sequoia’s flagship fund is widely cited as regularly delivering impressive results. However, investors in Sequoia’s flagship fund are required to invest in other Sequoia funds that do not perform as well. The blended return is underwhelming.

Confirming our assessment, CalSTRS’ highly respected Chief Investment Officer Chris Ailman has expresses his envy of (some) venture capital fund returns, he also pointed out that they make no sense for CalPERS smaller Sacramento sister because they could not put enough money to work in venture capital to affect investment returns. If venture capital is unattractive for CalSTRS, that goes double for the much larger CalPERS.

The idea that having CalPERS disclose who borrowed money from it would deter prospects is ludicrous. In fact, if CalPERS really intends to offer long-term loans and stay all in, that sort of stable source of debt funding is very attractive to many investors. And having stable, secure debt funding should also reassure other lenders and equity investors. The only reason to think otherwise is if CalPERS gets a reputation of being such dumb money that borrowing from them is seen as a sign of desperation. But Softbank is seen as a chump venture investor, yet no one has been shy about taking its dough.

Let’s look at other reasons why allowing CalPERS to make secret loans is a terrible idea.

CalPERS and CalSTRS are already major investors in private debt, via private debt funds, so AB 386 is unnecessary. CalPERS is already #16 in the world and CalSTRS, #30. Both giant funds have demonstrated that California’s disclosure laws aren’t an impediment to making this kind of investment. It should not be surprising that no other California public pension fund is supporting this bill.

There’s no good reason to create an internal team to do private debt investing. Plenty of experts have been urging large private equity investors like CalPERS to bring private equity investing in house for years. First, the fees and costs are so eye-popping, at an estimated 7% per year, that cutting that down to say 2% or 3% means that a relatively newbie investor like CalPERS could still fall a bit short compared to industry average gross returns and still come out ahead on a net basis. Second, industry experts also confirm that there are many seasoned, skilled professional who would trade a less pressured life (particularly the costs and stresses that relate to regular fundraising) for less lavish pay.

By contrast, the fees in private debt are much less egregious, so the economic case for cutting out the middleman is much weaker. And CalPERS would never invest as much in private debt in private equity, given its need for equity or better than equity returns.

An in-house private debt initiative would divert management energy and resources from building an in-house private equity team, which offers far more upside to CalPERS and its beneficiaries. It’s not credible to think CalPERS could spearhead two major initiatives that require significant new additions of staff at once, nor does CalPERS intend to. So why not do the higher potential one first, even if you charitably assume bringing private debt in house makes sense?

An internal private debt initiative is an albatross around the neck of a new Chief Investment Officer. CalPERS is trying to hire a new Chief Investment Officer. It hasn’t gotten anywhere despite increasing his maximum pay to $2.4 million from the $1.8 million tops for former Chief Investment Officer Ben Meng.

A new Chief Investment Officer should be given as much freedom as possible. Saddling him with an idea that has yet to be implemented from the former regime is a turn off, particularly since it’s not as if Meng’s other bright ideas were winners. His standout moves included cancelling a tail risk hedge right before a $1 billion payday, and implementing factor investing in a way that reduced risk…which also reduced returns, when CalPERS loads up on equities in order to goose total returns.

The timing for getting into private debt is terrible. Quite a while back, savvy players realized that private debt had an very attractive risk-return profile, with returns not that much far behind those of private equity, at markedly lower risk. But the post-crisis rush for yield changed all that.

Private debt is now described by fund managers as a cyclical play. You make most of your returns by being generous with funding at times of market stress. Would CalPERS even begin to have the nous and connections to play that game?

Please do your part to stop yet another CalPERS bad idea from coming to fruition.

For those of you in California: the Assembly hearings are Tuesday at 9:00 AM. You still have time to call or e-mail your Assemblyman (find his name and contact information here) and cc Judiciary Committee Chairman Mark Stone and Vice Chairman James Gallaher to voice your opposition to AB386. Or if you are time-pressed, you can call the committee at (916) 319-2334. A surprisingly small number of comments from real California voters can make a difference, so please speak up!

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