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http://www.nakedcapitalism.com/2015/08/calpers-private-equity-exposed-executive-summary.html

CalPERS Private Equity, Exposed: Executive Summary

Over the course of this week and next week, we will examine a recording from the most recent meeting of the
Investment Committee of CalPERS Board of Directors, This session was part of the regular process of the review
and oversight of CalPERS portfolio. We will focus on the agenda items related to private equity.
This video demonstrates that:

Senior private equity professionals at CalPERS do not understand the economics of private
equity funds, raising questions about the staffs competence
CalPERS staff made significant misrepresentations to the board about the private equity
practices and current legal/regulatory issues, either overtly or via omission of important information
CalPERS staff appears to be largely captured by the private equity industry. It has internalized
the viewpoint of the private equity general partners who manage the funds and recites their talking
points when challenged
When CalPERS staff faces questions that have the potential to expose either the limits of their
expertise or questionable private equity industry practices, staff members become highly evasive
at best and at worst, insubordinate and overtly defiant
Most CalPERS board members lack sufficient knowledge of private equity to compensate for the
failings of staff. That means they are not able to adequately supervise CalPERS substantial private
equity investments or judge whether staff members have succeeded at, or are even capable of
fulfilling that duty. It also means that the overwhelming majority of the board members are also
effectively captured by virtue of having to rely on staff members that are themselves captured.

It is hard to overstate how damning these findings are. CalPERS is widely recognized as one of the largest, most
disciplined, and most experienced investors in private equity. CalPERS goes to considerable lengths to identify
what it believes to be the best advisors to assist with program design, manager selection, negotiation of
agreements, and ongoing oversight. It also has a far larger staff than the overwhelming majority of private equity
investors (limited partners of LPs), including a team that specializes solely in private equity. And CalPERS
does in fact hew to what are widely considered to be high standards for oversight procedures: well-established
policies and processes, extensive data gathering and reporting, and a strong focus on cost minimization. Even in
my limited dealings with CalPERS, over a series of Public Records Act requests, CalPERS, in striking contrast to
other governmental bodies I have dealt with, has been meticulous about the formalities of handling the requests,
even when we have disagreed strongly about the substance of the response.*
But CalPERS, like many other private equity limited partners, has blinded itself to the fact that adherence to
formal procedures offers no protection from being swindled in private equity. The SEC expressed what came
close to shock, when you translated former examination chief Andrew Bowdens famous May 2014 speech,
Spreading Sunshine in Private Equity out of bureaucrat-speak, over how one-sided private equity contracts are
and how little private equity investors do in the way of oversight after they hand over their money.
The reality is that private equity is an extraordinarily one-sided arrangement that no sane person, let alone a
fiduciary, should enter into. One economic researcher, when first told how strong the rights the general partners
are to get their funds (capital calls with five- to at most ten-day notices, with draconian consequences if the money
is not delivered on time), that the general partners have very broad latitude within their mandate, that they provide
very little information about the investee companies, and that they control of when the limited partners get their

money back, said Its like being married to a drug addict.

To help obscure this power imbalance, the private equity firms tout the limited-partner-flattering line that the
contracts with them are heavily negotiated. In reality, as Oxford professor Ludovic Phalippou, who has read over
300 private equity agreements, has said, Contracts in PE are basically take it or leave it. Private equity insiders
say the same thing, that the negotiations focus on a few headline figures and terms, when the real artwork
typically lies in other technical, legally dense parts of the contracts, such as the definitions of terms or convoluted
tax language. To conclude the deal, the general partners make some minor tactical concessions so that the
limited partners can tell themselves and their constituencies that theyve gotten their interests protected, when in
fact virtually nothing of substance has changed.
As former banker Peter Morris, who now provides independent research on private equity, explains:

The video helps to explain a longstanding so-called puzzle. Academics and policy makers alike
make it an article of faith that big investors like CalPERS are sophisticated. This is a code word
meaning that on average, big investors know what they are doing and can safely be left alone to
make good investment decisions.
The so-called puzzle arises because it is hard to square the actual results in private equity over
time with the belief that big investors are sophisticated. Stubbornly excessive fees have meant
that investors on average have received mediocre net returns. The puzzle has been why
sophisticated investors would allow this to go on happening.
In reality, it was never much of a puzzle. It has long been an open secret among anyone who
knows about private equity that the prevailing article of faith is simply wrong. Many big investors
just do not behave in the way academics and policy makers assume they do. In other words, they
cannot be relied on to make good investment decisions. In private, other people involved in the
market (both investors and managers) will readily admit this. The CalPERS video is a piece of
direct evidence.

Or as a former private equity partner stated:

The essential, unspeakable truth of private equity is simply that the investors generally have no
idea what they are doing.
For example, the problematic tax behavior of private equity managers is clearly able to flourish, to
a large degree, because the limited partner investors dont at all understand the tax stuff. Similarly,
the egregious related party transactions with the portfolio companies have gone unchallenged
because, again, the LPs dont really understand them. Ultimately, because the LPs dont
understand how private equity managers make money, the LPs are unable to recognize the
complete inconsistency between professing to be dependent on the long-term health of the overall
economy and allocating capital to strategies that undermine that health.

What is striking about this board meeting is how much of the damage was self inflicted. You will see that the
presentations and exchanges that are the most damning focus on private equity fees. This topic is so prominent at
this August board meeting in large measure because CalPERS staff failed to deal openly and honestly with a
major embarrassment at a board meeting earlier this year. Then, Chief Operating Investment Officer Wylie
Tollette not only admitted that the giant public pension fund did not track the very sizable private equity profit-share
generally called carry fees but also made the remarkable claim that no one in the industry could obtain the
information. After we broke this story in June, a firestorm of expert and media consternation ensued. CalPERS
backtracked rapidly, and asked all of its fund managers to provide the data for the entire history of all of their
funds.

As youll see over this series of posts, rather than simply fess up to a long-standing error and say it was well on
its way to rectifying the matter, CalPERS staff instead engaged in the bizarre diversionary tactic of serving up
what ought to have been an insultingly basic tutorial to the board on how carried interest works, which as well
show was so oversimplified as to be misleading. The fact that the board seemed unaware of how badly this
reflected on what the staff appears to have correctly judged to be their level of expertise was also damning. As
Professor Phalippou said of the presentation, So simple it is incorrect, but if they have to show something that
simple this indeed shows that Investment Committee has zero knowledge. All my MBA students after the first
session of my private equity course would know more.
More generally, the fact that pulling on such a thin thread would produce such defensive responses shows how
brittle is the pretense of limited partner expertise. It is well nigh certain that CalPERS will go into intense denial
about what their own conduct at this board meeting says about the institution. The staff would have to admit to
themselves, and the board would have to acknowledge about the staff, that:

CalPERS is not a leader in this area; they know vastly less about private equity than they think
they do
CalPERS staff regularly provide the board with materially incomplete or false information
As it is currently practiced, private equity is so full of now well-understood contradictions that
CalPERS can no longer discuss the topic in public, on camera, without opening themselves up to
embarrassment and serious criticism
Unbeknown to themselves, the board and staff have become so badly captured that some of
their actions serve the interests of private equity managers more than CalPERS beneficiaries
They have lost control of a situation that has become volatile and somewhat dangerous to them

Obviously, no one wants to admit such negative things about themselves. It is also very difficult for the board to
think so poorly of the people to whom they have entrusted their fate. That means that this site and the media will
need to keep putting the mirror in front of CalPERS face until it can see itself accurately and take remedial action
Moreover, CalPERS must be made to recognize what is at stake, which goes far beyond the success or failure of
the organizations private equity investment program. For the last quarter century, CalPERS has wielded
significant and generally very positive influence in the world of finance. It has been a global leader in corporate
governance and also in encouraging investors to think about the economic impact of long-term issues like global
warming.
CalPERS acquired this influence for two main reasons: first, because other investors and opinion leaders
generally viewed the organization as sophisticated and knowledgeable; second, because CalPERS views were
widely viewed as righteous the organization was seen as essentially the good guy of finance.
If CalPERS continues to be unwilling to grapple with what the public can now see are both a huge expertise gap in
private equity and a propensity to side with private equity general partners over its own beneficiaries interests, the
organization will lose its power in the wider world. Indeed, one can sense that is already starting to occur.
Needless to say, we at Naked Capitalism do not want that to happen.
____
* To CalPERS credit, even though I lost a suit against them over them for private equity data with prejudice,
meaning CalPERS could then have ignored me, it had told the judge it intended to fulfill the request. And
CalPERS did live up to its word in the end, although it took a further six months of often heated exchanges with
CalPERS counsel to wrest all the information from them.