Pension360

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Yves Smith of Naked Capitalism wrote another stinging comment, CalPERS Board Members Defend Poor Performance by Staff, Capture by Private Equity (added emphasis is mine):

All of the private equity experts that we asked to look at the video of the latest CalPERS Investment Committee meeting were appalled by the performance not only of CalPERS’ private equity staff but also its board members. As Georgetown law professor Adam Levitin said via e-mail:

It’s shocking to see how many of the CalPERS investment committee are utterly ignorant. Aren’t these people supposed to know something?

And as Andrew Silton, the former Chief Investment Advisor to the State Treasurer of North Carolina, wrote on his website:

What’s the best defense against capture? A strong staff and informed trustees. The CalPERS video strongly suggests that CalPERS is lacking on both fronts.

It is hard to overstate the vehemence of the reactions I’ve gotten to the video of the CalPERS’ last investment committee meeting. In the majority of cases, when I’ve asked for a mere quote, the respondents were so disturbed by what they saw that they penned commentary that ran to multiple pages. For instance, Andrew Stilton, who had stopped financial blogging months ago to pursue his art, felt compelled to come out of retirement to write not just one, but three posts on the Investment Committee meeting train wreck.

CalPERS’ Investment Committee bears significant blame for the poor performance of CalPERS’ staff. Most CalPERS board members seem to regard their job as cheerleading and protecting CalPERS’ senior officers, rather than acting as vigilant protectors of CalPERS’ beneficiaries. This misguided sense of priories was evident when Investment Committee chairman Henry Jones repeatedly undermined fellow committee member JJ Jelincic’s questions. Jones acted as if Jelincic was putting the private equity team members on the spot, when competent industry professionals should have been able to field Jelincic’s questions easily. Similarly, other board members allowed staff to give misleading and incomplete answers.

But even worse than the board’s lax attitude toward oversight is its lack of expertise. The presentation that led Jelincic to pose those not-difficult questions that nevertheless put the CalPERS officer responsible for private equity, Réal Desrochers, on tilt, was an insultingly basic primer on “carry fees,” which is the 20 in the prototypical “2 and 20” private equity fee scheme. The “20” stands for a 20% profit share once a preferred return, typically 8%, has been met. Stunningly, most of the Investment Committee members seemed pleased by the slideshow and acted as if they had learned something from it.

In other words, the board is so utterly lacking in knowledge that it is incapable of providing adequate oversight, even if it were inclined to do more than governance theater. That means that staff operates with no meaningful supervision. The bumbling, evasiveness, and apparent lack of command of what should be basic material is exactly what you’d expect to see as a result of letting the inmates run the asylum.

Yet Investment Committee members display their ignorance as if it were a badge of honor. Consider this speech from the end of the session:

Vice Chairman Bill Slaton: What I’ve gleaned from this, and I’d like to just kind of make some comments at a higher level than where we’ve down in the weeds. It’s very clear to me that the terms and conditions of private equity deals vary by general partner and by vintage. There’s no set process. It’s a negotiation.

It’s also clear to me that there’s a large number of investors for GPs to choose from, that CalPERS is not the only investor out there, and so therefore, our ability to get the industry to change is something that I appreciate that we’re leading on, but we can’t control. But I think we’re making progress.

It’s clear this is a largely unregulated industry that we’re trying now….that the United States is trying to do a better job regulating. And I’m glad that CalPERS is a participant in that.

I read in the press terms like, you know, hide and cheat and steal. I think those are inappropriate terms. I think we have an industry that probably needs more regulation, but I — what I want us to focus on is to make sure that we are gleaning as much data as we can, and that we see the progress that’s attained, and we start to see the reports.

I have faith in this group in front of us that you’re negotiating on behalf of CalPERS, as well as it can be done. So I’m not trying to….and I don’t think we should spend a lot more time trying to find where there’s an error or a problem. I think you all are on to this, that you’re working hard at it, and I think that there’s value in us better understanding what the range of possibilities are. So bring scenarios back to us and how it works, like you did here, is instructive for us. But I don’t think it’s productive for us to spend a lot of time trying to play gotcha.

As Rosemary Batt, co-author of the landmark book Private Equity at Work, said:

I was completely appalled to listen to Bill Slaton as apologist for the staff. It reminded me of the Public Relations Director of Wal-Mart in the documentary, “Is Wal-Mart Good for America?” The notion that the GPs can choose whom they want to, putting CalPERS in a defensive posture, is absurd.

Let’s go through Slaton’s remarks in detail.

Slaton starts out by obliquely criticizing Jelincic’s efforts to get answers to what are simple questions by as being “down in the weeds.” He then parrots the diversion that Réal Desrochers relied on earlier in the meeting, that he couldn’t answer a question from Jelincic because everything was deal-specific. As Oxford professor Ludovic Phalippou said about that exchange, “The PE team line of defence is incredibly amateuristic. I would fail my private equity students if they wrote such a thing in their exam.”

Slaton continues with a claim straight out of the Private Equity Growth Council, the private equity industry’s chief lobbyist, and presumably also invoked by CalPERS’ staff, that private equity agreements are negotiated. Again, as Professor Phalippou, who has read 300 private equity agreements stressed, they are in fact “take it or leave it” agreements. As a former private equity partner said, “General partners have done a masterful job of dividing and conquering the limited partners on the negotiation process.”

Slaton then moves on to another bit of general partner propaganda that he, and apparently CalPERS’ staff, have swallowed, namely, that it is CalPERS that has to compete to get general partners’ attention, and not vice versa. As Elieen Appelbaum, co-author of Private Equity at Work, wrote:

I find these responses, which I am sure are sincere, simply incredible. Public pension funds make the single largest contribution to PE fundraising of any type of investor. Data provided by PitchBook show that public pension funds contributed between 15% and 25% of all funds raised by private equity in the years from 2000 to 2012. In 2013 public pension funds contributed 24.5% of all funds raised by private equity; and in 2014, 21.5%. One might reasonably expect pension funds to demand respect and deference from PE firms when the latter come, hat in hand, seeking capital for their private equity funds. Certainly CalPERS, which makes large investments in private equity year after year and whose lead is followed by many other pension funds should be sought after by GPs, not told by GPs – as is apparently the case – not to make demands because there are many investors for GPs to choose from.

Slaton then notches his defense of private equity up a register and objects to the usage of words like “hide and cheat and steal” when applied to private equity. Perhaps he needs to read the press more extensively or acquaint himself with a dictionary.

Private equity investors were upset when they leaned about fees like “termination of monitoring fees” of tens, sometimes hundreds of millions of dollars, via Gretchen Morgenson of the New York Times, particularly when they realized those fees were not shared with them in management fee offsets. They were similarly stunned to learn from Mark Maremont of the Wall Street Journal that KKR’s captive consulting firm KKR Capstone, was treated by KKR as being an independent contractor. That means KKR charged hundreds of millions of dollars of dollars for KKR Capstone services, when investors had assumed that was already covered by the management fee.

If someone is taking a lot of money out of your investment and hasn’t told you about it, pray tell how is that not hiding?

Similarly, how is it not cheating when KKR shifted nearly $20 million of broken deal expenses onto limited partners, when they should have been borne by co-investors that included KKR affiliates? The SEC deemed KKR’s conduct to be abusive enough to warrant $10 million in fines.

And how is it not stealing when former SEC enforcement chief Andrew Bowden said of private equity general partners, “Investors’ pockets are being picked”?

In other words, Slaton professes to support the effort to get tougher on the industry, as long as no one actually describes its bad conduct in simple, plain English terms. Perhaps he is concerned that the great unwashed public will wise up as to how general partners have fleeced limited partners like CalPERS for years, and the limited partners and overseers like him have done perilously little to prevent it .

Slaton then says, with a straight face, that the private equity team at CalPERS is doing a great job of negotiating, when he has no basis for his opinion. Andrew Silton, who has been the chief investment officer of a substantial private equity portfolio, begs to differ:

Like any large investor, CalPERS must systematically attack every sort of fee and vigorously negotiate deal terms. These are the only two techniques that can give a large institution marginally better performance and control over its private equity program. Clearly, the current team at CalPERS has failed to do both.

Slaton wraps up by saying he has no intention of doing his job as a board member: “I don’t think we should spend a lot more time trying to find where there’s an error or a problem.” Slaton finishes by plainly stating that he regards the work of supervision and governing as “gotcha” and sees it as beneath him. I trust Governor Jerry Brown is paying attention and finds someone else to install in Slaton’s slot.

We see similar undue protectiveness of staff in Henry Jones’ closing remarks. He used the fact that CalPERS has yet to complete its new private equity IT reporting system, PEARS, to justify the inability (and often, refusal) of staff to answer Jelincic’s questions, when he made clear that virtually all of them did not depend on data.

Chairman Henry Jones: Okay. I think it’s also important to realize that earlier in the day, Mr. Eliopoulos did indicate an update on the private equity project, the PEARS project, where he indicated that he has collected about 94 percent of the data that’s necessary to maybe answer a whole host of questions that we’ve been asking, and that he plans to come back to the Committee to present that information to us.

And so I think it’s important that we know. And matter of fact, he also stated in his comments this morning, that they actually went live and parallel on this particular project that they’re working. So it’s getting there.

And I know that we all are interested in understanding some of the complexities of private equity
investment. But I think we need to be patient too to make sure that we get all of the information and get the accurate information, because I think there’s been too many misquotes, too much misinformation that’s been in the public.

And as you know, when information is provided to the press, and many times they go with what they were told, and many times it’s not accurate information coming from our Investment Office. So I would encourage us all to be a little patient, and certainly answer J.J.’s questions when the data is available, or if he has specific requests that he can provide that request to you and – so that it can be responded to.

Jones’ repeated incantation, “We need to be patient” is mind-boggling. CalPERS has been investing in private equity for 25 years. Staff has, or ought to have, the sort of basic, general information that Jelincic has requested at hand.

And notice Jones tried to depict the press as being inaccurate. That’s simply bogus. I challenge Jones to cite a substantive point in which the media has provided faulty information about CalPERS in the recent fee controversy. The proof is that CalPERS does not appear to have asked for, and more importantly, has not gotten, a single retraction.

By contrast, as we’ve seen in the last two Investment Committee meetings, CalPERS’ staff has repeatedly told the board things that are flat out wrong or so heavily spun in favor of private equity general partners as to be incorrect. So how, pray tell, can Jones defend staff as the gold standard of accuracy?

Jones is effectively telling his fellow board members to regard the staff as the only valid source of information. And if board members don’t consult and cultivate independent channels for news and intelligence, they are guaranteed never to challenge staff. That guaranteed that the board will continue to do a poor job of oversight.

CalPERS’ reaction to having its private equity failings exposed has not been to correct these problems, but to attack the people who’ve unearthed them and defend parties who should be held to account. And its board reinforces this pathological response. Sadly, this behavior is guaranteed to produce more self-inflicted wounds and diminish CalPERS as an institution.

The comment above is part of a series the Naked Capitalism blog did “exposing” CalPERS’ Private Equity. If you haven’t read the entire series, I posted the links below:

Executive Summary
Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity Fees Work
CalPERS Chief Investment Officer Defends Tax Abuse as Investor Benefit
CalPERS, an Anatomy of Capture by Private Equity
CalPERS’ Chief Investment Officer Invokes False “Superior Returns” Excuse to Justify Fealty to Private Equity
CalPERS’ Senior Investment Officer Flouts Fiduciary Duty by Refusing to Answer Private Equity Questions
How CalPERS’ Consultant, Pension Consulting Alliance, Promotes Intellectual Capture by Private Equity

I recently covered CalPERS getting grilled on private equity and expressed my concerns with Yves Smith’s (aka Susan Webber) negative slant on private equity as well as stated where I agree with her:

I got to hand it to Yves Smith, she’s been on top of CalPERS and private equity like a fly on manure, but the problem with Yves is she’s on some crusade to expose private equity’s dirty little secrets and tends to focus exclusively on the negatives, ignoring how important this asset class has been to delusional U.S. public pension funds looking to make their pension rate-of-return fantasy.

Don’t get me wrong, there are plenty of problems in the private equity industry, many of which I cover on my blog, but if you read the rants on Naked Capitalism, you’d think all these private equity funds are peddling is snake oil and that investors are better off investing in a simple 60:40 stock bond portfolio.

This is pure rubbish and spreading such misinformation shows me that Yves Smith doesn’t really know much about proper asset allocation between public and private markets for pension funds that have long dated liabilities and a very long investment horizon. Ask Ontario Teachers’, CPPIB, and many other large pension funds the value-added private equity has provided over public market benchmarks over the last ten years (Canadian funds invest and co-invest with private equity funds, reducing fees, and invest in PE directly, foregoing all fees).

Having said this, I too watched the CalPERS board meeting and the clips Yves Smith posted, and was surprised at how much stonewalling was going on. To be honest, I felt bad for Christine Gogan as she was clearly used as a scapegoat. Her boss, Réal Desrochers and his boss, Ted Eliopoulos, and Wylie Tollette should have been the people answering all these questions and getting grilled by JJ Jelincic.

Now, full disclosure. I used to post my comments on Naked Capitalism and then moved over to posting them on Zero Hedge. I wrote all about it in a 2009 comment on blogging wars and bragging rights. I left both blogs in disgust and let Yves have it for editing my comments and Tyler have it for allowing short-selling gold bug morons to post completely asinine and offensive comments, often attacking me personally but not allowing me to respond with my own comments. 

Both blogs helped me gain “notoriety” (whatever that means in the blogosphere) so I am grateful to them for that and left their respective blogs on my blog roll (they cut mine out of theirs which shows you how infantile they truly are). I now prefer doing my own thing at the margin and not being affiliated with anyone (I post some of my market comments on Seeking Alpha). 

Yves’ latest comment on CalPERS’ capture on private equity is so popular that it got retweeted by Alec Baldwin, a famous actor and potential Democratic candidate. That’s all great for Yves as her popular blog is gaining even more popularity but is she being fair in her brutal criticism on CalPERS board, its private equity staff and the private equity industry?

I think Yves and her panel of academic experts raise many excellent points but when I read her comment I felt like she was being a bit harsh to some board members and even the staff. In fact, if Yves and her panel of private equity experts are so smart, why aren’t they sitting on boards of public pension funds or better yet, running the private equity portfolios at these large public pensions?

It’s always easy to criticize folks from the outside, especially when you hold a Harvard MBA and think you are god’s gift to finance, but what Yves Smith lacks is real-life experience working at a U.S. public pension fund and a bit of humility. 

Admittedly, I’m not the poster child for humility and have done my fair share of heavy criticism on my blog (read my latest on whether hedge funds are doomed), but I feel like telling Yves and her panel of experts to take a step back and realize who they’re directing their criticism to and not to judge them so easily before they understand the constraints they’re operating under. 

Having said this, I watched the investment committee and was also flabbergasted by some of the responses from the board and staff. I know Réal Desrochers and he’s no dummy on private equity. He had a successful track record at CalSTRS and a large sovereign wealth fund before joining CalPERS to take over what most people consider to be a huge private equity mess. He’s spearheading the latest effort to chop external managers by half in an effort to reduce the number of direct private equity relationships and to reduce fees.

But the responses to questions board member JJ Jelincic asked were completely unacceptable and a farce. CalPERS’ private equity staff should have the answers to these questions on their fingertips and if they don’t, they should respond at a subsequent board meeting. If they continue to stonewall, this is a breach of their fiduciary duty and they should be fired. It’s that simple.  

As far as CalPERS’ board members, apart from JJ Jelincic who is doing his job asking tough questions, I’m not terribly impressed. Most these board members need a primer on private equity so they can understand the J-curve, distribution waterfall, and many other topics that they clearly don’t grasp. And it’s not up to CalPERS’ private equity staff to educate board members on this stuff. The board needs to get outside experts to educate them and let these independent experts report solely to the board to maintain their impartiality. [ Update: JJ Jelincic, a member of CalPERS’ board, emailed me this: “Mike Moy and PCA is supposed to be the board’s independent consultant.  That’s what he is paid for.”]

What Yves Smith is exposing here is a fundamental structural flaw with all U.S. public pensions, namely, the lack of proper pension governance. I wrote about it for the New York Times when I discussed the need for independent, qualified board investment boards in a special series debating the public pension problem. 

Importantly, until the United States of America follows Canada and introduces meaningful reforms to the way U.S. public pension funds are governed, its public pension system will remain vulnerable to abuse and will eventually succumb from the weight of chronic pension deficits. Sure, some states will fare much better than others but that’s not saying much when discussing the pathetic state of state pension funds. 

What are the key reforms I’m talking about? Have public pensions supervised by independent and qualified board members that are not politically appointed  hacks; hire qualified pension fund managers and compensate them properly to manage public and private market assets internally; get rid of the pension rate-of return fantasy that delusional U.S. pensions are still clinging to and last but not least, introduce the shared risk pension plan model at all U.S.public pensions. 

Getting back to Yves’ comment on CalPERS’ capture by private equity, one area where I agree with experts is that limited partners need to do a hell of a lot more to tilt the balance of power in their favor. The Institutional Limited Partners Association (ILPA) recently published a press release on its Fee Transparency Initiative, an effort to increase transparency in private equity.  The story was picked up by major media outlets and was the focus of Private Equity International’s Friday Letter.  The full press release and coverage from some of these outlets are provided on the ILPA’s website here.

But that’s not enough. The ILPA which includes CalPERS, CalSTRS, and many other global pension and sovereign wealth funds needs to use its clout to promote significant changes to the way private equity funds (aka GPs or general partners) carry out their business, including the way they report fees and all other expenses charged to limited partners (LPs).

Back in 2004 or 2005, I attended one of these ILPA meetings in Chicago with Derek Murphy, the former head of private equity at PSP Investments. Great for networking and meeting other powerful limited partners but it was a joke in terms hammering out concrete proposals on valuations, fees, and a host of other issues pertaining to improving alignment of interests (I’m being a bit too critical but trust me, I’m not far off).

Anyways, I’m tired and have ranted enough on this topic. If my institutional readers, including CalPERS’ senior managers, have anything to add, please feel free to email me and I will edit and add your comments here (my email is LKolivakis@gmail.com).

Below, I embedded the second part of the CalPERS Investment Committee from August 17th, 2015 (discussion on PE begins at minute 50 of the clip or watch chopped versions on the Naked Capitalism comment). Take the time to watch this clip as it’s an issue pertaining to many other large pension funds that invest in private equity funds.

https://youtu.be/VN1HkGTWk5U

The North Carolina Retirement Systems are joining CalPERS and CalSTRS in their opposition to a recent governance change at the top of Bank of America.

Recently, BoA changed its bylaws to eliminate the requirement for an independent board chairman; now, one executive is allowed to man the roles of both chairman and chief executive.

The N.C. Retirement Systems, along with CalPERS and CalSTRS, will vote as shareholders later this month on the governance change.

More from the Charlotte Observer:

At the Sept. 22 gathering, shareholders will vote on whether to ratify the bank’s decision last October to change its bylaws and eliminate a requirement for an independent chairman. The bank did not consult with shareholders before making that bylaws change, a decision that upset some large investors, causing the lender to schedule the special meeting.

“It is our firm belief that an independent board is the most effective means of protecting shareholders’ interests and ensuring adequate board oversight of management,” Melissa Waller, chair of the pension fund’s corporate governance committee, said in a statement.

The announcement by the N.C. pension fund follows vows other big Bank of America shareholders have made to vote against recombining the roles.

[…]

Supporters of splitting the roles also say having two people hold the titles provides an independent check on management.

In getting rid of the requirement for an independent chairman, the bank undid a bylaws change it made in 2009 after shareholders voted at the time to split the roles.

The N.C. Retirement Systems own a $153 million stake in the bank, or about 1 percent of outstanding shares.

Photo by Sarath Kuchi via Flickr CC License

The assets under managements of the top 300 pension funds in the world grew 3.4 percent in 2014, according to a September report from Towers Watson.

The graphic above shows the annual total assets under management of the top 300 funds (orange) vs. global pension assets (yellow).

ValueWalk summarizes:

The top 300 pension funds worldwide did see AUM growth last year, but the 3.4% rate of growth was barely half the rate seen the prior year.

Also of note, the cumulative growth rate for the five year period from 2009 to 2014 was a robust 36.2%. This period, of course, does include several years when the stock market moved up significantly as it was recovering from the damage done in the 2007-2008 financial crisis.

TW’s GPAS study suggests that the 300 largest pension funds accounted for 42.7% of the total global pension assets in 2014. That figure is down slightly from 43.2% a year earlier (2013).

Read the report here.

Institutional investors on the whole are investing more money in infrastructure, and the majority of those investors aren’t done yet, according to a recent report from Preqin.

The average institutional investors’ infrastructure allocation has risen from 3.5 percent in 2011 to 4.3 percent in 2014, according to the report. Still, 67 percent of investors are looking to increase their investments in the sector.

The survey found that 33 percent of institutional investors are looking to maintain their allocation to infrastructure. But the most startling finding: none of the surveyed investors were looking to decrease their allocations.

The chart to the right shows the surveyed investors’ preferred methods of investment. Direct investment has nearly doubled in popularity since 2012, while the popularity of unlisted funds has fallen dramatically.

View the full report here.

Chicago’s recent pension overhaul law – struck down this summer by a lower court – is bound for the state Supreme Court sometime this fall.

With the hearing looming, two of the high court’s justices have disclosed conflicts of interest with the lawsuit; one justice has already recused himself from the hearing, but the other hasn’t.

More from Crain’s Chicago:

The high court is considering whether to uphold a state law that requires the employees and retirees in two city pension funds to bear 30 percent of the cost to stabilize a retirement plan for city workers, which has $7.29 billion in unfunded liabilities. The Emanuel administration is appealing a trial judge’s ruling in July that struck down the 2014 law as unconstitutional.

Justice Charles Freeman decided he had a conflict of interest and recused himself. Justice Anne Burke did not.

[Freeman] recused himself because he receives an annuity as the surviving spouse of a city worker, according to Joseph Tybor, a Supreme Court spokesman. Marylee Freeman, a former Department of Buildings employee, died in 2013, according to records of the Municipal Employees’ Annuity and Benefit Fund of Chicago, one of the retirement plans involved in the case.

Freeman receives a flat payment of nearly $2,300 a month before taxes, pension fund records show.

Anne Burke’s husband is chairman of the City Council Finance Committee and is covered by the same pension fund. Edward Burke, who has represented the Southwest Side 14th Ward since 1969, is 71 years old and has expressed no interest in stepping down. Yet if he were to retire this year, his pension would be $7,269 per month or $87,228 per year, according to a Crain’s estimate.

If the court upholds the law, he would have to contribute about $8,250 more toward his retirement from 2015 to 2019, and his pension would be reduced by an estimated $8,223 from 2016 to 2020, Crain’s estimates.

Anne Burke declines to comment, Tybor says. Judges are not required to give reasons either when they recuse themselves or decide not to do so.

Freeman’s recusal could benefit the city, although it’s hard to say. Last summer, Freeman delivered the opinion that the state couldn’t alter retirement health care benefits of state workers – an opinion that set the state for the ultimate overturning of the state’s pension reform law.

Photo by bitsorf via Flickr CC License

The Ontario Teachers’ Pension Plan on Sunday announced the appointment of Nicole Musicco as new Managing Director for Asia-Pacific investments.

Musicco, who has been with the pension fund for 15 years, will also head the fund’s Hong Kong office.

More from a press release:

In her new role, Ms. Musicco is responsible for the full investment cycle from origination to execution across asset classes in the region.

Ms. Musicco has a strong private equity background with experience in both direct and fund investing. She joined Teachers’ in 2002 and has held positions of increasing responsibility, most recently as Vice-President, Teachers’ Private Capital in Teachers’ Toronto office.

“Nicole’s new role reflects our growing commitment to the Asia-Pacific market and its importance to the future of our fund,” said Ron Mock, Chief Executive Officer and interim Chief Investment Officer. “Her experience with our partners internationally and her knowledge of the Asia-Pacific region specifically made her the logical candidate for this important, newly created position.”

Teachers’ opened its Asia-Pacific office in Hong Kong in 2013. It has a diversified portfolio of assets in the region valued at $12 billion as of December 31, 2014.

Ontario Teachers’ Plan manages $154 billion in assets.

Photo credit: “Asia Globe NASA”. Licensed under Public domain via Wikimedia Commons

Over the last 12 months, Japan’s Government Pension Investment Fund (GPIF) has doubled its allocation to domestic stocks as part of a portfolio overhaul.

The fund’s CIO, Hiromichi Mizuno, this weekend said the infusion helped bring confidence and foreign investors to Japan’s stock market. But now that the pension fund is done leading the charge into domestic equities, Mizuno wonders: will foreign investors stay?

From the Nikkei Asian Review:

Prime Minister Shinzo Abe’s administration has done a good job attracting foreign investors with economic and financial stimulus, but it has to show investors how it will lift growth in Japan to ensure investor confidence, the chief investment officer of Japan’s $1.2 trillion public pension reserve fund said Sunday.

“They have to prove the third arrow is working,” said Hiromichi Mizuno, CIO of the Government Pension Investment Fund at a conference in Tokyo on Sunday, referring to the structural changes proposed by Prime Minister Shinzo Abe’s administration to put Japan on a long-term path to growth. “It’s a kind of moment of truth.”

[…]

Mr. Abe’s economic policies, including a dramatic overhaul of the GPIF’s portfolio into more equities, have drawn more foreign investors to Japan’s once-overlooked stock market. The GPIF announced in October that it would roughly double its allocation to Japanese stocks to 25%. At the end of June, domestic stocks were 23.39% of its total portfolio.

Mr. Mizuno said the GPIF’s portfolio changes had helped draw foreign investors because they knew that GPIF had increased its stock allocation, but said that the Japanese government needed to create an environment in which foreigners would be confident to invest “without the sense of security that the GPIF is going to buy into the equity market.”

Japan’s GPIF manages $1.2 trillion in assets and is the largest pension fund in the world.

Photo by Ville Miettinen via Flickr CC License

In the city of Scranton, Pennsylvania, the pension boards representing the city’s police and firefighters this weekend sued the city to unfreeze retiree cost-of-living adjustments, which Scranton officials suspended in January.

The boards’ argument is a common one: the COLA raises were in workers’ contracts and approved by the pension boards; thus, the city didn’t have legal authority to freeze the raises.

The city says it does have legal authority, because an obscure piece of city code allows the suspension of COLAs if the pension funds aren’t “actuarially sound”. (Scranton’s pension system is severely distressed).

More from the Times-Tribune:

After the pension boards approved the raises late last year, the city threatened to block them. When the pension boards did not back down, city and council solicitors issued a directive on Dec. 29 to the pension plan administrator and trustee to not pay the raises and they complied.

Retiree raises were to coincide with 1.75 percent raises for active police and firefighters taking effect in January. Retired firefighters and police officers hired prior to 1987 are entitled to up to 50 percent of any increase granted to active duty personnel.

In the directive blocking retiree raises, city solicitor Jason Shrive and council solicitor Amil Minora cited state law, the 2A City Code governing Scranton. That law says retirement or cost-of-living increases “shall not be granted” unless the pension systems are actuarially sound and can afford them. They cited an October actuary report that declared Scranton’s pension funds financially unsound. They also noted that the state auditor general has described Scranton’s pension funds as the most distressed in the state and headed for insolvency.

The lawsuit seeks the following: a determination of whether the pension boards are authorized to pay retiree raises that have been the subject of contracts, ordinances and/or court awards; restoration of withheld raises; and an order barring the city from interfering in management of pension funds.

Read the full lawsuit here.

Photo credit: “Flag-map of Pennsylvania” by Niagara – Own work from File:Flag of Pennsylvania.svg and File:USA Pennsylvania location map.svgThis vector image was created with Inkscape. Licensed under CC BY-SA 3.0 via Wikimedia Commons – http://commons.wikimedia.org/wiki/File:Flag-map_of_Pennsylvania.svg#mediaviewer/File:Flag-map_of_Pennsylvania.svg

The Employee Benefit Research Institute (EBRI) released its annual Retirement Confidence survey recently, and — as usual — the report contained loads of interesting insights.

One major trend remained the same: current retirees have much more confidence in their retirement finances than current workers.

Above, you can see the chart for worker confidence. The percentage of workers that are “very confident” in their retirement income has jumped significantly since 2008; still, nearly a quarter of survey respondents are “not at all confident” in their retirement prospects.

Retirees are generally more confident, as you can see by the graph to the right. In 2015, 37 percent of retired survey respondents said they were “very confident” in their retirement finances. That marks a big, big jump from 2008, when retirees were hurting and only 20 percent of respondents were “very confident”.

Find the entire 2015 Retirement Confidence Survey here.

“JJ. Jelincic in my opinion is by far the most effective trustee on a US public pension plan ever. He was elected by State employees.

My understanding is that he is on indefinite leave from his staff position at CALPERS, (but receives his full pay) to actually be a full time employee.

The conflict issues were dealt with years ago. I fear you are getting misinformation from the PE industry who want to retaliate against him for exposing them.”

I don’t know if the private equity industry is going after JJ Jelincic but he’s definitely asking the right questions to CalPERS’ senior investment staff and it’s quite disconcerting to see the flimsy and evasive responses he’s been getting from them thus far.

In her latest blog comment, Yves Smith (aka Susan Webber) of the Naked Capitalism blog writes, CalPERS’ Senior Investment Officer Flouts Fiduciary Duty by Refusing to Answer Private Equity Questions (added emphasis is mine):

In the last CalPERS Investment Committee meeting, one of the most revealing incidents took place when Investment Director Christine Gogan repeatedly refused to answer a simple, direct question about a widely-used private equity tax abuse, management fee waivers, from board member JJ Jelincic. This was pure and simple insubordination and reveals serious governance problems at CalPERS. This is also not the first time we’ve seen staff show disrespect for a board member, but it is one of the most flagrant incidents.

Moreover, Gogan’s evasiveness suggests that she was not able to field a response, raising doubts about her ability to do her job. Finally, her misdirection served not simply to keep the board in the dark, but also conveyed inaccurate information to them.

Board Member JJ Jelincic: Okay. I won’t ask about offsets. Fee waivers. Can you explain to me what fee waivers are, how they’re used, and how the GP gets their money back?

Investment Director Christine Gogan: So by management fee waivers, just to make sure that we’re on the same page, what you’re talking about is the ability for a general partner to use a management fee waiver in place of a deemed contribution for their one to three percent…

Jelincic: Yes.

Gogan: …correct? And so your question is, to start with, you’re trying to get a sense of throughout our portfolio how common that arrangement is?

Jelincic: That’s a question that I had asked earlier. There’s some research apparently being done on it. But this question is just how does it work? What’s the process? What’s the economics of it? You know, quite frankly, I’m sure that the Wall Street hearts of private equity don’t say, you know, I overcharged you, I’m just not going to take the money.

Gogan: Well, I think, if I could, one thing that I would like to back up and offer up is that with respect to our entire portfolio, it’s important to note that the entire portfolio is audited. Everything is audited. Ninety-seven and a half percent of the portfolio is audited under standards that conform with U.S. GAAP. And so one of the questions without going into a lot of detail on how the management fee waiver mechanics work from partnership to partnership, and it depends to Réal’s earlier point on the waterfall computation, one thing that does give us comfort with respect to having assurance that the bottom line numbers that we’re relying upon are fairly stated, is that the majority of the portfolio, as I mentioned, the overwhelming majority is prepared in accordance with U.S. GAAP. And there are independent auditors typically, one of the top three, that provide a statement to us that provide information that we, as investors, are reasonable in relying on the fact that the financial presentation of the income statement, the balance sheet, and the capital accounts are materially accurate and fairly represent the financial position of the company.

Jelincic: And so how does the fee waiver function work?

Gogan: And so with respect to the fee waivers, to some degree, it’s going to depend on whether it is a European waterfall or whether it is a deal-by-deal waterfall. But my point in trying to go back to the audited financial statements is that in accordance with presenting the financial condition of the individual partnership, there are independent auditors that look every year to evaluate and assure that the computation of net income is consistent with the particular limited partnership agreement, and take into account each of the idiosyncratic conditions of the various waterfalls that exist for that particular partnership.

Jelincic: And the SEC would say they didn’t do a very good job of it.

As South Carolina Treasurer Curt Loftis wrote:

The staff responses are absurd.

Ms. Gogan failed a basic test of her fiduciary responsibilities. She is required to provide information in a timely and practical manner and she did neither. The Committee’s questions were direct and clearly stated and her replies were evasive, perhaps even obtuse.

Gogan’s repeated reliance on the audits for detail specificity is misplaced and is a “dodge.” GAAP audits are helpful but are not, as she implies, appropriate as the primary due diligence tool for PE fees, expenses and income. A sophisticated fund such as CalPERS has the ability and right to demand more stringent initial and on-going due diligence and the staff should be willing participants in that effort. Committee members should not be forced to “dance” with staff for information due them as a fiduciary.

As ugly as this picture is, it’s actually worse than Loftis indicates. If you watch the committee meeting in full, you’ll see again and again that if a staff member looks to be having difficulty answering a question, someone rides in quickly to their rescue. Here, no one more senior spoke up.

By contrast, recall our post last week where the CalPERS Chief Investment Officer, Ted Eliopoulos, described management fee waivers as beneficial to CalPERS when they are a tax dodge that  does not benefit limited partners like CalPERS. Eliopoulos had spoken up because the Managing Investment Director responsible for private equity Réal Desrochers was struggling to come up with the proper term of art, management fee waiver, in response to a question from board member Priya Mathur (and yes, the fact that Eliopoulos had to intervene was not a good sign). Similarly, when Jelincic was trying to get answers from Desrochers about another common provision in private equity limited partnership agreements, management fee offsets, Desrochers kept saying he’d be happy to answer the questions later, which almost certainly also meant out of the public eye. When Jelincic pressed onward, the chairman of the Investment Committee called Jelincic out of order, then reversed himself when Jelincic appealed the ruling and asked for a roll call vote.

Thus, as Gogan engaged in a heavy-handed form of obstructionism, no one intervened. By implication, her stonewalling of Jelincic had the full support of her boss, Réal Desrochers, and his superiors who were also present at the meeting, Eliopoulos and the Chief Operating Investment Officer, Wylie Tollette, as well as Mike Moy, CalPERS’ private equity consultant. In other words, staff and CalPERS’ outside advisors are apparently united in its position that the board is not entitled to honest and complete answers. As we discussed at length earlier this year, Tollette clearly and knowingly misdirected the board in trying tell them that it couldn’t get carried interest fees.

And most of the members of the Investment Committee seem to back staff’s apparently successful effort to tell board members as little as possible. You’ll notice that the chairman of the Investment Committee, Henry Jones, never once supported Jelincic’s efforts to pry information loose from the private equity team. Instead, he consistently weighed in on behalf of staff to uphold their apparent right to be less than forthcoming.

Gregg Polsky, former Professor in Residence in the IRS Office of Chief Counsel and now a professor of law at the University of North Carolina, surmised that the reason for Gogan’s slipperiness was that she could not answer Jelnicic’s question. That would be consistent with the performance of the rest of the senior staff. From Polsky via e-mail:

Gogan completely dodges the question, talking about financial statement audits and European versus deal-by-deal waterfalls. I can’t see any relevance at all of this to Jelincic’s questions.

There are two potential explanations for the dodging: she doesn’t actually know at all how fee waivers work or she’s defensive about where Jelincic is going with his questioning. I’d vote for the ignorance explanation for two reasons: (1) someone who knows the basics of fee waivers could have dodged whatever questions were coming without coming off as clueless (she could have fended off any criticism simply by noting that fee waivers can’t hurt CalPERS and she could have pointed out that, in any event, fee waivers are pervasive in the industry and the CalPERS lawyers thought fee waivers were fine at least until the recent guidance which requires them to take a fresh look); and (2) relatedly, there is no reason for someone well-versed in the basics of fee waivers to be all that defensive about them (at least from the LPs perspective). It’s a tax game between the GPs and the IRS; the LPs are really just bystanders.

Bottom line is that I think the exchange suggests that Gogan doesn’t know much about fee waivers. It’s like when I ask a law student in my class about something that he or she knows very little about even though they should know it. They change the topic to something they know about, even if it has little relevant to the topic at hand.

Actually, there could be a reason for Gogan to refer to waterfalls, but that would simply confirm that she indeed does not understand how management fee waivers work. The “distribution waterfall” determines how to divvy up the proceeds of the sale of a company between the general partner and the limited partners.

By focusing on the distribution of funds in the event of a sale, Gogan is cementing the misinformation that Eliopoulos also conveyed to board members in the same meeting, namely, that the management fees that the general partners forego are put at risk on the same footing as the monies provided by the investors. Earth to board members: they aren’t. As we discussed at length in a post last week, the general partners have the ability to gin up profits for purposes of recovering their waived management fees, including creating them even when there have been no sales of assets in the fund at all.

So take your pick. Gogan is either trying to cover for the fact that she is out of her depth or is choosing to mislead the board by doubling down on the false story that management fee waivers are a plus for CalPERS because they aligning the interests of the general partners with those of the limited partners.

At another point in the Investment Committee meeting, Gogan fails to answers a simple, direct question and shades the truth so heavily as to be engaging in distortion:

Board Member Dana Hollinger: In the past have we seen the financials of those underlying companies or no?

Chief Investment Officer Ted Eliopoulos: Well, I’ll turn that question over to Christine.

Gogan: With respect to what’s been occurring in the industry is there’s definitely been an evolution that’s occurred over time. And I would say we are moving towards an environment where we are receiving the much more detailed information with respect to the underlying. But to make a broad statement that we have always had access to the underlying detailed information in the portfolio companies is a stretch. It’s definitely improving.

The truthful answer to Hollinger’s question is “No, and we don’t typically get them now either.” Yet Gogan tries to give Hollinger the misleading impression that the limited partners get a considerable amount of disclosure, although she throws in some baffle-speak (“we are moving towards an environment”) to try to make her claim sound like less of a stretch than it is. Curt Loftis concurs:

Ms. Gogan’s response was bureaucratic gobbledegook. She chose to ramble incoherently for several minutes rather that submit a truthful and straightforward “no.”

Public pension plans should not accept as gospel the paltry representations from the GP as to the condition of the underlying investments, valuations and their attendant risk. The failure to perform the required due diligence and adequate ongoing oversight are unforgivable errors that will cost the fund substantial sums of money.

And that’s before you get to the fact, as we discussed in depth in a 2013 post, Why You Should Not Trust the Financials of Private Equity Owned Companies, that many general partners use a portfolio company software package called iLevel Solutions, which gives private equity general partners an unprecedented ability to cook the books of their portfolio companies while maintaining a facade of compliance. In other words, the portfolio company data that CalPERS does get is of questionable integrity.

Gogan’s stonewalling shows the true face of CalPERS’ private equity staff: that they deem it to be acceptable to defy and mislead the board to protect private equity general partners. This warped sense of loyalties is proof of serious governance problems at CalPERS. But the sorry fact is that the board itself, save JJ Jelincic, has made clear by its failure to press for better answers that it fully supports this abject failure of governance and neglect of fiduciary duty.

I got to hand it to Yves Smith, she’s been on top of CalPERS and private equity like a fly on manure, but the problem with Yves is she’s on some crusade to expose private equity’s dirty little secrets and tends to focus exclusively on the negatives, ignoring how important this asset class has been to delusional U.S. public pension funds looking to make their pension rate-of-return fantasy.

Don’t get me wrong, there are plenty of problems in the private equity industry, many of which I cover on my blog, but if you read the rants on Naked Capitalism, you’d think all these private equity funds are peddling is snake oil and that investors are better off investing in a simple 60:40 stock bond portfolio.

This is pure rubbish and spreading such misinformation shows me that Yves Smith doesn’t really know much about proper asset allocation between public and private markets for pension funds that have long dated liabilities and a very long investment horizon. Ask Ontario Teachers’, CPPIB, and many other large pension funds the value-added private equity has provided over public market benchmarks over the last ten years (Canadian funds invest and co-invest with private equity funds, reducing fees, and invest in PE directly, foregoing all fees).

Having said this, I too watched the CalPERS board meeting and the clips Yves Smith posted, and was surprised at how much stonewalling was going on. To be honest, I felt bad for Christine Gogan as she was clearly used as a scapegoat. Her boss, Réal Desrochers and his boss, Ted Eliopoulos, and Wylie Tollette should have been the people answering all these questions and getting grilled by JJ Jelincic.

Lastly, just so you all know, last month Richard Rubin of Bloomberg reported, IRS Tries to Curb Private Equity’s Fee Waivers With Tax Rule:

The IRS is seeking to limit private-equity executives’ practice of reducing their tax bills by reclassifying how their management fees are taxed.

Rules proposed by the agency on Wednesday would make it harder for firms to convert high-taxed fees into lower-taxed carried interest, and by doing so take advantage of a 19.6 percentage-point difference in top tax rates.

The proposal represents one of the U.S. government’s most concrete attempts to limit the tax benefits enjoyed by private-equity managers.

The “modest move” by the Internal Revenue Service would stop some of the most abusive maneuvers by private-equity firms, said Victor Fleischer, a tax law professor at the University of San Diego.

“The regulations strike me as more taxpayer-favorable than I would have expected,” he said. “The regulations try to accommodate some arrangements that are common in the industry and that in my view ought to be treated as payments for services,” and taxed as ordinary income.

President Barack Obama wants to tax carried interest as ordinary income at rates as high as 43.4 percent instead of as capital gains at rates up to 23.8 percent. That effort fell short when Democrats controlled Congress and isn’t going anywhere with Republicans in charge of both chambers.

Typically, private-equity firms charge their investors a 2 percent fee on their assets and also keep 20 percent of profits, known as carried interest.

Profits Share

By using waivers, firms can forgo some of their fees and take a bigger share of the profits — along with the tax benefit of doing so.

The rules, aimed at preventing “disguised payments for services,” say each case should be decided on the specific facts at hand, with weight given to whether fund managers bear a risk of losing money.

The Private Equity Growth Capital Council, an industry trade group whose members include the Carlyle Group, Silver Lake and TPG Capital, said it was still studying the proposal.

“It is important to remember that management fee waivers are and will remain legal, widely recognized, and part of negotiated agreements between the alternative investment community and investors, including pension funds and endowments,” Steve Judge, the group’s president and chief executive officer, said in a statement.

Capital Pledges

Private equity executives sometimes swap their cut of management fees into investments as a way to satisfy capital pledges they have made to funds managed by their firms.

The strategy surfaced as an issue in Mitt Romney’s 2012 presidential campaign, when documents from Bain Capital, which he co-founded and led, showed Bain used it to shave partners’ taxes by more than $200 million.

Apollo Global Management, another prominent firm, offered waivers to its partners until 2012, it said in a regulatory filing. Blackstone Group, the world’s largest private equity manager, and Carlyle have said they avoid the practice.

Fleischer said he was surprised at one example in the rules: fund managers were deemed to have enough at risk when they choose whether to reclassify their fees as few as 60 days before a tax year starts. By that time, future profits may be relatively certain.

“At the point where the general partner is making the decision whether to waive the fee,” he said, “they’re in a very good position” to know how successful the investments will be and can control the timing of realized gains and losses.

There are differing opinions on the new regulations aimed to stop private equity managers from converting fee income to capital gains and the IRS is still studying this proposal and invited public comments. I personally think these proposed regulations make sense. Also notice how Blackstone and Carlyle, the two giants in the industry, avoid the practice, so why can’t others follow them?

Photo by  rocor via Flickr CC License