Using a new data system, CalPERS last week issued its first report on fees paid private equity firms, a type of investment that created a new class of billionaires and is criticized for debt-laden company takeovers resulting in job losses and bankruptcies.
Private equity has yielded the highest CalPERS investment returns, needed to reach a goal of earning an average of 7.5 percent a year, while providing some protection against stock market plunges.
Private equity also has given CalPERS its biggest scandal. A former board member, Alfred Villalobos, collected about $50 million in “placement” fees from firms seeking CalPERS investments.
Villalobos died last January, an apparent suicide about a month before his trial. A former board member who became the CalPERS chief executive, Fred Buenrostro, pleaded guilty to bribery-related charges for aiding Villalobos and awaits sentencing.
After the pay-to-play scandal surfaced in 2009, the California Public Employees Retirement System and the Legislature made a number of reforms. Several large private equity firms agreed to lower their CalPERS management fees.
In 2011 CalPERS began work on a data collection system, the Private Equity Accounting and Reporting Solution. A staff remark last April that CalPERS could not track big incentive payments and other fees drew criticism in the national media.
Last week the first report from the new system showed that since CalPERS private equity investments began in 1990, the private equity firms received $3.4 billion and the pension fund had net gains of $24.2 billion, an annual net return of 11.1 percent.
A CalPERS news release did not say how this compares to what is often said to be a typical “2 and 20” private equity fee structure — 2 percent for management and 20 percent of the profits after a basic amount, an incentive known as “carried interest.”
A New York Times report last week said the CalPERS disclosure of carried interest “could help to pave the way to more transparency in the private equity industry, historically one of the most secretive corners of the financial world.”
CalPERS has several kinds of private equity investments. The largest and most controversial is the “leveraged buyout.” Often a company is purchased, mainly with loans based on the takeover target’s own cash flow or assets, and then restructured and sold.
“Some see them as tools to streamline corporate structures, to rationalize meaninglessly diversified companies, and to reward neglected stockholders,” Inc. magazine said of the leveraged buyout. “Others see the LBO as a destructive force destroying economic and social values, the activity motivated by greed-driven predation.”
A list of “the 18 richest people in private equity” was published last March by Business Insider, based on a Forbes list of the world’s billionaires. Private equity also gets what critics say are major tax breaks.
Managers pay taxes on the 20 percent carried interest share at a lower capital gains rate, not at the higher ordinary wage rate. Some also get the capital gains rate on the 2 percent payment by waiving the fee and taking a larger profit share.
The pros and cons of private equity, or “benefit” and “challenge,” were outlined at the opening of a CalPERS board workshop held this month to provide a better understanding of the fees. (See chart below.)
Private equity, once a cottage industry, is said to now represent a “multi-trillion dollar” global industry, expanding investment options for pension funds, institutions and other large investors.
Private equity returns are usually higher than publicly traded stocks, but performance can vary widely among managers. Private equity investors are “limited partners” with little control over the “general partner” managers in private equity firms.
“The funds are blind pools,” Ted Eliopoulos, CalPERS chief investment officer, told the workshop. “When you go into them, you don’t know the investments that will be made subsequently by your external managers in these areas. So it’s hard to predict the characteristic and nature of the return streams that you will be receiving.”
In contrast to their lack of control over private equity firms, both CalPERS and the California State Teachers Retirement system have corporate governance units that use shareholder clout to push for change and reform in publicly traded companies.
On corporate boards, for example, pension funds and other institutional investors advocate diversity, majority vote, allowing shareholders to put candidates on corporate ballots, splitting chairman and chief executive roles, and controlling executive pay.
In 1985 the Council of Institutional Investors was formed mainly by pension funds. “Members use their proxy votes, shareowner resolutions on regulators, discussions with companies, and litigation where necessary to effect change,” says its website.
The late state Treasurer Jesse Unruh and others are said to have organized the council in response to “greenmail.” Corporate raiders would buy enough shares to threaten a takeover, causing the company to buy back the shares at a premium.
In the wave of leveraged buyouts that came later, private equity firms go beyond threats and actually take over a company, hostile or friendly, by getting enough investors and big loans to buy all of the stock and take the company private.
A private equity group, the Institutional Limited Partners Association, was formed in 2002. It’s an education, research and networking group, with little means to “effect change” beyond issuing guidelines and principles.
For better or worse, California public pension funds, once limited to bonds before voters lifted the lid in 1966 and 1984, are now arms of government that help shape the private-sector economy through large ownership stakes, active or passive.
Private equity is about 10 percent of the CalPERS investment portfolio. At the workshop, Eric Baggesen, a CalPERS investment official, said academics have suggested that private equity could be replaced by “levering up” a stock portfolio.
Baggesen gave several examples of how that switch would cause the “volatility” or risk of a major loss to soar and diversification to drop. “There are no obvious simple answers to finding alternative ways to express the private equity exposure,” he said.