Fixing CalPERS

Although it rarely comes up in mainstream financial media there is an enormous problem in the US with underfunded public pension funds. Unless this problem is addressed, it will have a serious impact on millions of pensioners and on the overall economy. Politicians will inevitably cut benefits which they will perceive is the only avenue open to them.

The California Public Employees Retirement System (CalPERS) is by far the largest pension fund at $326 billion. CalPERS provides pension and medical benefits for approximately 1.9 million state and municipal employees and retired employees in California.

CalPERS’ investment record can be described as lousy. By January 2009 before the financial markets had even bottomed out, its assets had declined in value by almost 30% from the preceding year and a half.  A lot of people saw the bubble rising before 2008. What was CalPERS thinking?

At that time the fund had about 65% of the dollars needed to pay the benefits it was obligated to pay. By June 2016 it was funded at almost 77%.  The fund posted an 11.2% return for 2016-2017 and is projecting an 8.7% return for its fiscal year 2017-2018.  Still, today it estimates that it is back to having $70 for every $100 it will eventually pay out. This is in the midst of a raging bull market when the DJIA more than doubled.

The fund needs to do a lot better if it is going to keep up with the pension demands of an increasing number of retirees who are living longer and increased medical and pharmaceutical costs for its aging population. Understanding why this happened is the first step to fixing it.

I do not want to mince words. The problem is that CalPERS is managed by a bloated bureaucracy of state employees and overseen by a board made up of largely incompetent political hacks.  In many ways just hiring professional managers would go a long way to solving the problems.  (No I do not expect this article will lead to a lucrative consulting contract. Telling the truth rarely does.)

Part of the problem can be attributed to the diversification policy being used. You cannot invest over $300 billion in just a handful of stocks but diversification for the sake of diversification is not the answer either.

In its last annual report, the fund reported that it held more than 1 million shares each of Chevron and Disney. Both are solid, blue chip, dividend paying California based companies.  No one would suggest either is a bad long term investment.

At the same time the fund owns hundreds of other equities, some well know and many not so well known.  Most pay no dividends. In more than a few cases the fund held only a few thousand shares of some of these companies. For a fund this size to own 5000 shares of small companies hoping that their price will increase $5 or $10 it is not worth the cost of a cadre of analysts to follow them.

CalPERS employs about 400 analysts all of whom are state employees and most will get a pension when they retire.  While they are not the most expensive analysts in the world (and they do not have to be) neither are they Wall Street’s best and brightest.

The portfolio also contains bonds issued by foreign companies and foreign governments.  There is nothing wrong with that, per se, but do we really need CalPERS to employ analysts to follow the economies of Chile, Germany and France?

Suggestion No. 1:  CalPERS could consolidate its portfolio a little, do away with smaller positions and foreign offerings and lay off a few analysts. There are individuals teaching economics and finance on the faculties of UCLA, Berkley and other state schools who are already employed by the state and who already get a state pension.  A blue ribbon panel composed of some of these individuals to help CalPERS see where the economy and the markets are going might help CalPERS avoid a substantial loss when the markets get ready to correct again (like now).

But that is just a start.

CalPERS seems to have a love /hate relationship with hedge funds and private equity managers.  In 2014 it announced that was going to begin severing relationships with its private equity and hedge funds, citing the high cost associated with these private managers. At the time these funds represented about 10% of its total portfolio — including $4 billion of hedge funds and $31 billion of private equity.

A year later, CalPERS disclosed that it still paid $700 million in performance fees to private equity firms and that it had paid a whopping $3.4 billion in fees since 1990. CalPERS justified the fees by pointing to the $34 billion in profits it made from these funds in the same period. Despite its promise to cut down on private equity funds, the fund was still invested in more than 280 funds at the end June 2015. In its most recent annual report, CalPERS cites the private equity funds as the most profitable segment of its portfolio.

Suggestion No.2 If CalPERS is considering investing a few hundred million dollars in a private equity fund, shouldn’t the fees be negotiable? Perhaps the legislature should step in and cap the fees that can be paid to a hedge fund or private equity manager.  No one can suggest that any private equity firm is going to say no to an investment of that size and the savings would go right to CalPERS’ bottom line.

Perhaps nothing points to the foolish way in which CalPERS invests its money than its history of real estate blunders. CalPERS invested almost $1 billion with home developer Lennar and lost most of it when Lennar went bankrupt. It invested and lost $500 million in Stuyvesant Town, a complex of 56 buildings with 11,000 rental units near the East River in Manhattan.  CalPERS response to this loss was to get back into the NYC real estate market and invest more than $300 million in 787 Fifth Avenue, reported to be the most expensive office building in Manhattan at the time.  Does CalPERS really need to invest in NYC real estate?

Suggestion No, 3.  There is a significant shortage of affordable housing in California. In Silicon Valley there are stories of police and firefighters living in RVs and trailers and school teachers living in their cars. Many of those people pay into CalPERS. CalPERS should consider funding at least 100,000 units (and perhaps a lot more) of affordable housing around the state. That will not really put a dent in the problem but it would be an excellent start.

In addition to the benefit from the construction jobs and the housing for people who need it, it should be obvious that people without a permanent place to live do not buy furniture and appliances.  Creating these permanent communities would certainly boost the sales tax revenue that the counties and municipalities are collecting. A population boost of 5-10,000 people in some smaller counties might create the need to hire more teachers and police who would pay into the CalPERS fund for decades.

More importantly, CalPERS could hold the mortgages on these properties and collect 5% and possibly more on its investment for 25-30 years.  I would think this is a more attractive investment than a bond issued by a foreign corporation even if the bond is rated triple AAA.  It certainly makes more sense than investing in high end office buildings whose tenants will move out when the market tanks.  Low end affordable housing is not sexy but the tenants tend to pay the rent in good markets and bad.

CalPERS also provides medical benefits for about 1.6 million current and retired state and municipal employees.  CalPERS does not break out the costs but it is obvious the skyrocketing costs for prescription drugs must be substantial and probably growing faster than the any other outlay.

Suggestion No.4. Instead of buying generic drugs for plan members, buy a generic drug manufacturer. CalPERS certainly has the money to own or joint venture with an FDA approved manufacturer to produce a lot of the pills it doles out every month.  One or two manufacturing facilities could make 10 or more of the top 20 generic prescriptions and mail them directly to plan beneficiaries who need them. This cuts out the manufacturer’s profit and the profit of at least one middleman. If one half of its plan participants get one prescription per month at a savings of $10 it could bring close to $100 million per year to CalPERS’ bottom line and that is probably conservative. I suspect that Kaiser or one of the other healthcare plans might be willing to take excess production or jump on the chance to invest as well.

People are always telling me that my blog articles expose problems and scams but that I rarely offer solutions or suggestions. At least when I expose a scam some people might not invest and thus not get hurt. The odds of anyone at CalPERS actually reading this are very slim, but who knows, it might actually resonate with someone who matters.

 

BrightCOIN- The Legally Compliant ICO?

I recently read an article citing a study that concluded that as many as 81% of initial coin offerings (ICOs) are scams. Several people contested that number but it cannot be too far off. If you have more than a cursory interest in crypto currency and ICOs it is hard to miss all of the discussion about ICO scams and what to do about them.

There is a general consensus among many in the ICO community that the ICOs need to stop kidding themselves that they are not securities and begin to seriously comply with US securities laws.  In crypto industry parlance, there is an expectation that ICOs have begun to evolve into STOs (securities token offerings).

A company issuing a securities token will need to register the offering with the SEC or seek an exemption from registration such as Regulation D.  Most STOs will be sold under Reg. D,in part because the SEC has yet to approve a registered offering and does not seem to be in any hurry to do so. US securities laws require that investors be given full disclosure of the facts that they need to make an intelligent decision whether or not to invest.

Around the same time, I came across a discussion on LinkedIn about an ICO for a company called BrightCOIN. The company is raising between $1 and $40 million to expand its tech platform which enables companies to launch their ICO in a “legally compliant” manner.

I read the white paper which is anything but legally complaint and I said so on LinkedIn. This got some brush back by the company’s CEO who commented, among other things that the company had a great lawyer who had helped prepare the white paper.  The CEO claims to be a Y Combinator alumnus with several successful start-ups under his belt. So, of course, he should have an excellent lawyer.

I offered to explain why I thought that lawyer needed to go back to law school and the CEO scheduled two appointments with me so the lawyer could tell me that he was right and I was wrong. They cancelled both appointments at the last minute.

The ICO for BrightCOIN is intended to be a Reg. D offering. I would have thought that since it was selling a service and a platform where other companies can make “legally compliant” offerings, BrightCOIN would have taken pains to make its own offering “legally complaint”. They missed by a mile.

The BrightCOIN offering document is in what is now being called a “white paper format”.  If you look at a lot of ICOs, a great many use this format. I do not know where it originated, but it does not generally make the disclosures that are required for a Reg. D offering in the format that the SEC expects. Using this format is an invitation to the SEC, state regulators and class action lawyers to come after you.

A Reg.D offering is also called a private placement and the offering document is called a private placement memorandum (PPM). There is a reason that most PPMs look alike. Back in the 1980s and 1990s regulators in several states required hands on review of every offering. I personally spent hours on the phone with the staff at these various state agencies going over specific language in Reg. D offerings. They usually wanted additional disclaimers; more risk disclosures; the words “this is a speculative investment” in the cover page in bold.

Congress eventually took away the states’ ability to comment on these offerings; but a lot of lawyers, including me, appreciate that much of what they wanted amounted to good practice. Disclosures are made for the benefit of the company that is raising the money. They are a prophylactic against legal action claiming fraud and misrepresentation.

BrightCOIN calls itself the Kickstarter for ICOs.  It is essentially a crowdfunding platform for ICOs including those private placements offered under Reg. D and registered offerings filed under Reg. A+.  BrightCOIN charges no upfront fees and will provide everything that a company needs to prepare and launch an ICO including “audited documentation”.

Of course Kickstarter does not handle any securities offerings. They operate in the world of “rewards based crowdfunding”, not securities crowdfunding, so the comparison to Kickstarter that BrightCOIN makes in its ICO white paper is meaningless.

Elsewhere BrightCOIN claims that it will become the “next Goldman Sachs” and compares itself to Goldman, Merrill Lynch and JP Morgan.  The white paper included the logos for those companies, all of which I suspect are trademarked.

Did Merrill Lynch give permission for its trademark to be used in this offering? Does Goldman Sachs even know that BrightCOIN exists?  Is there any way to read this hyperbole and not consider it to be misleading?

BrightCOIN claims that its tech platform is valuable because an entrepreneur considering launching their own Reg. A+ or Reg. D offering in the form of a token might spend as much as $500,000 to have the tech built.  By “tech” it appears to be speaking about the crowdfunding platform that they are offering.

The last time I saw a bid to build a crowdfunding platform from scratch (November 2017) the cost was $50,000 and that had some unique CRM capabilities built in. I made a few calls and to add a token capability to that would cost no more than another $50,000 and probably a lot less. Where BrightCOIN gets that $500,000 number is anyone’s guess.

In any event there is no reason to create the crowdfunding technology from scratch. If you want to open your own crowdfunding platform there are several companies that offer white label products for a small upfront fee and even smaller monthly charge. At least one that I know of comes with AML/KYC capability attached.

For any offering of securities to be “compliant” it must present information in such a way that it is balanced to point that it is not misleading. The BrightCOIN white paper is full of interesting and unsubstantiated hyperbole.

Around the world, it appears that 10% of the funds that have been invested in ICOs have been hacked. BrightCOIN claims its platform is “100% hack proof”.  I have spoken with large, mainstream financial institutions that spend a lot of money making their platforms “hack-resistant” but I do not know a single attorney who would put the phrase “100% hack proof” in a securities offering document.  The truth is no one knows if a platform is hack proof until it happens.

The white paper discusses how BrightCOIN can be used to “tokenize” assets like real estate making those assets more accessible to small investors who will be able to trade those tokens on a global basis. The white paper notes (in bold type) that there are over $200 trillion worth of assets that can be tokenized.  In the context it is presented, that statement is akin to me saying that there are 1 million single women in California implying that I will always have a date on Saturday night.

BrightCOIN claims their platform is fully functional and that they are already in business. Do they disclose how many offerings they have done and how much money those offerings have raised? They do not. They also claim that they offer consulting services to help a company prepare and market its ICO. Do they identify the people who perform these services? No.

BrightCOIN estimates that it may be able to list and sell 20 ICOs per month and might be able to take in $6.5 million per month in “success fees” if it does. The lawyer who they claim prepared this offering and who was supposed to call me and explain it to me should have told them that unless the platform is a licensed broker/dealer “success fees” are forbidden.  No where does the white paper suggest that BrightCOIN intends to become a licensed broker/dealer.

People always ask me how is it that I can spot these scams when other people cannot.  In most cases, like here, they do not pass the simple “smell test”. The founder, in my opinion, should simply stop this offering until it is actually compliant. If not people at Y Combinator should pull him aside and ask that he stop using their name.

In my opinion, the attorney, if he actually wrote this offering, which I doubt, should go back to chasing ambulances.  When you prepare an offering of securities, it is expected that people will call up and ask some questions as part of their due diligence investigation. Any attorney, who agrees to field those questions, cancels two phone calls and makes no attempt to reschedule them, should refund the client’s money.

The entire ICO market has been one con after another. Telling investors the truth is not that difficult but it seems to be the one thing that the ICOs just cannot seem to do.