Regents push risk

Investigation shows some officials profited while UC investments performed poorly

Last fall, amid an unprecedented state budget crisis, the University of California Board of Regents took extraordinary measures to cut costs and generate revenue. Lecturers were furloughed, classes eliminated. The regents — the governing body for the vast public university system — also reduced admission slots for in-state students while increasing the cost for out-of-state students. And to the consternation of tens of thousands of students, the regents raised undergraduate tuition by a whopping 32 percent, with more hikes to come.

It now costs about $30,000 per year to attend the UC system as an in-state undergraduate (more if out-of-state.) Even with financial aid, it’s a sum beyond the means of many students and their families.

But while education is taking a beating, this investigation reveals that some members of the board of regents have benefited from the placement of hundreds of millions of university dollars into investments, private deals and publicly held enterprises with significant ties to their own personal business activities. Conflicts of interest have arisen because some members of the regents’ investment committee, individuals who are also Wall Street heavy hitters, modified long-standing UC investment policies. Specifically, they ordered the UC treasurer to steer away from investing in more traditional instruments, such as blue-chip stocks and bonds, toward largely unregulated and risky “alternative” investments, such as private equity and private real-estate deals. There is no evidence that the regents advised about specific funds or companies, but the riskier investment categories they steered the UC treasurer toward investments that significantly overlapped with the regents’ own business interests.

The activities of two regents in particular — Richard C. Blum, financier and husband to Sen. Dianne Feinstein, D-California, and fellow financier Paul Wachter — are spotlighted. Blum, for example, benefited from $748 million in UC investments in public companies and private deals in which he held significant financial interests.

Governor Arnold Schwarzenegger (who is a regent) and his long time business partner, Wachter, benefited from $486 million in UC investments into firms and deals in which they held significant interests. And regent Sherry Lansing benefited from a UC investment of $397 million in a firm on whose board she sits. (The details of the Schwarzenegger and Lansing conflicts, as well as substantial Blum and Wachter conflicts of interest not covered in this article due to space considerations can be found at Spot.us. For example, UC has invested $53 million into two for-profit “diploma mills” largely owned by Blum Capital Partners, and Feinstein initiated federal legislation that benefited these two educational corporations.)

State Sen. Leland Yee, D-San Francisco, was asked to review the findings of this investigation prior to publication. “These are amazing conflicts of interest,” he concluded.

Other ethics experts agreed. Robert Weissman, president of Public Citizen, the liberal good-government advocacy group based in Washington, D.C., was also appraised of the findings of this investigation prior to publication. “A third-grader can see that what the regents on the investment committee are doing is unethical,” he said. “It goes far beyond the ‘appearance’ of a conflict of interest. These are core conflicts of interest.”

Blum would not respond to repeated telephone calls and written requests for comment.

THE PRIVATE EQUITY FIASCO 

UC’s current operating budget is $20 billion. The various endowment and retirement funds totaled $63 billion at the end of 2009. With such an enormous amount of public funds in play, the regents are bound to meticulously adhere to state laws and university policies that prohibit self-dealing. It is incumbent upon those individuals who are charged with overseeing the UC pension and endowment funds to avoid influencing or voting on investment decisions that potentially, actually or even appear to affect their personal business affairs.

Many members of the current crop of regents have failed to consistently hold themselves to these ethical standards — especially when it comes to private equity investments.

Private equity investing is attractive to sophisticated investors and large institutions because it has the potential for large returns. But unlike deals that take place on public stock exchanges — where sales and purchases are public information and regulated by the U.S. Securities and Exchange Commission — the realm of private equity is opaque, largely unregulated and extremely difficult to exit should a deal go bad.

It was 2003 when regents Blum, Wachter and Parsky, who left the board in 2008, consolidated control of UC’s investment strategy. The committee instructed the treasurer to bypass the university’s in-house investment specialists and to hire private managers to handle many of these new kinds of transactions. This action increased management costs and limited transparency since the external managers are not subject to public record laws. Soon, the amount of money placed in private equity had more than tripled, and by March 2009, the university’s books carried a balance of $6.7 billion in 212 private equity partnerships, which consisted primarily of leveraged buyout funds — more than 10 percent of the investment fund total of $63 billion. This investigation determined that at least seven of these partnerships were linked to regents on the investment committee. And these investments have not proven to be prudent.

UC’s private equity returns, as of spring 2009, were running at negative 20 percent since the inception of the investment. According to operating reports made to the investment committee by the current UC treasurer, Marie Berggren, much of the loss to the portfolio was tied to the souring of leveraged buyouts during the recession. In a leveraged buyout, private equity firms act as a “general partner” by arranging private investment opportunities to purchase companies or real estate. The general partner finds “limited partners” — typically institutions, pension funds or wealthy individuals — to invest in that fund. The limited partners have little or no say in how the fund operates, since it is being managed by the general partner.

The capital provided by the limited partners is used as a down payment for the purchase, and a large bank loan that covers the remainder of the sale price. Although leveraged buyouts can be lucrative for both the limited and general partners, the buyout can also take on a predatory quality. In this scenario, the limited partners have the most to lose.

Here’s how the darker version of these deals goes down: Once a company has been acquired, the investors can offload the responsibility for paying back the large bank loan onto the company itself. Meanwhile, the new owners can strip the acquired company of cash and other valuable assets to pay dividends to the general partners.

Looted companies often collapse from a lack of operating capital brought about by trying to pay off the combination of the unsustainable debt burden and the dividend payouts.

Collapse can cause the limited partners to lose their entire investment. The private equity firm’s general partners may survive because they can charge their investors management fees regardless of a deal’s outcome. While less predatory leveraged buyout acquisitions can certainly benefit both the acquired company and all of its investors, the companies involved in the UC deals discussed in this story, for the most part, do not fall into the beneficial category.

In 2009, Berggren reported that the average annual internal rate of return for the retirement plan’s private equity portfolio since 1979 was a mere 1.8 percent. But fixed-income investments had generated an average annual rate of return of 6 percent over a similar period. The only sector of the portfolio that fared worse than private equity was private real estate.

After the financiers took control of the investment committee, the university’s allocation to private real-estate deals increased from nearly zero to $4.5 billion in less than a decade. By mid-2009, the private real-estate portfolio had lost an astonishing 40 percent of its value. Nonetheless, this notable shift in strategy toward alternative investments — leveraged buyouts, in particular — has had clear benefits for individual regents. And good government experts question the ethics of these investments. “The investment committee’s act of increasing UC’s allocation to private equity was an extraordinary conflict of interest,” said Public Citizen’s Weissman. “Some of these regents obviously had vested interests.”

QUESTIONABLE INVESTMENTS

The private equity losses should not have surprised the regents. In 2008, Berggren stated in her annual report to the investment committee that private equity and private real-estate investments were “overweighted” relative to other financial vehicles during the boom years. She also noted that the regents’ preference for private investment was disproportionately affecting UC during the economic recession. Amazingly, in the face of the disastrous performance of private equity and private real estate, Wachter and Blum have continued to advise Berggren to increase UC’s investments in these two ailing sectors, according to minutes of committee meetings.

At the February 2009 meeting of the regents’ investment committee, Wachter, then the committee chair, observed that although private equity and real-estate investments were already “overweighted” in the portfolio, they should be “even more overweighted.” At an investment committee meeting three months later, Blum, who was then the chairman of the board of regents, urged his colleagues to continue on the same questionable course. According to the meeting minutes, “Chairman Blum expressed concern that the University might become too risk averse.” At the same meeting, Wachter suggested that UC buy bundles of distressed real-estate and mortgage debt to profit off of the collapse of the housing market. (Though a matter of continued debate, experts say such investments are a risky undertaking, since another wave of home foreclosures is expected.) Recently, Wachter has championed increasing the volume of UC’s investments in risky timber and oil ventures.

But the entire investment committee does not share Wachter and Blum’s predilection for alternative investments. Regent George Marcus, a real-estate executive who sits on the committee, has consistently opposed them.

In a March 2010 meeting, he described this strategy of overemphasizing private equity as the equivalent to “gambling in Las Vegas.”

In an e-mailed statement, Berggren’s spokeswoman Lynn Tierney said, “It’s misguided to assume that there’s a conflict of interest simply because there’s an overlap between personal investments by University of California Regents and investments made by the UC Treasurer’s Office. The real issue is whether regents communicate with the Treasurer’s office about specific investments.”

ANATOMY OF THREE DEALS

Blum Capital, based in San Francisco, handles a $2 billion portfolio. Regent Blum is the chairman of the investment firm’s board. He is also a principal executive and an owner of Fort Worth’s $45 billion private equity firm, TPG Capital, which has a history of partnering with a New York-based private equity firm called Apollo Management. Wachter, meanwhile, has disclosed multimillion-dollar holdings in a range of Apollo Management funds.

During Blum and Wachter’s seven-year tenures on the regents’ investment committee, UC has invested nearly $750 million in private equity deals involving Apollo Management, Blum Capital Partners and TPG Capital.

Several of these deals received contributions from the California Public Employees’ Retirement System, the country’s largest public pension fund, for which Blum Capital Partners is a paid investment adviser. What follows are summaries of just a few cases in which UC had invested and where Blum had concurrent business interests; one of these deals involving Harrah’s Entertainment, which operates 52 casinos in seven countries, also involved Wachter.

These facts were ascertained from reviewing thousands of pages of U.S. Securities and Exchange Commission filings, commercial databases, UC public records and press accounts.

1. Harrah’s Entertainment, Las Vegas, Nevada.

The company: Harrah’s Entertainment.

The deal: In 2008, investment firms TPG Capital, Apollo Management and The Blackstone Group partnered in a leveraged buyout of Harrah’s for $30.7 billion.

The Blum connection: In 2008, Blum disclosed investments worth “over $1 million” in various TPG funds (including funds named TPG IV and TPG V). He was also a TPG Capital owner and executive.

The Wachter connection: Since becoming a regent, Wachter has disclosed investments worth “up to $1 million” in two Apollo investment funds (Apollo VI and VII) that provided capital to the Harrah’s deal.

UC’s investment: At the time of the Harrah’s transaction, UC had $75 million invested in the same two Apollo Management funds in which Wachter was invested and which were themselves invested in the Harrah’s deal. During that period, UC also held $4.1 million in two TPG Capital funds, including one that helped finance the Harrah’s deal (TPG V). The investments in the TPG funds were made by several UC campus endowment foundations overseen by the regents while Blum — a TPG Capital executive who was himself invested in the Harrah’s deal (via TPG V) — served on the regents’ investment committee. UC also had $120 million invested with a private equity fund run by The Blackstone Group (Blackstone Capital Partners V), which participated heavily in the Harrah’s buyout.

In total, UC’s general endowment and retirement funds committed $200 million to four private equity funds that financed the Harrah’s buyout, a deal in which Blum and Wachter each had significant financial interests.

The fallout: Since the buyout, Harrah’s has hemorrhaged capital due to the overall decline of the gambling industry amid the global recession. Its ability to generate enough cash to pay back limited partner investors such as UC has been hampered by the $12.4 billion acquisition debt that Apollo Management, TPG Capital and The Blackstone Group placed on the books of the casino empire after acquiring it. UC’s investment in the private equity funds that participated in the Harrah’s deal had lost up to 40 percent of their value as of March 2009. 

2. Washington Mutual, Seattle, Washington First American Corporation (now CoreLogic) Santa Ana, California.

The companies: Before its acquisition by New York’s JPMorgan Chase, Washington Mutual was one of the country’s largest banks. In the fall of 2007, it stunned investors by declaring a loss of several billion dollars in the sub-prime housing market. Simultaneously, the attorney general of New York sued a title company, First American Corporation, for conspiring with Washingon Mutual to inflate real-estate appraisals. The price of Washington Mutual and First American stock fell through the floor.

The deal: In June 2008, in a major miscalculation of risk factors, TPG Capital bought a $7 billion stake in Washington Mutual, becoming its largest shareholder.

The Blum connection: Blum participated in the Washington Mutual investment through an interlocking series of TPG Capital funds (including TPG V and a related fund named Olympic Investment Partners). Blum Capital Partners also invested heavily in First American shares when the price plummeted following the allegations of appraisal collusion.

UC’s investment: In 2008, the UC Berkeley campus endowment fund invested $4.1 million in two TPG Capital funds that financed the Washington Mutual deal (TPG V and TPG VI). UC retirement fund managers made a bad bet by increasing UC’ stake in Washington Mutual bonds sevenfold, from $31 million in 2006 to $215 million by the end of 2007. Through its external managers, UC also purchased First American stock when its share price fell, putting $7 million into the failing company by the end of 2009.

The fallout: The Federal Deposit Insurance Commission seized Washington Mutual in September 2008, selling its assets on the cheap to JPMorgan Chase. Stockholders were wiped out. TPG Capital is reported to have suffered a loss of $1.3 billion, which would likely negatively affect the fund that UC had invested in (TPG V), although this information is not public. By the end of 2008, the value of UC’s investment in Washington Mutual bonds had declined by $48 million. First American continues to struggle financially and in the courts.

3. Univision Communications, New York, New York.

The company: Univision Communications is the dominant Spanish-language media company in the United States, operating 62 television stations and 69 radio stations.

The deal: In March 2007, a consortium of five private equity investment companies led by a former UC regent named Haim Saban acquired Univision Communications in a $13.7 billion leveraged buyout. The private equity investors were Saban Capital Group, TPG Capital, Madison Dearborn Partners, Providence Equity Partners and Thomas H. Lee Partners.

The Blum connection: Blum participated in the Univision deal through his investments in two TPG Capital funds (TPG IV and TPG V). His spouse, Sen. Dianne Feinstein, disclosed Univision as an asset in 2007. Blum also maintained a financial interest in the deal by virtue of being a principal executive and owner of TPG Capital.

UC’s investment: A member of the UC investment committee, Saban resigned as a regent in 2004. Saban then put together the Univision deal. During the acquisition, UC campus endowment funds had invested $4.1 million in two relevant TPG Capital funds (TPG IV and TPG V). Additionally, UC had invested $150 million in the two Madison Dearborn funds that financed the Univision buyout (Madison Dearborn IV and Madison Dearborn V).

The fallout: Following the buyout, Univision’s new owners — including TPG Capital and Apollo Management — placed the $10 billion debt from the buyout on the company’s balance sheet, creating a financial burden. The value of UC’s investment in one Madison Dearborn fund decreased by 17 percent as of the spring of 2009, while the other showed a gain of 18 percent. Apollo Management and TPG Capital collectively charged its investors, including UC, a $200 million transaction fee for managing the deal.