Spinning Public Funds into Private Profit – Four Case Studies in Conflict of Interest by University of California Regents

The details behind UC’s $486 million investments in deals in which Gov. Arnold Schwarzenegger and Paul Wachter—both UC Regents—had significant interests.

Study No. 1: Dimensional Fund Advisors and Apollo Management:

Study No. 2: Glenborough Realty Trust: UC buys a company from Richard Blum.

Study No. 3: Colony Capital: UC invests in private equity alongside Mr. Blum.

Study No. 4: Janus Capital Group: A remarkable confluence of investments.

Study No. 1: Dimensional Fund Advisors and Apollo Management: When Gov. Arnold Schwarzenegger assumed office in 2003, he appointed Paul Wachter, his business partner of more than 20 years, to the UC Board of Regents. Mr. Wachter was hired in 2003 to handle Gov. Schwarzenegger’s investments in a blind trust, which (in theory) is set up to sequester investments from all but the trustee’s view in order to limit possible conflicts of interest. For reasons that should be obvious, it was not ethically kosher for the governor to put a business partner, close friend, political advisor, and public servant such as Mr. Wachter in charge of this blind trust.

Still, Gov. Schwarzenegger, who is an ex-officio regent, chose not to place a large portion of his real estate and business partnership holdings in the trust overseen by Mr. Wachter. These assets—valued at about $100 million—became a matter of public record through the governor’s financial disclosure statements.

An analysis of the economic disclosure statements filed by Gov. Schwarzenegger and Mr. Wachter reveal that since 2003, specific UC investments have benefited the financial holdings of both men. UC has placed $411 million with Dimensional Fund Advisors, an investment firm in which Gov. Schwarzenegger and Mr. Wachter each have an ownership stake. An additional $75 million of UC’s monies was invested in private equity funds run by Apollo Management, a firm in which both men hold substantial financial investments.

Government watchdogs say that this presents a clear conflict of interest. “The regents putting public money into Dimensional Fund Advisors and Apollo is a conflict of interest just like if Schwarzenegger was a plumber and the regents gave plumbing contracts to his company,” says Robert Weissman, president of Public Citizen.

The deals are summarized below.

Dimensional Fund Advisors
Santa Monica, California

The Company: Dimensional Fund Advisors is a privately owned company that operates a type of mutual fund known as an index fund. Stock in Dimensional Fund Advisors is not publicly traded; ownership of the firm is available only by invitation, and investment opportunities are limited to its directors, employees and select individuals, such as Gov. Schwarzenegger and his blind trustee, Mr. Wachter.

Gov. Schwarzenegger’s Interest: According to financial disclosure statements, Gov. Schwarzenegger owns “more that $1 million” worth of Dimensional Fund Advisors stock. (Note: this is not the same as investing with the firm, it is direct ownership of the firm.) Media reports put his ownership stake in the firm at a minimum of 5 percent, and he receives annual cash dividends of “more than $100,000.”

Mr. Wachter’s Interest: According to public disclosure statements, Mr. Wachter owns “more than $1 million” worth of stock in Dimensional Fund Advisors.

UC’s Investment: Since 2004, UC’s retirement fund has invested $329 million with Dimensional Fund Advisors. The UCLA Foundation, an endowment fund overseen by the regents, placed $82.3 million—or nearly 8 percent of its total endowment—in three investment funds offered by Dimensional Fund Advisors. The grand total of UC’s investment in Dimensional Fund Advisors is $411 million.

Fallout: When the economy tanked in 2008, UC’s investments with Dimensional Fund Advisors took a hit. By the end of 2008, the value of UC’s investment with Dimensional Fund Advisors via the retirement fund had fallen to $151 million. UC Treasurer Berggren declined to state whether this was a loss or a divestment.

Apollo Management
New York, New York

The Company: Apollo Management is a private equity firm that specializes in leveraged buyouts. It is run by financier Leon Black, who got his start selling “junk bonds” to small banks prior to their collapse during the savings and loan debacle of the 1980s. Mr. Black now raises large amounts of Apollo’s investment capital from university and union pension funds.

Gov. Schwarzenegger’s Interest: Gov. Schwarzenegger has “more than $1 million” invested in two Apollo Management funds (Apollo IV and Apollo V). Since 2004, he has reported income of more than $200,000 a year in dividends from these two investments.

Mr. Wachter’s Interest: Main Street Advisors, Mr. Wachter’s private investment firm, has invested up to $100,000 in Apollo IV (alongside Gov. Schwarzenegger). He holds up to $1 million in each of two other Apollo Management funds (Apollo VI and Apollo VII).

UC’s Investment: Since 2004, the regents have invested $75 million in two Apollo Management funds in which Mr. Wachter is invested (Apollo VI and Apollo VII). Both Apollo funds helped finance the less-than-lucrative Harrah’s Entertainment leveraged buyout in consortium with the investment firm TPG Capital, where Mr. Blum is an owner and executive. UC is not directly invested in Apollo IV or Apollo V, but all the Apollo funds share the same general partner, Apollo Management. See Harrah's Entertainment from Part Four.

Toeing the ethical Line - As the official who appoints most of the regents, Gov. Schwarzenegger has the ability to influence his colleagues on the board. But state laws and UC policy provide theoretical guidance on how to avoid a conflict of interest. If Gov. Schwarzenegger chooses to influence a regent, he is obligated to do so in a manner that does not conflict with his own financial interests. He could also ensure that his personal holdings do not overlap with UC’s holdings—not a difficult task since both the holdings of the governor and UC are part of the public record.

However, this did not happen with Gov. Schwarzenegger’s investments in Apollo Management and Dimensional Fund Advisors. The two firms received a total of $486 million in UC investments after he and Mr. Wachter joined the board of regents in 2003.

Mr. Wachter defended these investments by saying that the regents do not direct UC staff to either select specific investment vehicles or to contract with specific outside investment fund managers, such as Dimensional Fund Advisors. (However, during a UC investment committee meeting, UC Treasurer Marie Berggren told the regents that she is open to their suggestions when hiring outside investment management firms.)

Study No. 2: Glenborough Realty Trust

In addition to his executive position with the global real estate giant, CB Richard Ellis, Mr. Blum’s business interests include the purchase and sale of real estate companies for his personal portfolio. At least one such transaction, the 2006 leveraged buyout of Glenborough Realty Trust, was made possible by a UC investment.

The Deal: A real estate company based in San Mateo, California, Glenborough was sold to Morgan Stanley Real Estate in a $1.8 billion leveraged buyout that took the company private in November 2006.

UC’s Investment: UC invested $42 million in the Morgan Stanley private equity investment fund that bought Glenborough.

The Blum Connection: At the time of the Glenborough sale, Mr. Blum owned Glenborough stock worth about $2.5 million, and he sat on the company’s board of directors. U.S. Securities and Exchange Commission disclosure statements filed by the real estate company prior to the sale asserted that as a member of its board of directors, Mr. Blum would see direct financial benefit from the buyout.

Details of the Deal: Glenborough owned scores of high-end office buildings in a half-dozen major cities, including San Francisco. Private equity suitors regularly came calling on the Glenborough board of directors, hoping to buy the profitable company. Morgan Stanley won Glenborough’s hand with a $1.9 billion offer via one of its private equity investment funds called MSREF V.

Public records show that before the sale, UC held $8 million in this Morgan Stanley fund (MSREF V). After the sale of Glenborough was announced, UC increased this amount by $34 million, for a total investment of $42 million.

The Morgan Stanley fund (MSREF V) put up a cash payment of $325 million to realize the Glenborough deal (UC’s contribution, via the Morgan Stanley investment fund, was equivalent to 13 percent of the cash that was made as a down payment). The majority of the remaining $1.8 billion purchase price was leveraged by a loan from Deutsche Bank Securities. The original members of the Glenborough board of directors, including Mr. Blum, sold their stock at a premium price.

Fallout: Glenborough was saddled with a tremendous debt load from the acquisition and it struggled mightily to meet the loan obligation. The deal turned out to be a bad investment for UC. By the end of 2009, due to the collapse of the real estate market and the company’s debt burden, the value of UC’s investment in the Morgan Stanley fund (MSREF V) had plummeted to $3.5 million, recording an apparent loss of $38.5 million from its height.

Study No. 3: Colony Capital

Since 2007, UC has invested millions of dollars with Colony Capital, a Los Angeles private investment firm. One of Colony Capital’s principal partners is Richard Nanula, a longtime trustee of the University of California, Santa Barbara. One of Colony’s business partners is Mr. Blum. The intersection of financial interests between UC, Colony Capital, and Mr. Blum is revealed through the workings of the leveraged buyout deals of Fairmont Raffles Holdings International in Toronto and Station Casinos in Las Vegas.

Summaries of both deals are presented below.

Fairmont Raffles Holdings International
Toronto, Canada

The Players:
• Colony Capital is a $45 billion private equity firm specializing in the privatization of hotels and casinos. It owns one of the world’s largest casino-hotel conglomerates, Resorts International.
Prince Alwaleed bin Talal bin Abdulaziz Alsaud is a member of the royal family of Saudi Arabia and one of the world’s wealthiest individuals.
• Kingdom Holding Company (KHC) is Saudi Arabia’s largest corporation. Prince Alwaleed owns 95 percent of KHC, which in turn owns large stakes of American corporations, including Citigroup, Apple, and News Corp.
• Kingdom Hotels International is a KHC subsidiary.
• Fairmont Raffles Holdings International is an international luxury hotel chain. Mr. Blum has been a member of its board of directors since 2006.

The Deal: In 2006, Kingdom Hotels and Colony Capital partnered to realize a $5.5 billion merger and acquisition of two hotel chains: Fairmont Hotel and Resorts and Raffles International. The companies were combined into a privately held entity named Fairmont Raffles Holdings International.

The Blum Connection: To finance the buyout deal, Colony Capital set up a series of private equity investment funds. Sen. Dianne Feinstein has disclosed that Blum Capital Partners invested in the hotel chain merger through a Colony Capital investment fund named Colony HR Co – Investment Partners III. Mr. Blum was appointed to the new corporation’s board of directors by Colony Capital and Prince Alwaleed.

UC Investment: As the hotel deal was in process, Colony Capital created a related fund (Colony Capital VIII) to develop hotel and casino properties in the Middle East and elsewhere. Between 2007 and 2009, UC’s endowment and retirement funds invested $16.6 million in this Colony Capital fund. This fund did not directly finance the Fairmont Raffles merger, but its hotel and casino funds interlock, each sharing an interest in the success of the others.

Fallout: California conflict of interest law deems a limited partner in a private equity fund to be invested in the general partner of that fund. Consequently, say the state’s conflict of interest guidelines: “When the limited partner has such an investment, he or she must disqualify [from the decision making process] with respect to decisions affecting the general partner personally or through business entities controlled by the general partner.”

In sum, Mr Blum’s investment in Colony HR Co – Investment Partners III gave him an economic interest in all of Colony Capital’s funds, including the fund UC invested in, Colony Capital VIII. But, apparently, Mr. Blum did not recuse himself from making any policy or other decision making consideration that could have affected UC’s investment in Station Casinos via Colony Capital VIII.

Station Casinos
Las Vegas, Nevada

The Players:

The Fertitta family operates and partially owns Station Casinos, one of the largest casino chains in Nevada. Until three years ago, it was a publicly traded company.
• Real estate firm CB Richard Ellis bills itself as “the leading global casino real estate advisor.”

The Blum Connection: Mr. Blum is the chairman of the board and a controlling shareholder of CB Richard Ellis. He is a member of the board of directors of the hotel chain Fairmont Raffles Holdings International, owned by Colony Capital. He is also an investor in a Colony Capital acquisition fund.

The Deal: In 2007, Colony Capital partnered with the Fertitta family in a $5.7 billion leveraged buyout (taking the public company private). Colony partly financed the deal with Colony Capital VIII. U.S. Securities and Exchange Commission records show that as the deal was being negotiated, Station Casinos hired CB Richard Ellis to evaluate the Fertitta-Colony offering to Station Casino’s public shareholders. CB Richard Ellis was charged with determining if the offering was fairly priced. Mr. Blum’s firm told Station Casino shareholders that the deal was a solid investment.

UC’s Investment: While Mr. Blum served on the regents’ investment committee, UC invested $16.6 million in the Colony Capital fund (Colony Capital VIII) which bought Station Casinos in a deal that was partly overseen by CB Richard Ellis, a company Regent Blum controls. The deal benefited Colony Capital, a firm to which Mr. Blum is deeply connected through investments and a board directorship.

Fallout: Not long after it was privatized, Station Casinos declared bankruptcy due to the combined effects of the recession and the $1.6 billion operating debt that its new owners had imposed on the company via the buyout. Former shareholders of Station Casinos claimed that the deal was not in their best interest, as CB Richard Ellis had claimed. The Colony Capital fund that financed the Station Casinos buyout (Colony Capital VIII) has lost more than half its value due to the soured deal, enraging institutional investors. As of December 2009, the value of UC’s investment in Colony Capital VIII had decreased by $6.3 million.

Study No. 4: Janus Capital Group

The Players:

Axa Rosenberg, a division of the global investment firm, Axa, was one of several dozen external investment managers retained by the regents to handle millions of dollars from the UC’s retirement and endowment portfolios after Treasurer Small was ousted.\\Janus Capital Group is a financial company that manages mutual funds.

•  Blum Capital Partners invests in both private and public equity on behalf of its private clients (whose identities are not public).

UC’s Investment: UC Treasurer Marie Berggren has disclosed that her external investment managers—she declined to specify which ones—bought and sold $26 million in Janus Capital stock on UC’s behalf between 2005 and 2008. During the same time period, Axa Rosenberg’s parent company, and three other UC external managers, invested heavily in Janus Capital stock using non-UC funds. These investments were made concurrently with large investments in Janus by Mr. Blum’s investment firm, Blum Capital Partners.The Deal: These substantial investments by four UC external managers—using UC funds and also on behalf of other clients—had the effect of ratcheting up the price of the Janus stock because these purchases increased demand.

Fallout: Even if the substantial investments in Janus by Blum Capital Partners and UC’s external managers were purely coincidental, there is an appearance of a conflict of interest because Blum Capital Partners, a market mover, invested heavily in Janus stock in tandem with UC, another market mover, and several investment firms contracted to manage UC investments, all market movers. And UC’s investments were overseen by Mr. Blum, as a regent.

The story ends differently for the various parties. Blum Capital Partners sold its Janus stake at its apogee in 2007 for a substantial profit. Meanwhile, it appears that the investment resulted in a financial loss for UC.

TIMELINE OF BLUM CAPITAL PARTNERS’ and UC’S INVESTMENT IN JANUS CAPITAL GROUP (Sourced from SEC filings, UC investment data, commercial databases, press reports.)

2004 to 2005
• In April 2004, UC hires Axa Rosenberg as an investment advisor, ultimately making it responsible for managing $156 million of the UC retirement and endowment funds.
• In the first quarter of 2005, Blum Capital Partners makes an initial investment in Janus of $102 million, paying about $13 a share.
• Throughout the course of the year, UC (though external managers) purchases $5.6 million in Janus shares.

• Early 2006: Axa Rosenberg’s parent company, Axa, invests $7.8 million in Janus.
• Mid-2006: Axa increases its holding in Janus to $56 million. Dimensional Fund Advisors (a UC external manager that is partially owned by Regents Wachter and Schwarzenegger), holds $39 million in Janus stock. Adage Capital, also a UC external manager, holds $2.9 million.
• Third quarter 2006: Blum Capital Partners purchases more Janus stock, and now owns $388 million worth of shares in the company for an ownership stake that exceeds 10 percent. The Janus stock price continues to rise.
• Fourth quarter 2006: Blum Capital sells a portion of its Janus stock, and Axa increases its investment ten-fold to $575 million. The share price reaches $21. Dimensional Fund Advisors nearly doubles its holdings in Janus.
• Throughout the course of the year, UC engages in a series of rapid trades of Janus stock, buying and selling $3.4 million worth of shares. Rather than maintaining a solid position, UC external managers often trade the stock several times a day, hoping for small profits in the margins as the stock price continues to rise.

• Early to mid-2007, Blum Capital Partners buys, sells, and re-buys Janus stock, turning a profit by taking advantage of fluctuations in the market (this tactic is called “arbitraging”). On their own accounts, four UC external managers—Axa Rosenberg, Dimensional Fund Advisors, Adage Capital, and Goldman Sachs Group—also buy large amounts of Janus stock, for a combined total of $781 million worth of shares, or about 15 percent of the company.
• September: After buying and selling Janus stock throughout the year, the value of Blum Capital Partner’s Janus holdings increases to $502 million, making it the third-largest Janus shareholder. Axa remains the largest shareholder, holding $622 million in Janus stock.
• Throughout the course of the year, through its external managers, UC trades $4.2 million in Janus stock. In at least one instance, UC buys and sells $3.1 million worth of shares in a single day.
• Late November: Due to high demand—created in part by the large Janus investments made by UC’s external managers—the price of Janus stock peaks at $36 per share. During the last quarter, Blum Capital Partners sells its entire stake—about 17 million shares—for more than a half-billion dollars, clearly reaping a huge gain.

• As the recession hits, Janus’ stock price freefalls, bottoming out at $3.95 a share.
• UC continues to trade Janus stock, buying and selling a total of $12.7 million in rapidly failing Janus stock—sometimes more than $2 million a day—in an effort to squeeze pennies out of minor fluctuations in the meltdown process. By the end of the year, UC has traded $26 million in Janus stock since the beginning of 2005.
• The amount of money Axa Rosenberg manages for UC plummets from $156 million in 2007 to $69 million by the end of 2008. UC Treasurer Berggren declined to say if this was a result of Janus investments.

• December: Axa holds $1.7 million worth of Janus stock and UC still has nearly $2.5 million in Janus shares on its books. Since gainfully divesting itself of Janus stock in 2007, Blum Capital Partners has not reinvested in it. UC Treasurer Berggren declined to say how much UC has gained or lost as a result of the Janus investments.


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