How CalPERS strategy backfired

Huge portfolio losses tied to heavy leverage, lack of oversight

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Safer: Joe Dear said the fund will now concentrate on less risky investments.

Behind CalPERS' staggering real estate losses lies a strategy that took on too much risk and lacked adequate oversight.

Once the fund's star asset class, the real estate portfolio of the $201.1 billion California Public Employees' Retirement System lost nearly half its value during the one-year period ended Sept. 30. The fund's real estate consultant, Pension Consulting Alliance Inc., predicts losses will continue for at least another year.

At the heart of the problem is a freewheeling approach that took on massive leverage, gave enormous discretion to staff and experienced poor timing with its investments.

The decision-making process and risk management need to be much more rigorous, acknowledged Joseph A. Dear, who joined CalPERS as chief investment officer earlier this year. The control over leverage was not as robust as it needs to be, he added. The system will focus more on income-producing, less risky core investments in the future, he said.

“We're inclined toward investment vehicles where we have control,” Mr. Dear said. “This does not rule out fund investing,” he added.

“Hindsight suggests that a large number of CalPERS' real estate investments were extraordinarily ill-timed and inadequately underwritten,” said Stuart Gabriel, professor of finance and director, UCLA Ziman Center for Real Estate in Los Angeles. Mr. Gabriel is not connected with CalPERS.

In recognition of the portfolio's problems, the CalPERS board has imposed new limits on staff's independent investment authority, system officials are revamping its $13.5 billion portfolio and they might ax some of the fund's roughly 70 external real estate managers. (Already, MacFarlane Partners has resigned its account after a nearly $1 billion failed land deal.)

What went wrong?

Just more than two years ago, CalPERS' real estate portfolio was valued at $20.1 billion and staff estimated it would grow to $30 billion over the next five years.

What went awry? In the first half of this decade, when the real estate market was soaring, CalPERS began selling off its least risky, higher-income-producing core properties and shifting the portfolio emphasis to non-core, riskier investments. In particular, the system went after value-added real estate, taking on a bit more risk in the major property types, hotels, student and senior housing, and investing in opportunistic transactions, those taking on the most risk and leverage, according to CalPERS' 2007 strategic plan for real estate.

Some 61% of the portfolio now is in non-core investments as of June 30, the most current information available. So far, some of these strategies have been the worst performers. For example, the system's California Urban Real Estate portfolio lost 40.9% for the quarter and 56.7% for the year, ended June 30. Senior housing dropped 68.2% for the quarter and 71.9% for the year.

In addition, the 2007 strategic plan calls for increasing the portfolio's international exposure to 50% of the portfolio, with a range of 10% to 60%. CalPERS is expected to retain that global focus.

CalPERS is a global investor, Mr. Dear said. “We look worldwide for the best opportunities,” he said. “Some are in California and some are worldwide.”

In short, real estate's role in the portfolio morphed from one of adding diversification — cushioning the impact of volatility in other asset classes — to a “return enhancer.”

CalPERS focused the real estate portfolio on riskier, non-stabilized (meaning properties that were not fully leased or needed some improvements) and non-income-producing properties that were highly leveraged, according to a report by Portland, Ore.-based Pension Consulting Alliance, which has been the system's real estate consultant for years.

The fund also increased leverage across the portfolio.

According to definitions in CalPERS' 2007 strategic plan, core properties, which include real estate investment trusts and substantially leased properties, had up to 50% leverage; value added investments, which require some improvements, could have 50% to 70% leverage; and opportunistic, such as development, could include 70% or more leverage.

But CalPERS' problems didn't stop there. The board delegated enormous authority to its senior investment officer for real estate and to its CIO to invest billions without board or investment committee oversight. By February 2007, the senior investment officer for real estate could invest up to $1.8 billion in a single deal with an existing manager in a core property and $2.7 billion if the chief investment officer also approved the deal. The senior investment officer could invest close to $900 million with a manager new to CalPERS in a core property and around $450 million in a non-core property such as housing, senior housing, REITs or natural resources.

This meant that very few deals needed board approval.

What's more, the fund did not begin an external due-diligence process, which it has had in its private equity portfolio for years, until January 2008, according to a December 2009 investment activity report.

Damage control

CalPERS was not alone. Between 2005 and 2007, many institutions sold off core real estate holdings and invested in riskier investments, such as opportunity funds and overseas properties, said Dennis Yeskey, senior adviser to AlixPartners LLC, a Detroit-based restructuring firm. Alix Partners does not have a relationship with CalPERS.

“It's a boom-and-bust scenario. During the boom they (institutional investors) invest in more managers and more product types, and there's a bust,” Mr. Yeskey said. “Then they do damage control and consolidate managers.”

And when things went bust, they did so in spectacular fashion. In some cases, CalPERS defaulted on loans, returning properties to the lenders.

Among the deals that have gone sour:

• In October, CalPERS real estate manager PageMill Properties LLC missed a $50 million mortgage payment to Wells Fargo Bank on rent-controlled low-income housing in East Palo Alto, Calif. CalPERS' $100 million investment would be lost if Wells Fargo forecloses.

• In July, CalPERS and joint venture partner CommonWealth Partners LLC defaulted on a mortgage on an office building in downtown Portland, Ore.

• Also in July, the system, in a joint venture with Hines, also defaulted on a $152 million mortgage on Watergate Office Towers in Emeryville, Calif.

• CalPERS faced its biggest loss in a core strategy separate account relationship with CalEast Global Logistics, run by LaSalle Investment Management. The portfolio had been valued at $3.8 billion in the first quarter, but its value fell to $1.52 billion by the end of June 2009.

• In June 2008, LandSource Communities Development LLC filed for Chapter 11 voluntary bankruptcy protection and CalPERS ended up losing its roughly $1 billion investment in the venture.

• CalPERS in the fourth quarter of 2006 invested $500 million in Peter Cooper Village and Stuyvesant Town, a giant middle-class housing development in New York. Tishman Speyer Properties and its partner, BlackRock (BLK) Inc. (BLK), bought the development in 2006 for $5.4 billion; it is now valued at roughly half that amount. Tishman Speyer and BlackRock are on the verge of defaulting on their loans.

During the past two years, real estate went from being CalPERS' best-earning asset class — pulling in a one-year return of 14.8% and a three-year annualized return of 26.8% as of June 30, 2007 — to becoming a drag on CalPERS' total portfolio. The real estate portfolio lost $4.2 billion of its value between the first and second quarter of 2009 and $8.6 billion in the 12 months ended June 30.

Policy revamp

CalPERS staff, board and consultants are now weeding through its battered real estate portfolio to determine which properties and managers to keep. Some managers will be terminated outright, but others will be instructed to wind down or sell off their properties and quietly fade away, sources say.

“We're systematically restructuring the portfolio, reducing risk (and) leverage, and are reporting the results of independent appraisals that we required,” wrote CalPERS spokesman Clark McKinley, in an e-mail response to questions. “We're making investment decisions based on a rigorous process in the best interests of CalPERS members and not throwing good money after bad.”

The CalPERS board has revamped its real estate policy, adding stricter controls and oversight that some observers contend should have been in place all along. It has gotten independent appraisals.

It is working toward restructuring the portfolio in stages, starting with relationships such as separate accounts and direct investments, in which CalPERS has most control. The first of three phases could be completed early next year, Mr. Dear said.

This restructuring includes looking at the terms and conditions in all of its current investments, he said. That includes such things as fees, profit split and better alignment of interests, he said.

“Some managers will continue. Some won't,” Mr. Dear said.

The board also pulled back, at least for the next three to five years, the authority it had given to staff to make investments on their own. This discretion has been suspended for new managers and drastically slashed for existing ones. There is now an annual delegation limit of 20% of the real estate policy target for core to existing managers and 5% for non-core or riskier investments, and limits the total amount of real estate assets that can be allocated to one manager to 20% for core and 10% for non-core.

The system is also clamping down on the authority it had delegated to the senior investment officer and CIO to borrow, manage, retire and dispose of debt financing in the portfolio. For example, before a recent policy change, the senior investment officer could commit debt financing of up to 5% of the real estate policy target amount without oversight for a new manager and up to 10% for an existing manager. The CIO could commit up to 15% of the real estate policy target with an existing manager.

CalPERS about three months ago suspended the senior investment officer's authority to commit up to 5% of the real estate target to a new relationship and drastically reduced the senior investment officer and CIO's authority to invest with existing managers without investment committee oversight.

The fund has now gone full circle, focusing on “lower risk, income-producing opportunities,” Mr. McKinley wrote.