Health of CalPERS investment debated

Some board members questioning rocky start for private equity move

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Aiming: David Brailer said Health Evolution Partners’ goal is to invest ‘smartly’ in a changing industry.

The founder of a fledgling private equity firm is out to convince CalPERS executives they made the right investment by giving his company $705 million to manage and paying $5 million for a 15% equity interest in the firm.

But not all board members are convinced that officials of the $238.4 billion California Public Employees' Retirement System, Sacramento, made the right decision in June 2007 to invest in Dr. David Brailer's Health Evolution Partners, a private equity firm specializing in health care.

Board member J.J. Jelincic said the deal with HEP was flawed from the beginning. The firm was only in startup mode and didn't start investing most of CalPERS' money until 18 months later, he said.

“It wasn't a smart decision” to back HEP because CalPERS had to pay fees for a long period while the firm was gearing up to make investments, Mr. Jelincic said.

Documents show the pension fund has paid HEP $52.1 million in fees since 2007, but doesn't specify how much was in startup costs.

HEP's $505 million buyout fund didn't start deploying capital until mid-2009. Mr. Brailer said he was ready to make investments at the beginning of 2009, but CalPERS was having liquidity issues due to the financial crisis and asked him to hold off.

Mr. Brailer said he and HEP executives needed time to build the firm's health-care platform and long-term strategy before investing money. He said the 18-month startup period helped position HEP's staff to make investments in successful health-care companies poised for continuing growth.

Mixed returns

Investment returns have been mixed so far.

Data released at CalPERS' Aug. 13 board meeting showed HEP's $505 million buyout fund had a 0.5% internal rate of return from its mid-2009 inception through Dec. 31, 2011.

The $200 million Spectrum Fund, a fund of funds HEP launched in late 2007 to invest in health-care venture capital and private equity funds, had a -4.7% IRR through Dec. 31.

But HEP officials submitted new numbers to CalPERS last week that show the buyout fund's IRR at 12% as of June 30. The firm has not yet compiled new numbers for the Spectrum Fund.

Mr. Jelincic said he has a hard time believing the buyout fund's IRR could jump from 0.5% to 12% in just six months. “It seems incredible,” he said. “I am very skeptical.”

Mr. Brailer, HEP's founder and top executive, said the eight companies in which his fund has majority stakes are growing rapidly in revenue and profit, accounting for the huge spike.

CalPERS spokeswoman Amy Norris said the investment staff would not comment on the numbers. “We follow the HEP investment closely,“ she said in a statement. “It's too soon to tell how it will turn out.”

The arrangement with Health Evolution Partners was unique for CalPERS, Traditionally, the pension fund does not allocate that much money to a new manager. Mr. Brailer had been the first national health information technology coordinator during George W. Bush's administration, and created a health information program at the Wharton School of Business, but had no experience running a private equity fund. CalPERS agreed to provide funding, the amount of which has never been disclosed, to help Mr. Brailer set up HEP.

In exchange, the firm agreed to make CalPERS its sole investment client for one year. In an interview in his San Francisco office, Mr. Brailer said he and CalPERS officials agreed the firm needed to validate its investment philosophy before taking on new clients. He said CalPERS officials were concerned that new investors might attempt to alter the firm's investment philosophy or enter into side deals.

Rob Feckner, CalPERS board president, also disclosed at the time the investment was announced that HEP would use the expertise of CalPERS' health benefits branch, the third-largest purchaser of health care in the U.S., to get feedback on health-care trends, which in turn would help HEP with its investments.

But Mr. Brailer said CalPERS never set up the so-called innovation committee from the health-care branch of the system.

He said HEP's goal is to invest “smartly” in a changing industry. He insists returns will increase as investments continue and portfolio companies mature.

“We are looking out the windshield and see where the companies are going, and we know that will turn into valuations and exits,” Mr. Brailer said. “I feel very good at where we are, I frankly think the trajectory looks very promising over the next year or two for our companies.”

Mr. Brailer set an overall 20% IRR for the buyout fund and an 18% IRR for the Spectrum Fund. Both funds are scheduled to run for 10 years.

Mr. Brailer said the Spectrum Fund, while a fund of funds, also made three direct investments, including one in Prematics Inc. Prematics was sold at a loss, accounting for Spectrum's low IRR, he said.

Henry Jones, CalPERS investment committee chairman, said the financial crisis has meant problems for many private equity funds, including HEP. “The performance of all these funds is going to be challenged to get back to their original expectations.

Mr. Brailer said he understands why some board members might be skeptical about his firm's results, noting the “proof is in the pudding.” But he is optimistic the buyout fund will continue its positive course and the Spectrum Fund will recover.

“My agreement with CalPERS and my operating philosophy is to be patient, to build for long-term value and to be able to focus on generating something that has enormous returns,” he said.

Mr. Brailer said two or three more investments are planned by the buyout fund in the next year or so. He said five companies were acquired in 2011 and one in 2012.

HEP has invested in a wide range of companies. They include Prolacta Bioscience, which offers human breast-milk additives for premature infants; Mollen Immunization Clinics LLC, which provides flu shots at retail stores such as Wal-Mart; Freedom Innovations LLC, which provides high-tech prosthetic devices; Halcyon Healthcare, which runs hospices in Georgia; and CenseoHealth, which sends doctors to homes of managed-care Medicare patients to provide better medical monitoring to drive down costs.

Another portfolio company, Kisimul Group Ltd., runs schools and residential treatment facilities for seriously autistic children and adults in the U.K.

Mr. Brailer said his firm of 23 staffers includes investment officers with experience focusing on health-care companies at private equity firms, as well as former executives of health-care companies. The combination allows HEP to do the proper due diligence in acquiring majority stakes in companies while also providing operating expertise to the young companies.

He said one company in which HEP invested, CambridgeSoft, a provider of software for the life sciences and chemistry industries, was sold at a profit in April 2011.

Tough selections

William S. Custer, associate professor and director of the Center for Health Services Research at Georgia State University in Atlanta, said some of the companies in which HEP is investing could be successful, if they are able to take advantage of growth trends in the health-care industry. But Mr. Custer said picking the winners could be difficult given strong competition in the industry.

Mr. Custer cited as an example Mollen Immunization, which he says competes with a host of immunization providers, including major drug chains Walgreen Co. and CVS Caremark Corp.

Mr. Brailer said he is intent not only on delivering the promised returns to CalPERS, but also on bringing value to the fund's $5 million investment in HEP.

That investment will come to fruition, he argues, as HEP launches new buyout funds in the next several years, with multiple institutional investors as limited partners. n

This article originally appeared in the September 3, 2012 print issue as, "Health of CalPERS investment debated".