An aggressive plan by CalPERS investment officials to ax more than two-thirds of their private equity managers will likely benefit industry giants at the expense of smaller firms, CalPERS officials and consultants say.
The $277.3 billion California Public Employees' Retirement System, Sacramento, is the largest U.S. public pension fund investor in private equity, with more than $31 billion invested and another $10 billion committed, but yet to be deployed, according to Cliffwater LLC, Marina del Rey, Calif., an alternatives investment consultant.
CalPERS officials want to cut to 120 from 389 the number of private equity firms the fund does business with, Real Desrochers, CalPERS senior investment officer, private equity, told the investment committee on Dec. 16. There is no official timetable for the reductions, but CalPERS officials say full implementation could take from five to 10 years.
The plan is to weed out firms with poor investment returns, but performance will not be the only factor, say board members and those familiar with CalPERS' operations.
“In general, larger managers have larger capabilities” and are a better match for the nation's largest defined benefit plan, CalPERS board member J.J. Jelincic said in an interview.
Mr. Jelincic said he doesn't believe larger firms always have more skill than smaller ones, but the bigger managers have the resources to do the large deals. Smaller firms, he said, “don't have the ability to buy up (J.P. Morgan) Chase.”
The largest private equity firms already are the biggest managers of CalPERS private equity assets: Apollo Global Management LLC, Carlyle Group LP, TPG Capital LP, Blackstone Group LP and KKR & Co. LP.
CalPERS has $3.3 billion invested with Apollo or 11% of the private equity allocation; $3 billion invested with Carlyle, 9.5%; $2.1 billion with TPG, 6.8%; $1.4 billion with Blackstone, 4.6%; and $1.1 billion with KKR, 3.5%.
Apollo, with a 20.66% annualized net rate of return, was the only one of the five managers to make CalPERS' top quartile of private equity managers for the 10-year period ended Sept. 30. Carlyle, with a 17.56% annualized net return, and Blackstone, 17.29%, were in the second quartile.
The remaining managers were in the third quartile of CalPERS' private equity managers for the 10-year period, with KKR at 11.64% and TPG, 10.51%.
Among private equity partners managing active funds, Advent International Corp. produced the best results for CalPERS in the 10-year period, with an annualized net return of 35.63%, followed by TowerBrook Capital Partners LP, with 34.34%.
CalPERS assets invested with Advent International totaled $871 million and TowerBrook, $356 million, as of Sept. 30.
But being in the bottom half won't necessarily exclude managers because CalPERS' decision whether to invest in new funds will also take into account the extensive platforms and capabilities of the firms, sources familiar with the pension fund's operations say.
"Bench is not that deep'
It makes sense that “wide-body” private equity firms will be in the best position as CalPERS cuts managers, said Stephen L. Nesbitt, Cliffwater's CEO. Cliffwater is not one of CalPERS' alternatives consultants.
“When you look at private equity, the bench is not that deep,” he said.
Mr. Nesbitt said firms need to produce top-quartile results to achieve a common private equity return objective of 300 basis points above a listed equity benchmark.
Mr. Nesbitt said there are no more than 100 private equity managers that can achieve top-quartile results globally, so CalPERS having more than 300 managers makes it hard for its private equity program to achieve superior results.
In the 10-year period ended Sept. 30, CalPERS' private equity program produced an annualized internal rate of return of 12.78%, 144 basis points below the pension fund's custom index. CalPERS' goal is to achieve 300 basis points above that index, which is based on the FTSE U.S. index and the FTSE All World ex-U.S. index.
Mr. Nesbitt, however, said some smaller, boutique managers that already have solid track records might be able to build a relationship with CalPERS based on a specific investment area of expertise. For example, he said private equity firms that specialize in European debt and equity funds are in strong demand today.
One advantage of the largest firms is their ability to find good investment opportunities for their funds as well as co-investments for CalPERS, Mr. Nesbitt said.
CalPERS has increased the pace at which it is putting capital into co-investments, which save on fees, under a strategic private equity plan announced in September 2011. Private equity partners do not normally charge CalPERS and other pension fund investors for the co-investment, offering the investment opportunity as a no-fee bonus, Mr. Nesbitt said.
Since the plan went into effect, CalPERS' statistics show $600 million has been committed to co-investments, and its investment staff is actively looking at new-co-investments. It took a 21-year period before that for CalPERS to invest $2.1 billion in co-investments, the statistics show.
Managers that survive the cuts will get more and bigger commitments, Mr. Jelincic said.
A source with knowledge of the private equity operation, but who requested anonymity, said CalPERS officials will prefer investments of $500 million or more.
CalPERS spokesman Joe DeAnda said manager reductions will be done on a case-by-case basis.
Funds of funds
CalPERS also will be looking closely at private equity funds-of-funds structures. There are more than 200 managers in the private equity funds of funds in which CalPERS invests, accounting for 12% of the private equity portfolio, CalPERS' data show.
The pension fund has limited control over manager selection in the funds of funds, and pays higher fees because it is paying both the funds-of-funds managers and the underlying private equity managers, Mr. Desrochers said.
Mr. Desrochers did not go into detail at the meeting and has not returned phone calls.
As CalPERS investment officials look into reducing the number of private equity managers, they also face a quandary.
State lawmakers and executives at woman- and minority-owned private equity firms, some of them in an underperforming CalPERS fund of funds, have been pushing pension fund officials to make more investments with them.
Some of the managers in the emerging managers program that have been underperforming should not be getting new assignments, but could because of political pressure, said one CalPERS official who asked not to be identified because he is not authorized to speak for the pension fund.
CalPERS officials say a review of best practices for evaluating emerging managers is being conducted with the aim of helping determine the right managers for new commitments. The review is scheduled to be presented at CalPERS' March investment committee meeting. n
This article originally appeared in the December 23, 2013 print issue as, "CalPERS' plan to drop 269 firms may help giants".