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Private Equity

Bumpy ride seen for CalPERS proposal

Theodore Eliopoulos believes direct investment could boost returns.

Salary controversies, oversight woes could stymie creation of direct investment program

CalPERS Chief Investment Officer Theodore Eliopoulos wants to boost returns by starting a direct investment program in private equity or finding another alternative to the traditional limited partner model, but the road ahead won't be smooth for the largest U.S. defined benefit plan.

The CIO of the $333.3 billion California Public Employees' Retirement System would face hurdles that would make it difficult to implement a direct investment program, say private equity and pension experts.

Competing on salaries for top talent against private-sector asset managers is considered the biggest challenge. How the program would be set up and whether it would answer to trustees is another challenge, experts and board members said.

If the direct-investment plan moves forward, Sacramento-based CalPERS would be taking ​ a page from its Canadian peers, which started making direct private equity investments in the 1990s, pension experts said. CalPERS officials, who discussed the idea at a July 17 board meeting, plan to issue a more details about the direct investment program in six months.

Direct investing would reduce some of the approximately $800 million in fees CalPERS pays annually to private equity managers. But the size of the reduction is unclear because Mr. Eliopoulos said CalPERS would continue to participate in some private equity funds as a limited partner.

Private equity is CalPERS' best-performing asset class over the 10- and 20-year investment periods. But the fund's program shrunk to $26.2 billion as of May 31 from $34 billion four years earlier because of the difficulty private equity firms are having in finding suitable investments.

"There is a lot of competition," Mr. Eliopoulos said in a July interview, noting the large number of investors seeking available opportunities in commingled private equity funds.

In private equity, CalPERS expects to earn an annual net return of 8.2% over the next decade. By comparison, on a net annualized basis CalPERS private equity program earned 8% for three years; 11.4% for five years; 8.9% for 10 years and 11.3% for 20 years.

Another option — never done before by a public pension plan — would be to outsource much or all CalPERS private equity program to a money manager that could potentially leverage better deals with private equity managers than CalPERS staff. Sources say Mr. Eliopoulos has talked to BlackRock (BLK) Inc. (BLK) about possibly taking over all or part of CalPERS private equity program. BlackRock is the world's largest asset manager with more than $5 trillion in assets under management, but its private equity program is a relatively small part of its business, a fund of funds with $21.5 billion in assets under management.

A CalPERS spokesman said Mr. Eliopoulos would be unavailable for comment. Mr. Eliopoulos was scheduled to update the investment committee in closed session on Sept. 18 on his staff's research on alternatives to CalPERS' current private equity model. Sources say they expect Mr. Eliopoulos to offer more information on the potential deal with BlackRock.

High future returns in doubt

Mr. Eliopoulos' plan to find an alternative to the traditional private equity model comes at a time when high future investment returns are in doubt for most institutional investors including CalPERS, which had an estimated funding ratio of 68% for the fiscal year ended June 30.

Consultants and CalPERS investment staff expect a 6.2% annualized return for the entire fund over the next decade, below its assumed 7% rate of return.

Erik Gordon, clinical assistant professor at the University of Michigan's Stephen M. Ross School of Business, said in an interview it's understandable that Mr. Eliopoulos would want to find a way to lower private equity fees by starting a direct investment program. But Mr. Gordon, who consults with institutional investors on private equity, said even if Cal- PERS could pay the higher salaries necessary to assemble a top-notch investment staff, it could take time to garner strong investment results.

"I think it's going to be really hard, and I think if the new team doesn't show performance advantages pretty quickly, they don't get to the long term," he said. "People aren't going to sit on their hands for 10 to 20 years saying, 'we know your performance isn't great, but we know it will be, hope it will be.' "

Finding deals is difficult too. "When you talk to the private equity people, they will tell you that sourcing the deals, especially these days, at reasonable pricing is really tough," Mr. Gordon said. "And any company that can be had at a reasonable price, you're competing with other funds, other people who want to buy the company."

Another skeptic, Josh Lerner, the Jacob H. Schiff professor of investment banking at Harvard Business School, said he questioned the idea that CalPERS could pay competitive salaries and compete credibly for investments. "It's quite optimistic."

Salaries for CalPERS private equity investment officers vary, with a state database showing, for example, that investment managers are paid $225,000 a year while an investment director, senior staff, earns $373,000. That pales in comparison to millions of dollars senior investment officials can make at the largest private equity firms, recruiters said.

On its own

Aiming to give itself more flexibility on pay, Mr. Eliopoulos at the July 17 meeting said he envisions the CalPERS-backed direct investment unit to have its own CEO, board and staff who would take buy-and-hold stakes in companies.

He said the investment staff would be all new. Current CalPERS private equity staff specializes in picking the right funds or fund of funds but doesn't have the expertise in sourcing and managing investments in portfolio companies that would be bought by the Cal- PERS-owned investment entity.

Mr. Eliopoulos said the direct investment staff would be paid more than what in-house staffers make now but less than executives at major private equity firms.

At the meeting, board members questioned the direct-investment strategy, which would need their approval to move forward. Board members, and even the pension plan's own investment consultants, expressed fear of "headline risk" if the public became aware that a particular direct investment had caused major losses while staffers responsible had made millions of dollars a year in compensation.

Board members also expressed concern over Mr. Eliopoulos' statement that a new investment organization would need to operate independently of the board.

Board member Theresa Taylor questioned whether the board could act if members learned that a portfolio company acquired by the investment organization had practices or policies that violated, say, the pension fund's ESG guidelines or workers rights.

Mr. Eliopoulos said the CalPERS board could impart its values on the new organization's staff, but warned that frequent meddling could scare away investment talent.

Board member J.J. Jelincic said CalPERS should develop in-house direct investment expertise in private equity — not outsource to a separate corporation.

"We are going to create this separate company and we're going to say here's $30 billion, go invest it, and we are not going to have any control over what they do, any control over who the staff is and any control of who the board is," he said. "As Ted had proposed it, we create this company, say here's the money, goodbye and tell us what the results are — and for a fiduciary, that should not be acceptable."