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California pension funds on separate paths to direct investment

The Stanford Global Projects Center’s Ashby Monk

CalPERS and CalSTRS have a common goal of investing in private equity in a way that lowers costs and offers a better alignment of interests than their current programs, but the country's largest pension plans are taking different paths to get there.

The $355.9 billion California Public Employees' Retirement System, Sacramento, would create a separate corporation known as CalPERS Direct to make direct private equity investments. The $224.8 billion California State Teachers' Retirement System, West Sacramento, has launched what could be a two-year odyssey to creating a collaborative model to join with managers and other asset​ owners to make direct investments.​

Direct investing is not new. Canadian pension plans have captive money management subsidiaries investing directly in alternative investment strategies ranging from infrastructure to private equity. But increasingly, asset owners worldwide are taking a direct investment ​ approach to lower fees and exercise more control over their portfolios.

"This is less about disintermediation and insourcing than it is about reintermediation and redefining the relationship between the LP and the GPs," said Ashby Monk, the executive and research director of the Stanford Global Projects Center, an interdisciplinary research center at Stanford University, Palo Alto, Calif. The center studies asset owner approaches to alternative investing.

The traditional limited partner-general partner model is falling short for many investors, he said. "The market is not giving us (asset owners) ... what we want and so we are taking the future into our own hands," Mr. Monk said.

One catalyst is the fees asset owners are paying their private equity managers. CalPERS paid $689.6 million in private equity fees in fiscal year 2017, a bit less than the $700 million it paid in fiscal year 2015.

"If you take 10% of that ($700 million) to fund a new team in an arm's length entity, it could do wonders," Mr. Monk said. "That's $70 million per year in compensation! You could build an incredible team with that. Now, take the remaining $630 million in savings and, every year, compound that savings at 7% (CalPERS' expected return). In 30 years, the value of the savings alone will be over $700 billion."

Stanford research has found that direct investing is most cost-effective. But the term has a range of meanings; direct investments could refer to anything from co-investing alongside managers to investing in assets directly, noted a CalSTRS staff memo to the board's investment committee. And it requires a great deal of resources, including staff salaries, which is a challenge especially for public pension plans, the memo noted.

The increased amount of investment in staff and other resources is what has stopped many public pension plans from investing directly, Mr. Monk added.

"Can you retain and recruit the people to do all this investing in-house? We pay football coaches millions of dollars, but we don't pay CIOs like that," Mr. Monk said. "Which one has a bigger effect on a state's financial position?''

The board and staff at CalPERS have been quietly working in closed sessions on plans to invest directly in private equity for more than a year, said Theodore "Ted" Eliopoulos, CalPERS' chief investment officer, in an interview. The plan was announced on May 17.

The board has yet to create the separate corporate entity. So far, the board has given staff authority to begin putting together the details of what this structure might look like and to begin talking about these models with the financial industry. The board will decide the next steps after that, said Richard Costigan, CalPERS board member.

"We thought about this deliberately ... what would be the right business model to invest in private assets," Mr. Eliopoulos said. The answer was to partner with external management talent that would work for CalPERS Direct to pursue direct investments, he said.

"For us, that's a business model that allows us to ... attract the strong talent we need to succeed, and be able to compensate those individuals and teams at market rates," Mr. Eliopoulos said.

At the same time, CalPERS would be able to incorporate its culture, values and belief systems into the new entity, he said. CalPERS Direct would be governed by a separate independent board that would advise on allocation and longer-term capital markets perspectives.

CalPERS would not be looking to join with a general partner, but instead would hire teams to invest in two funds: one focusing on late-stage venture capital investments in technology, life sciences and health care, and another making long-term investments in established companies.

Part of larger review

CalPERS officials are embarking on the enterprise as part of a larger review of the private equity program. The pension fund has an 8% to 10% target range for private equity, but officials won't release the allocation going to direct investments or the size of the portfolio.

The direct investment program would be two of four strategies or "pillars" used to invest in private equity, Mr. Eliopoulos said. The first is CalPERS' emerging manager fund-of-funds program. The second pillar is the current investment portfolio with traditional private equity managers, strategic partnerships to augment "our own very experienced staff's capabilities to invest in private equity ... to include things like co-investments and co-sponsorships as well as secondary investments in separate account," he said. The third and fourth pillars are the two direct investment funds to be run by CalPERS Direct.

Across the river, much of CalSTRS' process has been in open session, which started in November with an overview of the fund's current direct investments. CalSTRS now owns general partner stakes in real estate firms only.

It also does co-investing in private equity, real estate and infrastructure. The fund had 11.8% in real estate, 7.6% in private equity and 1.6% in inflation-sensitive assets, which includes infrastructure.

The goal for 2018 is to study the collaborative model of direct investing, "what is it and what will happen" as well as studying any challenges, roadblocks and opportunities, said Christopher J. Ailman, CalSTRS' chief investment officer, at the May investment committee meeting.

CalSTRS also expects to study what the collaborative model means to each of its asset classes. Staff expects to return to the investment committee in the fall with a start on specifics, Mr. Ailman said. Policies and procedures might need to change, as well as state laws, he said.

Mr. Monk moderated a panel discussion on the direct investing model at CalSTRS investment committee meeting in February, saying the system "will collaborate with peers to put new platforms and companies and firms in business."

And at CalPERS, Mr. Eliopoulos said he expects active collaboration between CalPERS internal staff and CalPERS Direct. "CalPERS staff will not be a passive party," he said.

CalPERS officials will seek out talented investment executives who have experience investing in the desired sectors, he said.'

He said his investment team has learned — through direct separate account investments in real estate — that interests between investor and manager "are much more aligned."

"Owning businesses is more complex than owning buildings, which is why we a gave a lot of thought to the governance structure" and settled on a corporate model, Mr. Eliopoulos said.