SACRAMENTO, Calif. - Officials for the California Public Employees' Retirement System are considering establishing the pension fund's own merchant bank.
One key aim is to recruit other pension funds and penetrate Asia's closely knit business community to make direct equity and other alternative investments that U.S. pension funds find difficult to do.
Charles Valdes, chairman of the $97 billion fund's investment committee, said the merchant bank is in the conceptual stage. He said other proposals of somewhat similar breadth and scope also are being examined. He declined to identify them.
But sources familiar with the merchant bank proposal said a recommendation to establish the bank was presented by one of the fund's consultants, Hamilton Lane Advisors. And the merchant bank idea and an "Asia fund" were recently identified as a possibility by Sheryl Pressler, chief investment officer.
A preliminary proposal calls for the merchant bank to be capitalized first by the fund with $500 million to $750 million. One of the prototypical investment structures of the bank would be to pursue hard-to-find investment deals in Asia and elsewhere for the fund's $3.4 billion alternative investment program. Some $200 million to $250 million of that would go to an investment partnership formed by the bank, called Pacific Pension Investors. The partnership would seek to include five public pension funds.
Sources said one fund that might be interested would be Australia's State Superannuation Investment and Management Corp., the investment arm of an Australian public employees' pension fund.
Mr. Valdes said large state pension funds along the West Coast could be potential investors. He did not identify the pension funds, but the idea of a merchant bank has been circulated at group where officials of those funds meet.
Contributions coming from other pension funds would increase the amount the partnership could invest internationally to $500 million. If leverage was used, the full extent of the partnership's investment would be even more.
The partnership would make direct private equity investments in the Pacific Rim countries and Europe. Though Asia might be the first target of the merchant bank, it would have considerable investments in the United States, with as much as 25% to 35% in California alone.
The concept of pension funds establishing merchant banks in Asia is not new. In 1994, the pension funds of U S WEST Inc. and Hughes Aircraft Co., along with the Rockefeller Foundation, joined Bridgewater Associates as founding partners of a merchant bank in China, to do deals there. But the California fund's proposal would invest in most of Asia outside Japan and eventually be a worldwide operation. Also, the bank eventually could have more than $1 billion at its disposal.
The investment return hurdle rate for the partnership would be 30% per year over the life of the investment.
The merchant bank might have an office in Darwin, Australia, which has important links to Indonesian and Malaysian economies, and one in San Francisco.
Separate from the partnership, the merchant bank would do credit enhancements, asset-based lending and U.S. private equity investing and co-investing.
Its investment discipline would be similar to that of GE Capital Corp., according to the Hamilton Lane proposal, sources said, Each investment opportunity would be evaluated against a hurdle rate on equity.
Hamilton Lane said the merchant bank would provide many advantages to the California fund, including: timely reaction; reduced transaction costs for private debt and equity transactions; expansion of investment opportunities; increased access to attractive investment opportunities; superior risk-adjusted returns; and additional diversification for the pension fund.
The merchant bank operations would not interfere with existing alternative investments of the pension fund.
Mr. Valdes said the pension fund board wants direct and alternative investments deals in Asia. But, he noted, it is difficult for a U.S. public pension fund to acquire the deals.
"The good deals are taken by the people there (in Asia) who have connections," he said.
Some fund officials believe a merchant bank could give the fund the speed, connections and visibility to make good deals. The fund has been making investment deals through limited partnerships in Europe since 1990 and recently approved investments in Latin American and South African partnerships.
The fund's primary investment targets would include Singapore, Indonesia, Thailand and Korea, said Mr. Valdes.
A merchant bank established by the pension fund would be an efficient method of investment "if you had the right people," Mr. Valdes said.
Philip Halpern, CIO of the $32 billion Washington State Investment Board, Olympia, said California fund officials discussed the concept of a merchant bank at a meeting attended by West Coast pension funds.
Mr. Halpern said pension fund executives meet once a year at the Pacific Pension Institute, sponsored by several groups, including the University of Oregon and Stanford University. CalPERS executives, including Mr. Valdes and Ms. Pressler, have attended these meetings.
Discussions at the institute have included private equity investments and how plan sponsors might help each other invest more efficiently.
Other officials attending the meetings, he said, included those from British Columbia, Australia and from the Oregon Public Employes' Retirement System.
Mr. Halpern said one problem facing big funds is the cost-effectiveness of putting small amounts of money in limited partnerships internationally. The pension funds ideally would like to find deals with comparatively large investments, totaling about $500 million initially in Asia, so that the cost of due diligence would be amortized.
Meanwhile, executives of the California fund are discussing potential problems with the merchant bank concept, including the lack of knowledge and expertise in setting one up. That, they understand, would create a painful learning curve.
But Hamilton Lane has recommended the investment committee direct its staff to develop a plan to set up the merchant bank. Apparently, the fund's staff is still considering the Hamilton Lane recommendation.