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June 01, 1998 01:00 AM

CALPERS ALTERS BUYOUT STRATEGY: SMALLER U.S. FIRMS TO BE EMPHASIZED

Steve Hemmerick
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    SACRAMENTO, Calif. -- The $140 billion California Public Employees' Retirement System is de-emphasizing the same buyout markets to which other investors still are flocking.

    CalPERS, the nation's largest pension fund, is moving away from deals involving large companies in the United States and United Kingdom. CalPERS officials say heavy competition has driven prices to near historic highs, which they expect will result in lower investment returns.

    CalPERS intends to focus on smaller U.S. companies and companies in continental Europe and parts of Asia and Latin America.

    Its revamped alternative investment strategy, accepted by trustees last month, also calls for raising the fund's commitment to the sector to $9.7 billion from $7.2 billion by the end of 1999.

    More developments

    In other developments:

    * CalPERS is considering whether to grant international money managers' requests for permission to invest as much as 20% of portfolio assets in emerging markets.

    * Trustees picked Wilshire Associates, Santa Monica, Calif., to review managers offering partnership-style investing in publicly traded securities. Such investments carry higher fees than traditional investment management.

    In the buyouts area, CalPERS intends to de-emphasize financial engineering strategies in the U.S. Such strategies, unlike value creation, attempt to fix balance sheets by merging companies. The companies then are taken public, said Barry Gonder, a senior investment officer at CalPERS.

    As for large U.S. corporate buyouts, Mr. Gonder said: "Lots of money is chasing a limited amount of domestic transactions at a time when valuations are near record levels."

    CalPERS already is heavily invested in large-company corporate finance deals.

    RETURNS LIKELY TO FALL

    Private equity industry returns are likely in future years to be in the low- to mid-teens with a long-term annualized average return of approximately 15%, he said. Typically, pension funds want private equity annualized returns of 20% or higher. CalPERS has a target of 23%.

    Meanwhile, commitments to U.S. alternative investment partnerships increased 41% in 1997 from already high levels, according to CalPERS documents. Also in 1997, commitments to buyouts were up 39%, commitments to venture capital investments were up 30% and merger and acquisition commitments were up 33%.

    "There is no indication that the pace of commitment is going to slow," Mr. Gonder said. He noted some of the top funds are over-subscribed -- that is, they have received larger commitments from investors than what they originally targeted for the funds.

    CalPERS plans to put money into the less-competitive domestic buyout funds that invest in small and emerging companies.

    Other less competitive markets targeted by CalPERS include: Western Europe, excluding the United Kingdom; Eastern Europe; and Latin America and Asia. CalPERS is also underweighted in international alternative investments.

    The pension fund plans to increase its commitments in venture capital with the help of third parties. It also will target distressed companies, orphaned public companies that need to return to the private market, health care, information technology, biotechnology and power companies.

    EFFECT OF EMU

    Separately, some international money managers believe the European Economic and Monetary Union will lessen investment opportunities for them in Europe. Some are asking CalPERS and other pension funds for permission to invest as much as 20% of their portfolios in less developed markets, said Robert L. Boldt, a senior investment officer at CalPERS.

    At the May meeting, trustees heard that two of CalPERS' four international fixed-income managers want to increase the amount of debt from less developed countries to 20%. CalPERS currently limits the level of debt to 5% in aggregate to investments in countries such as China, Colombia, Greece, Hungary, Israel and Korea.

    With the advent of the EMU, debt markets in those countries won't deviate as much as they once did, Mr. Boldt said. As a result, active fixed-income investment mangers say they have fewer opportunities to add investment value there.

    Similar concerns are voiced by international equity managers, Mr. Boldt said. Some of them also want expanded ability to invest in emerging markets.

    Staff could make recommendations on the issue in a few months as part of a fundamental restructuring of CalPERS' international investment program, he said.

    FEES WOULD INCREASE

    Additionally, some top-performing equity managers are seeking to increase their fee income by 50 to 100 basis points by offering institutional investors partnership-style investment opportunities in publicly traded securities.

    Wilshire will review those offerings for CalPERS.

    Traditional equity money managers typically can't charge above 1% of assets under management, Mr. Boldt said.

    Consequently, they have turned to partnership investments, where they can double their fees.

    In such partnerships, Mr. Boldt said, managers generally have more aggressive investment styles and concentrate their portfolios in fewer securities.

    Pension executives, he said, are willing to pay the higher fees because the managers offering them generally have very good investment track records and the funds stand to make higher returns.

    One existing partnership that uses corporate governance principles -- Relational Investors LP -- caught the attention of fund trustees.

    That partnership returned an annualized 88.83% between the initial investment in April 1996 and March 31, 1998. The S&P 500 Index return for the same period was an annualized 38.26%.

    Some CalPERS trustees saw the high return from Relational Investors as confirmation that corporate governance action works.

    Relational uses aggressive corporate governance strategies to increase investment returns. Trustees approved an additional $275 million investment in Relational Investors, bringing its total commitment to $500 million.

    "I would have to say that corporate governance is working very well . . . 89%-90% -- that is awfully attractive," said CalPERS trustee Thomas Clark.

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