SACRAMENTO, Calif.- The $149 billion California Public Employees' Retirement System has begun its long-awaited move into hedge funds, taking just a baby step.
In addition, CalPERS has dropped the industry standard internal rates of return in favor of cash distributions as the primary performance measure for its $7 billion private equity portfolio.
"IRRs don't pay benefits. Cash is what counts," Rick Hayes, senior principal investment officer for alternative investments, emphasized in an interview. The fund will use IRRs only as an interim benchmark for newer funds that wouldn't yet be at a stage to return cash.
In hedge funds, CalPERS committed a total of $50 million to five managers, with the option of increasing those mandates to a total of $240 million. That's still a far cry from the $1 billion initial commitment the pension fund has made to this area.
"We're just trying to be prudent on this before we make any additional commitments," explained Brad Pacheco, a CalPERS spokesman. He said CalPERS plans to disburse the rest of its allocation in the next 12 to 18 months.
Selected to manage initial commitments of $10 million each were:
* Andor Capital Management, New York,a U.S. technology stock firm recently formed by Dan Benton and Art Samberg after an internal split at Pequot Capital Management. Ninety of Pequot's 120 employees went to the new firm.
* New York-based Atticus Capital Management's global fund, an aggressive merger arbitrage fund that takes more concentrated bets than the firm's traditional merger arbitrage fund, and uses various short-term strategies to enhance returns
* Evnine-Vaughan Associates, San Francisco, a dollar-neutral statistical arbitrage fund that uses a highly automated trading model to predict relative price movements of a stock when its price moves away from others in its cluster. The manager should lower overall portfolio volatility and downside risk to CalPERS' hedge fund program, the system's staff noted in a memo.
* Liberty Square Asset Management, Boston, a long-short international equity manager that picks both undervalued and overvalued stocks. The portfolio should help lower overall volatility while not harming returns, the staff wrote.
* Symphony Asset Management's Rhapsody Fund, a credit-oriented convertible arbitrage strategy. Unlike most such strategies, San Francisco-based Symphony's use of fundamental equity and credit research provides better downside protection in tough markets. The strategy has a low correlation with hedged equity managers in CalPERS' portfolio.
Observers said CalPERS had picked some of the bigger, better-known hedge fund managers.
Diego Winegardner, vice chairman of Plus Funds Ltd., New York, a developer of passive hedge funds and hedge funds service provider, said CalPERS had chosen "a well-diversified mix of strategies." He called the allocations "more of a starting point" and "a good indication that they are committed to the asset class."
CalPERS has the option to place $50 million in each of the funds except for Liberty Square, where it is limited to $40 million. In total, the five managers could account for nearly one-quarter of CalPERS' initial $1 billion commitment to hedge funds.
Jim Hedges, president of LJH Global Investments LLC, Naples, Fla., while complimenting CalPERS' manager selections, said CalPERS' first step was too timid. "It will never make any material impact on the overall portfolio and it just shows they are going at this in a way that doesn't make a lot of sense to me."
In discussing the fund's change in performance measure for private equity, meantime, CalPERS' Mr. Hayes said: "IRRs often involve unrealized investments, and it's hard to know how many of those have really performed. (General partners) can calculate them many ways.
"But at the end of the day, cash is indisputable, if you look at how much is returned compared with how much is invested. And that's what we care about. For every dollar we invest with a private equity fund, we need to get back $2 to $10 net of fees by the end of the partnership - usually around 10 years," he explained.
He pointed out the firms that haven't been able to return much to their investors in cash distributions are having a hard time raising new funds, leading to an overall slowdown in fund-raising. "But that's healthy, and will give GPs time to work on the investments in their portfolios and turn them into viable companies. When they (general partners) come to us looking for money, we will ask them about other funds they have raised; we'll ask how much has gone into each fund and how much has come back to the investors after the fees and carry. We expect to see significant exits and cash distributions before we invest in a new fund."
When the market was hot two years ago, general partners often set out to raise new funds just nine months after closing the previous one, Mr. Hayes recalled. "But they had all these investments which they hadn't sold. Many were technology companies, whose stock went to $100 from $10, but even then most funds didn't sell. They held onto the shares, because they were waiting for the stock to go to $200. Instead it plunged to $2, and there were no cash distributions."
No longer buying
Some general partners might still be boasting about their 100% IRRs, but CalPERS is no longer buying that concept. "When (private equity) groups come back who can't show that they distributed more cash than they took in, or if they lack strategies for significant exits in their existing funds, we're telling them to return in a couple of years," Mr. Hayes said.
CalPERS could be setting the stage for an industrywide change in performance valuations.
Several private equity investors said they use various techniques to measure performance, including cash distributions and IRRs.
Jay Fewel, senior equity investment officer at the $36 billion Oregon Public Employees' Retirement Fund, Salem, said: "Looking at multiples is one of many measures of the success of a fund. It's something we've always done and will continue to do."
Said Chris Wagner, who oversees its $1.4 billion private equity portfolio for the $25 billion Los Angeles County Employees Retirement Association, Pasadena, Calif.: "IRRs are subjective, because they use estimated market valuations from the GPs, who are often reluctant to mark down or mark up their companies...The problem with going away from the IRR method to a cash method is, what time period do you set for cash? When you start measuring it's already the fourth or fifth year in the life of a fund, and by then another fund is being raised."
Mr. Wagner praised CalPERS' new approach. "It seems they're doing this to take out the subjectivity (of the managers), which is a good thing."
Ignoring basic issue
The problem with the cash approach is that it ignores the basic issue of what amount you're holding an investment at, argued Charles Froland, managing director for private markets at the $64 billion defined benefit plan of General Motors Corp., New York.
"We did an informal survey of three dozen of the top buyout funds in the billion-dollar club and found that since 1995, 75% of the money that was drawn down is still waiting for exit strategies. The fact that there is still so much cash sitting around means you have to find a way to treat that. There are only a few ways to measure it that the accounting industry will accept (for audits). The fact that a fund has a number of unrealized investments during a time when it's been so hard to get liquidity doesn't mean that they may not be worthy of future investment," he said.
While GM uses IRRs for its own internal performance, it's a minor part of their evaluation process, Mr. Froland said. "Our approach is to break down an organization, look at it deal by deal and see what's driving performance."
The $95 billion California State Teachers' Retirement System, Sacramento, has no plans to change its performance measurements; it will stick with IRRs, said Christopher Ailman, chief investment officer of the $95 billion system. "While not perfect, at least IRRs give us an idea of what's happening during the life of the deal. Cash in/cash out is the actual return, but it will take a decade or more to know how a fund performed."
But CalPERS' Mr. Hayes said he is studying the monthly distributions to gauge performance.
In March, for example, CalPERS invested $125 million and got back $89 million. "We checked to see which partnerships had returned money, and most of it came from Hellman & Friedman LLC (San Francisco) and Leonard Green & Partners (Los Angles), partnerships that have each done very well." He declined to name the funds in the CalPERS portfolio that performed poorly, "because then they won't be able to raise any money."
He noted Hellman & Friedman sold most of its holdings at the peak of the market. "It was a smart move - not many did this. They saw prices were good and sold. They were also the largest limited partner in their fund, putting up more money than anyone, which was an important alignment of their interests and ours."
Calculating both ways
General partners queried about how they calculate performance of their funds all said they use both the cash method and IRRs, and emphasized they're happy to comply with whatever their limited partners want.
Clinton Harris, managing partner at Grove Street Advisors LLC, Wellesley, Mass., agreed with Mr. Hayes that IRRs don't mean much. "The main benchmarks are those of Venture Economics and Cambridge Associates, but the data is highly suspect, and there are always questions about just who is submitting data. No one likes it. But the problem is there is no meaningful data for the first five to six years of a fund."
Grove Street, which has $2.8 billion in commitments from CalPERs for a venture fund of funds, does its own homework on the funds it invests with, digging deep to understand what is going on at each company its funds are backing, Mr. Harris said.
Donald Phillips, chief executive officer, WestLB Asset Management LLC, Chicago, said his firm has always reported cash distributions as well as IRRs. "The plan sponsors mainly want the IRRs because that's the standard, but many want multiples (another term for cash) too. CalPERS' adoption of this is a formal recognition of where the industry is going. It's all part of the evolution," he said.