Poor returns forcing CalPERS to cut cord on health-care fund

CalPERS is ending its unique experiment as the sole limited partner of Health Evolution Partners Inc., a private equity firm that focuses on health-care companies.

The pension fund's private equity investment staff blocked already committed funds from being used and issued the firm an ultimatum — find another partner to buy out CalPERS or liquidate the entire fund, multiple sources say.

The issue came to a head in early April. CalPERS staff told HEP founder and CEO David Brailer the pension fund was going to end the partnership and block the San Francisco-based firm from making an additional $10 million investment in one of its portfolio companies, Optimal Radiology, which was experiencing financial difficulties.

Real Desrochers, senior investment officer, private equity, for the $300.6 billion California Public Employees' Retirement System, Sacramento, explained his decision to the board in closed session. Sources said he was convinced that poorly performing HEP would never realize its goal of delivering returns of 20% or more and that CalPERS needed to get out of the investment.

CalPERS made an almost unheard of bet in 2007, committing a total of $705 million to the firm headed by Mr. Brailer, a physician who had no private equity experience. Of the total, $505 million was to be allocated to the Health Evolution Partners Growth Fund, which was to invest in health-care companies poised for growth, and $200 million was slated for a fund of funds that would invest in other private equity funds investing in health care.

Mr. Brailer was the national coordinator of health-care information technology in the George W. Bush administration from 2004 to 2006. He maintained that the deal would make CalPERS a national leader in health-care investing and other institutional investors would join later.

CalPERS officials also planned to leverage information about health-care trends they learned from Mr. Brailer and his staff, helping them to make smarter decisions in providing benefits to employees.

The returns Mr. Brailer promised never happened, nor did other asset owners invest. The exchange of information to help the pension system deliver health-care benefits more efficiently also went by the wayside.

Mr. Brailer repeatedly told CalPERS officials they needed to give him more time to produce the double-digit returns, sources said. But he was unable to sway Mr. Desrochers.

CalPERS data show the HEP Growth Fund had an internal rate of return of 6.5% from its inception in mid-2009 through Dec. 31, 2013. By contrast, the $5.3 billion growth fund portion of CalPERS' private equity portfolio returned 12.72% for the five years ended Dec. 31, the closest comparison that could be made with the data the pension fund made available.

The HEP fund of funds has had more serious performance problems. Its IRR from inception in 2007through Dec. 31, 2013 was -5.2%, show CalPERS statistics. CalPERS also wants out of that investment, but sources say a complicated fund-of-fund structure may make that difficult.

Mr. Desrochers would not comment on HEP, telling a Pensions & Investments reporter the matter was too sensitive to discuss.

CalPERS spokesman Joe DeAnda, in an e-mail, said, “We continue to evaluate all options relating to Health Evolution Partners.”

Mr. Brailer did not return several phone calls.

HEP has hired Evercore Group LLC, an investment banking advisory group, to help find a buyer for CalPERS' stake in the growth fund. (HEP has a small, several-million-dollar stake in that fund.)

It is unclear if CalPERS also is trying to sell its 15% minority interest in HEP, which CalPERS purchased for $5 million when it began its relationship with Mr. Brailer.

Evercore has only been hired to find a new investor to replace CalPERS in the growth fund.

Typically in private equity, a limited partner reserves the right to exit a partnership, but needs permission from about 75% of other limited partners to sell its stake on the secondary market. But CalPERS, as the sole limited partner, didn't need anyone's permission. Sources said CalPERS executives did not try and sell the stake because they felt it was more logical for HEP, as the general partner, to do so.

CalPERS paid HEP more than $19 million in fees in the year ended June 30, 2012, the most recent period for which statistics are available.

A source tied to HEP called the matter “a business dispute” and said HEP officials were hopeful of finding a new partner.

A person familiar with the negotiations between HEP and potential buyers, who would speak only under the condition his name not be used, said there are several potential offers, but negotiations as to how much of a discount buyers would demand are only just starting.The current book value of the growth fundis around $400 million, he said. CalPERS had given HEP $425 million in committed capital and fees through Dec. 31, information from the pension fund showed. HEP has distributed $67.7 million to CalPERS, according to the pension fund's statistics. HEP had about $50 million it had not yet deployed when CalEPRS cut off its ability to use committed capital, sources say.

Besides the radiology company, HEP portfolio companies in the growth fund include a prosthetics manufacturer, a provider of services for autistic children in England and a hospice company.

The source, who has been in the private equity industry for about 12 years, said what also is unique in this case is CalPERS refusing to release to the general partner already-committed capital.

But CalPERS' Mr. DeAnda said the funding cutoff is not unusual.

“In talking with our staff, I can assure you that it has happened before and we have done it many times when merited,” he wrote in an e-mail, without providing details. “While each relationship is different, and it depends on the nature of the fund and involved parties, there is nothing abnormal or unique about the practice.” n