CalPERS studies ways to keep private equity afloat

The California Public Employees' Retirement System is grappling with ways its $26.4 billion private equity program can continue to produce superior results in an era of expected lower returns across asset classes.

Theodore Eliopoulos, chief investment officer of the nation's largest pension fund, has ordered a review to see what the $299.9 billion fund can do to maintain the returns that made private equity its best producing asset class, with a 10.2% annualized net return over the past decade.

But Mr. Eliopoulos and CalPERS private equity staff will face headwinds. One way to make up for weaker future returns would be to save on fees paid to private equity general partners — in effect, cutting them out of the equation.

Mr. Eliopoulos told the system's investment committee Nov. 14 the review will examine a number of possibilities, including direct private equity investments.

CalPERS paid about $900 million in fees to private equity general partners for the year ended June 30, and outside experts say those fees could be cut significantly if the system ran a direct investment program.

The review comes at a critical time. CalPERS is already facing diminished return expectations in other asset classes over the next decade. Staff and consultants are considering whether the assumed rate of return should be reduced from the current 7.5%, a move that would trigger increased contributions from government units, adding to their financial pressures. The investment staff and consultants are expected to make a recommendation on reducing the system's return assumption at a meeting Dec. 20.

One critical problem for the private equity program is the high valuations of companies that are potential targets of buyout funds, CalPERS officials and consultants say. Buyout funds make up 57% of CalPERS private equity portfolio, according to the system.

The problem is not unique to CalPERS; other institutional investors with private equity programs are facing the same challenges, said Michael Moy, a Mission Viejo, Calif.-based managing director at Pension Consulting Alliance Inc., CalPERS' private equity consultant.

Higher valuations mean the multiples paid for portfolio companies will be higher — and those multiples will need to expand even further to make a large profit when the company is sold, something that might not be easy to do, said Mr. Moy.

And while many private equity managers remain disciplined, holding out until the price is right to acquire portfolio companies, that creates another problem, Mr. Moy said — capital can't be put to use.

CalPERS data show gross cash distributions from private equity partners to the pension system of $15.6 billion for the two years ended June 30. During that same period, private equity partners only called $7.4 billion of capital from the pension fund.

As of June 30, the system had $13.7 billion in commitments that had not yet been called because private equity general partners can't find the right investments at the right price.

“Return expectations are compressing,” said Mr. Moy. “Maintaining the allocation level is going to be difficult because of the level of distributions that have been occurring and the reduction in the investments that are being made by the managers. What ultimately is going to happen is an unknown, but private equity is not going to be as vibrant in the very near future as it has been historically.”

The challenges to the asset class are clear. Statistics from London-based alternatives data provider Preqin, show U.S. private equity funds had capital calls of $79.5 billion in the six months through June 30, while making $160.3 billion in cash distributions. In calendar year 2015, capital calls totaled $170.5 billion, while distributed capital was $259.3 billion, Preqin data show.

For CalPERS, as billions of dollars allocated to private equity remain on the sidelines, the amount of capital deployed in funds is shrinking, and that could mean smaller cash distributions coming back to the system in the future. The $26.4 billion deployed in private equity funds and vehicles as of June 30 is down from the $34.2 billion invested as of June 30, 2012, system statistics show.

For the fiscal year that began July 1, CalPERS now plans to commit $4 billion, down from an earlier estimate of $6 billion, said CalPERS spokeswoman Megan White in an e-mail. Ms. White said the switch was made because “current valuations and capital overhang in private equity are elevated vs. historical long-term averages.”

Mr. Eliopoulos and staff are already in the process of reducing the number of private equity managers the pension fund uses, but focusing on those with top results can also means higher fees. The number of managers had been reduced to 99 as of June 30 from more than 200 in 2015, according to fund statistics. CalPERS cut several dozen managers by selling its interest in funds on the secondary market, officials disclosed at the Nov. 14 meeting.

Mr. Eliopoulos has said his goal is to get down to 30 private equity managers by 2020, but Mr. Moy said it would be difficult for 30 managers to have the capability to handle the private equity program's net asset value of $26.4 billion.

Requests to talk with Mr. Eliopoulos or other members of CalPERS investment staff members were declined. Ms. White said they were not available for an interview.

“We continue to examine alternatives to investments in private markets,” she said in an e-mail. She also stressed the review was in its early days and that “there are many challenges to sort out before we could potentially bring forward a new, more direct approach to investing in private equity.”

Large public Canadian pension funds have successfully run direct investment programs for more than two decades, reducing expenses by about two-thirds by cutting out external managers, said Keith Ambachtsheer, director emeritus of the Rothman International Center for Pension Management at the University of Toronto.

Mr. Ambachtsheer said key to running a successful program is paying investment staff attractive salaries of several million dollars each, as the Canadian pension plans do. While that is still below what can be made at private equity firms, he said, there is the incentive of not having to do sales, in addition to investment duties and the satisfaction of working on behalf of public-sector employees.

“There are a lot of good people who would rather work for half their salary for an organization that has a clear public purpose,” Mr. Ambachtsheer said.

But CalPERS private equity investment staffers make far less than $2 million a year. An investment manager at CalPERS who supervises portfolio managers makes less than $250,000 annually, according to California state salary guidelines, though they are eligible for a bonus.

Mr. Ambachtsheer said CalPERS board would not be “doing its fiduciary duty” if it doesn't seriously evaluate running a direct private equity program, noting the cost saving is enormous.

In one sense, CalPERS has an advantage over other institutions in that it has a private equity program large enough to attract a talented investment staff, he said.

CalPERS has considered running a direct private equity program before. It looked at the issue in 1999 and several times after that, said Michael Flaherman, who served on the CalPERS board from 1995 to 2003, the last three years as chairman of the investment committee.

Mr. Flaherman, a former private equity firm executive and now a visiting scholar at the Center on Governing & Investing in the Future at the University of California, Berkeley, said one idea floated in the past was forming a separate state corporation to run private equity investments for CalPERS to get around state salary rules.

“I don't think it is an insurmountable problem,“ he said. “If (CalPERS investment staff and board) go to the Legislature and try to change the law, there is a possibility that they can succeed.”

Board member J.J. Jelincic thinks CalPERS can eliminate general partners and run its own private equity program without a revision of state law.

Mr. Jelincic said the real issue is that board members would be afraid of the publicity surrounding the revelation they several dozen staff members are making $2 million a year each. “They don't have the stomach for it,” he said.