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.