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Private Equity

New CalPERS private equity model keys on staff delegation

Eric Baggesen sees private equity as the best bet for excess return.

CalPERS' latest iteration of its private equity investment model mostly falls under staff's delegated authority, even though the pension fund has been without a permanent private equity head since the project started 18 months ago.

Its CIO's last day was Nov. 16 and its new CIO is not due to arrive until January.

The newly tweaked model has four parts: two evergreen investment strategies that would be run by separate partnerships set up by — but not owned — by the $346.6 billion CalPERS, both of which are called CalPERS Direct; a portfolio of commingled funds, a fund-of-funds type portfolio that invests in emerging managers; and the current model, investing mostly in commingled funds.

Under CalPERS Direct, CalPERS staff would not be investing directly in companies. Instead, CalPERS Direct will have relationships with two independent general partners whose sole limited partner would be CalPERS.

Employees of the two partnerships would not be CalPERS employees, nor would they be subject to civil service rules.

Pension fund officials expect to at least double the pension fund's annual commitment to private equity to about $10 billion a year in an effort to scale the portfolio to its 10% long-term target.

Officials at the California Public Employees' Retirement System, Sacramento, discussed the latest incarnation of the private equity investment model at the pension fund's Nov. 13 investment committee meeting, the same day they announced that CIO Theodore Eliopoulos' last day would be on Nov. 16.

His permanent replacement, Yu Ben Meng, deputy CIO at China's $3.2 trillion State Administration of Foreign Exchange, is expected to arrive in January.

CalPERS' board will decide whether to move forward on the private equity business model early in 2019.

Going big

CalPERS officials expect big things from the private equity portfolio. Two years ago, its asset-liability study concluded that private equity is the only asset class that would earn more than the pension plan's 7% expected rate of return.

That led officials on a quest for a rebooted program that would achieve those returns but also have a better alignment of interests and lower costs.

"If we had lots of other alternatives, then maybe we would say that we don't like the liquidity (of private equity), we don't like the fees, we don't like a lot of things about it," Eric Baggesen, CalPERS' interim CIO, said at the pension fund's investment committee meeting. "But we don't have a lot of substitutes to try to generate that level of excess return."

As of Aug. 31, CalPERS had $27.6 billion in private equity and $39.2 billion in real assets.

So far, private equity returns have failed to exceed CalPERS' benchmark for all time periods, except for the 20-year, according to the pension fund's latest private equity program review. And officials expect lower private equity returns in the future, in part, due to higher investment prices and the $1.8 trillion in dry powder poised to make private equity investments. Last year, CalPERS lowered its private equity benchmark to 150 basis points over the public markets from 300 basis points.

"We think the 150 basis points is a real expectation. Quite honestly, we do not have any other easy-to-identify alternatives to try to add that excess value on top of what we extract from the public equity markets," Mr. Baggesen told the investment committee.

To attain its 10% target to private equity, CalPERS would need to double its annual $5 billion commitment to the asset class, said John Cole, a CalPERS senior investment director who has been leading the reboot of its private equity investment model. Indeed, when Cal- PERS first discussed a remaking of its private equity program publicly in May, a report showed pension fund officials could commit $10 billion to $13 billion annually to private equity under the new structure.

The entire time CalPERS has been reimagining its private equity investment model, it has been without a permanent private equity head. Sarah Corr has served as interim managing investment director of private equity since the April 2017 departure of former private equity head Réal Desrochers.

An evolving plan

During the review of the private equity investment business model, CalPERS staff has provided regular updates to the investment committee, which can decide whether or not to fund the revised business model, Mr. Cole noted in a separate interview.

Currently, CalPERS mostly invests in commingled funds, with smaller investments in co-investments, secondaries and direct investments.

Most of that work is being done by staff on its own, under authority delegated to it by the investment committee, he said.

Staff will need to return to the investment committee to seek an exemption and/or change in its delegated authority to commit larger amounts of capital to the two proposed partnerships. They are expected to return to the board by early next year.

CalPERS' private equity plan has been evolving since officials went public with bits of its plan earlier this year. In May, CalPERS had envisioned a separate corporate-like structure with one board overseeing CalPERS Direct strategies. Its new plan specifies that each partnership will have its own advisory board, Mr. Cole told the pension fund's investment committee.

One of the partnerships would run an innovation strategy, dedicated to investing "in late-stage venture capital, at the nexus of life sciences, health care, and technology," Mr. Cole said. It would make commitments of $1 billion to $2 billion a year.

The second partnership would make long-term investments without an expiration date. This so-called horizon portfolio would focus on "core economy companies … with durable business models, capable of attractive cash yields over time with the opportunity to grow revenues by taking advantage of longer-term investments and a platform approach to building a portfolio," he explained. CalPERS would make larger, less frequent commitments to the second partnership. The size of these multiyear commitments has yet to be determined.

The two outside partnerships would be the general partners and funded by CalPERS, which, at least in the beginning, would be the sole limited partner. Nor would CalPERS have a seat on either of the partnerships' advisory boards or own a slice of the general partnerships, Mr. Cole said in the interview. CalPERS' investments in the partnerships are expected to grow to $10 billion each in 10 years, he said.

To get the partnerships up and running, CalPERS would commit some capital upfront for executives at the two partnerships to hire the rest of the team and begin investing, Mr. Cole said in the interview.

The plan eliminates the need for the investment teams to have to go out and raise capital, he explained.

Rather than pay management fees based on the partnerships' assets under management, the partners would agree to "an appropriate and competitive operations budget that would allow them to do their jobs ... but no more," Mr. Cole said. The reason is to establish a better alignment of interests between the outside partnerships and CalPERS.

CalPERS could not provide information on what it intends to pay in performance fees.

"As the numbers have grown and limited partners have been forced to pay a percentage of assets in management fees, management fees are becoming a windfall ... a profit," Mr. Cole said. An operations budget brings management fees back to their original purpose, which was to give private equity firms money to do their jobs, he said.

CalPERS' clout with the outside partnerships would come from being the sole limited partner, he said.

"They will be focused on creating value for one master (CalPERS)," he said. The partnership would need to align their compensation and mission with CalPERS.

A CalPERS spokesman said CalPERS could not veto investments other than not committing capital for a particular period of time.

Another difference in the private equity investment model from the earlier version is that CalPERS has jettisoned the idea of outsourcing much of its current, mostly commingled fund portfolio to a single manager. Under the new investment model, CalPERS' commingled fund portfolio also includes co-investments, separate accounts and secondaries.

As of June 30, CalPERS had $18 billion, amounting to 66% of its private equity portfolio, in funds, $2.7 billion (10%) in fund-of-funds, $2.5 billion (9%) in co-investments and direct investments and $4 billion (15%) in separate accounts, according to its latest private equity report.

Now, Mr. Cole said, instead of outsourcing management of that portfolio, CalPERS staff could hire a firm in an advisory role to assist staff with the portfolio.

CalPERS PE returns lag
Net returns of CalPERS' $27.2 billion private equity portfolio as of June 30, 2018.
One-year returnThree-year returnFive-year return10-year
return
20-year
return
16.1%10.4%11.9%9.0%10.5%
Policy benchmarkPolicy benchmarkPolicy benchmarkPolicy benchmarkPolicy benchmark
18.6%12.3%14.2%13.5%9.1%
Excess returnExcess returnExcess returnExcess returnExcess return
-2.5%-1.9%-2.2%-4.5%1.4%
Source: California Public Employees' Retirement System