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Private Equity

CalPERS not alone on private equity shift

Yu Ben Meng wants to see the changes as soon as possible.

A growing list of investors act to enhance returns, lower fees

CalPERS is busy fielding questions about its plans to adopt a new private equity investment model, but it's far from the only asset owner to change up its investment strategy to boost returns and lower fees.

Asset owners including the $226.5 billion CalSTRS, the $44 billion University of Texas/Texas A&M Investment Management Co. and $55.8 billion Los Angeles County Employees Retirement Association are making changes to their private equity investment approaches to evolve beyond commingled funds, which in the beginning came with high fees and take-it-or-leave-it terms but potentially higher returns than stocks and bonds.

Like the $354.8 billion California Public Employees' Retirement System, they are hoping to boost returns, reduce costs and gain control, even as private equity moves into a phase with expected lower returns that nevertheless are projected to outperform public markets.

CalPERS' $27.8 billion private equity portfolio is now roughly 66% invested in commingled funds, with 15% in separate accounts, 10% in fund-of-funds, and 9% in co-investments and direct investments.

Plans call for the fund to move toward a four-pillar model that emphasizes direct and co-investments, and increases its private equity allocation to an as-yet-undetermined higher percentage from its current 8% target. Details, though, are murky and in a state of flux.

"We need private equity to be successful, we need more of it, and we need it sooner rather than later" for its superior expected returns and diversification benefits from lower than expected volatility and drawdowns, CIO Yu Ben Meng told the investment committee on March 18.

CalPERS cannot invest in private equity at the scale it needs with the traditional model, he added.

A new model

Under CalPERS' plan, the first of four private equity pillars would consist of commingled funds, co-investments and separate accounts; a second pillar would hold an emerging manager fund of funds; a third pillar would set up but not own one or more limited liability companies to make late-stage venture capital and growth equity investments in technology, life sciences and health-care companies; and a fourth would set up but not own one or more LLCs to make long-term investments in core economy companies.

"We expect these new vehicles (Pillars III and IV) to improve our ability to deploy assets in private equity opportunities, so we can invest more in private equity, and over time, to lower costs as well as improve both CalPERS' level of control over and the transparency concerning our private equity exposure," Mr. Meng said.

CalPERS' investment committee approved the third and fourth pillars in concept at its March 18 meeting. However, Mr. Meng said many of the details, including the commitment amounts, governance structure, the new model's cost compared to the current model, and exit strategies for the limited liability companies' investments have yet to be determined.

"I think in this world, you're either an LP or a GP. It's very difficult to be both," said Antoine Drean, Paris-based founder and chairman of secondary market placement agent Triago. "Each time things are booming, LPs look to become GPs" by direct investing or co-investments.

Before the global financial crisis, some asset owners also began investing directly. But they retreated back to commingled funds when investing became difficult during the crisis, Mr. Drean said.

CalPERS is waiting to nail down the specifics of its model for the next steps of its process, Mr. Meng said. In the meantime, the recent investment committee vote gives staff the ability and the board's support to negotiate with potential partners for the LLCs. The investment committee will have to approve funding for the LLCs and investment policy changes, including increasing staff's delegated commitment sizes.

Those details will be determined after staff starts shopping the LLCs in the market, he said. And the investment office will negotiate with potential private equity partners on two new business models, he added. Also to be determined in the next steps is whether CalPERS will be partnering with an executive, a team or a private equity manager, Mr. Meng said.

While Mr. Meng refers to the limited liability companies as a sort of captive manager, the approach is different from the one taken by some of the larger Canadian pension plans. Asset owners such as the C$368.5 billion ($276.2 billion) Canada Pension Plan Investment Board and C$193.9 billion Ontario Teachers' Pension Plan, both out of Toronto, have internal money managers run by their staff that invest directly in alternative investments, including real estate, private equity and infrastructure.

At the March meeting, Mr. Meng said that while all private equity investment strategies are on the table, CalPERS officials do not currently plan to adopt the Canadian model and bring its private equity portfolio in-house.

"Regarding the Canadian model, we evaluated that option and it is clear that it's not available for us at this time," Mr. Meng said. "We must learn how to walk before we can run. CalPERS, as of today, simply does not have the organizational structure nor the compensation options capable of matching what top-tier managers can secure in the private sector."

What's more, CalPERS is not located in a global financial center, "which seriously hinders our ability in attracting and retaining the top talent," Mr. Meng said.

Collaborative model

The California State Teachers' Retirement System, West Sacramento, however, is in the midst of adopting what officials call the "collaborative model" across its portfolio, said Scott Chan, deputy CIO, in an interview.

"The objective is to benefit from internal management," through higher returns, cost savings and a better ability to control risk, Mr. Chan said. "A lot of people associate that with building an internal team but we define it more broadly."

CalSTRS' broad definition of internal management includes everything from co-investments to joint ventures with managers and other asset owners, private equity firms and operating companies, and creating internal teams to manage assets in-house, Mr. Chan said.

"It deepens on our strengths and weaknesses," he said. "We took realistic stock of what we can do and what we can't do."

CalSTRS officials see the movement toward internal management and each asset class is at a different stage, he said.

CalSTRS is building internal teams for public assets. Some 85% of CalSTRS' fixed income and more than 50% of its public equity portfolios are invested by internal staff. CalSTRS also owns or partially owns five real estate operating companies that he declined to identify.

The idea is to collaborate rather than compete in the marketplace, Mr. Chan said.

In private equity, CalSTRS officials hope to double co-investments to 15% of its private equity portfolio from 7.5%, in three to five years. Private equity, like the other asset classes, is evolving in the spectrum of internal management, which starts with limited partnerships and ends with building an internal team, Mr. Chan explained. CalSTRS has a $20.1 billion private equity portfolio as of Sept. 30.

It makes sense that investors are moving toward direct investments to avoid the fee drag and boost returns in a promising asset class, said Josh Lerner, the head of the Entrepreneurial Management Unit and the Jacob H. Schiff Professor of Investment Banking at Harvard Business School. But direct and co-investment returns have been mixed, in part due to adverse selection, according to two of Mr. Lerner's studies.

What's more, institutional investors tend to make most of their direct and co-investments at market peaks in the largest deals. At market peaks, investors are "hungry for returns and frustrated with fees," he said. General partners generally need their investors' capital in the largest deals.