As New Jersey cuts hedge fund ties, CalPERS' experience shows that can take years

New Jersey's plan to slash about $2 billion of its hedge fund investments sounds simple: Pick the top managers, ask others for redemptions and collect the cash.

Yet overseers of the state's pension system can look cross-country to see how long that can take. Five years after California's biggest retirement plan decided to pull out of all hedge funds, its managers are still waiting to retrieve roughly $150 million from Chatham Asset Management.

Most of the hedge funds that once tended investments for the $365.1 billion California Public Employees' Retirement System have returned the pension system's cash, leaving Chatham with the bulk of money still outstanding. New Jersey, too, has $363 million in a Chatham hedge fund, and while the portfolios are different, they share at least one controversial investment: Holdings tied to American Media, longtime owner of publications including the National Enquirer.

After CalPERS asked to withdraw its money from a special fund managed by Chatham, the pension system watched the vehicle's performance decline. The Chatham fund generated an annualized return of 7.3% in the five years through 2014, when CalPERS made its decision to cut ties with hedge funds. But by the middle of last year the lifetime annualized return had slumped to 2.3%, according to the most recent data publicly available.

In 2016 alone, the special fund suffered a 16% loss without any public explanation. The broader high-yield market rallied that year, and Chatham's main high-yield fund gained 24%. CalPERS and Chatham declined to comment on the divergence.

It's worth watching CalPERS's experience extricating itself from hedge funds because it's the first major player in its industry to attempt it. The biggest U.S. pension system rattled Wall Street in September 2014 by announcing it would pull every investment in the asset class, deeming them too complex and expensive. Other pension funds have followed.

Officials in New Jersey have yet to say whether they might pull their money from Chatham, among others. In February, they said they were so bothered by Amazon.com founder Jeff Bezos' claim that the Enquirer had tried to extort him that they would consider "all available options" for their investment with Chatham. Then late last month, the the fund board voted to halve its allocation to hedge funds in general. It has yet to decide which firms to cut from a stable that also includes Winton Capital Management, Davidson Kempner Capital Management and Elliott Management.

Chatham founder Anthony Melchiorre, known as a bare-knuckled fighter in business dealings, has waded deeper into contrarian bets over the years and stuck by them. His firm has reported significant gains on New Jersey's $300 million investment from 2014 — adding $193 million through March this year, according a pension report.

Yet, CalPERS's exit from Chatham illustrates a risk investors face generally when entrusting money to funds that take big stakes in assets that may be hard to sell: Full withdrawals can be slow.

"We have been encouraging the fund to sell for several years now," said Wayne Davis, a spokesman for CalPERS, speaking of its desire to dispose of the remaining positions it has with Chatham. Still, the California fund isn't a "distressed seller" and doesn't want to accept a depressed price, he said. Its relationship with Chatham remains good, he said, noting that the hedge fund has signaled it will hand over more money this year.

In a letter to Bloomberg, Chatham's lawyers said the firm has generated an annualized return of 6% for CalPERS when including investments before the special fund was set up in 2010.

By the end of March, they added, the annualized return on Chatham's special fund was "significantly higher" than the 2.3% reported through the middle of last year, though a Chatham spokesman declined to provide a current figure. Given the length of time Chatham has held CalPERS's money, the assets that remained at the end of last June would've had to jump significantly in value to bring annualized gains since 2010 to even just 3%.

The 2.3% reported is "not an acceptable return," said J.J. Jelincic, a former CalPERS board member. "Even if there are rational reasons, that shouldn't be acceptable. Clearly somebody was asleep at the switch," he said, referring to CalPERS' oversight of its investment with Chatham. The pension system has said its goal was to generate more than 5% on hedge fund investments.

For years, hedge funds focused mainly on liquid markets, such as stocks that are easily bought and sold. But as competition mounted — including from a growing number of buyout firms — money managers began hunting opportunities more widely. Now, "part of the problem with the industry is that it has some hedge funds that have private equity envy and get into illiquid investments," said Mr. Jelincic, who worked as an investment professional at CalPERS for three decades before retiring. He's now seeking to rejoin its board.

By definition, illiquid assets can be challenging to sell. Ultimately, disposals can help show how well money managers tracked their portfolios over the years.

There are many reasons holdings can be illiquid. Large positions, unusual businesses or investments hinging on complex contracts or that take years to yield profits — as a few examples — tend to draw fewer buyers. That can force owners to decide between waiting for an attractive bid or selling quickly at a depressed price. The infrequency of sales, in turn, leaves less data publicly available to set valuations in other portfolios. CalPERS' broad retreat has essentially been testing how hedge funds valued its positions, according to Tim Jenkinson, a finance professor at the University of Oxford's Said Business School.

"The proof of the pudding is in the eating," Mr. Jenkinson said. "Ultimately when you sell it, an investor gets to see whether you are valuing the assets aggressively or conservatively."

Chatham's lawyers disagree.

"The price at which an asset is sold in the future is not correlated to how a party valued that asset in the past," they wrote in a letter to Bloomberg this week. Chatham, they noted, uses "an independent, well-known, third party" to set quarterly valuations for assets that are harder to value because of a dearth of market prices.

The pension system originally expected to complete its pullout from hedge funds in about a year, according to comments it made when announcing the move in 2014. At the time, it had about $4 billion parked with a variety of managers. Its most recent disclosure shows there was $234 million still outstanding as of last June, with about 87% of it at Chatham. That's enough to meet the annual needs of more than 6,000 pensioners.

One person close to Chatham said the amount still at the hedge fund is now less than $150 million. The pension plan has rejected several proposed sales that would've immediately turned its assets into cash, choosing instead to wait to realize better prices, Chatham's lawyers said. The hedge fund has never shown CalPERS a bid below where the assets were valued, they said.

The challenges of investing in illiquid assets became most acute during the 2008 global credit crisis, when buyers flocked to the sidelines. Some fund managers ultimately halted client withdrawals and waited for the turmoil to subside. The experience left many customers wary of less-liquid markets.

"Chatham is proud to have never restricted redemptions, including during the financial crisis," a spokesman for the firm said. "Since 2017, Chatham's assets under management have increased by approximately $1.6 billion, 80% of which is in three- to seven-year locked vehicles."

Chatham began attracting scrutiny last year as it became clear that American Media's chairman, David Pecker, had worked with Donald Trump's fixer during the 2016 presidential race to head off stories about Mr. Trump's alleged extramarital affairs, a practice known as "catch and kill." In exchange for its cooperation with a federal probe of Mr. Trump's campaign, prosecutors agreed not to criminally charge American Media as long as it stays on the right side of the law for three years.

That was before Mr. Bezos levied his accusations of extortion, saying the Enquirer threatened to publish steamy photos he sent to a woman with whom he was having an affair. Federal prosecutors have said they're reviewing their deal with the publisher, but no decision has been made public. The company has said it engaged in journalism, not extortion.

American Media said in April it's selling the Enquirer to James Cohen, the owner and CEO of Hudson Media, who's previously done business with Chatham. They have yet to announce that the $100 million transaction has closed.

New Jersey has the right to liquidate some or all of the hedge fund that Chatham manages for the state near the end of the year. Chatham also manages a $225 million private debt fund for New Jersey that is locked-up for several years.

CalPERS first invested with Chatham more than a dozen years ago. In 2010, the hedge fund created a separate portfolio for CalPERS called the Chatham Eureka fund. For years, the vehicle reported gains.

After CalPERS announced its pullback from hedge funds in 2014, Chatham met part of the redemption relatively swiftly, shrinking the special fund from its peak of about $600 million in assets.

Chatham's contract to manage the Eureka fund runs out at the end of the year. If the fund still holds securities, the pension plan can choose to take over the investment itself, extend the life of the fund, or even replace Chatham with another manager, according to Mr. Davis, the CalPERS spokesman.

American Media said the Enquirer sale will help eliminate $100 million in debt. That, in turn, could make CalPERS' investment more valuable and help return the pension system's money.