The proposal by the California Public Employees' Retirement System to create its own merchant bank seems like an appropriate outgrowth for the energetic and innovative system, the largest defined benefit fund in the Western Hemisphere. Operating a merchant bank, however, is different from investing through an outside merchant bank. The issues the proposal raises in terms of staffing, compensation, monetary incentives, competition, performance and oversight, among others, prompt questions as to whether such a move is appropriate or can be successful.
Running a merchant bank is more complicated than running an in-house equity or fixed-income portfolio. CalPERS would capitalize the bank with $500 million to $750 million and invite some other major public pension funds on the West Coast and in Australia to join it. The bank would pursue direct equity deals and other alternative investments in Asia.
Certainly CalPERS has the wherewithal to establish pretty much anything it wants. Few organizations have as much capital or latitude in investing or operating. But money can't buy it everything.
Clearly there is a worthy need for alternative investment and merchant banking activities. This financing fosters the development of new or re-engineered businesses to keep economies vibrant.
The only reason for starting a business is because you think you can make more money at it than by using solely outside providers. Merchant banking is a highly competitive, skilled business and needs professionals of keen expertise and contacts. These people demand very high compensation. If successful, they could easily bolt to other merchant banks or start their own, raising capital and finding deals with the contacts and expertise they've developed. The pension fund-operated bank would have to find qualified people to replace those who leave.
CalPERS, like any public pension fund, has an obligation to taxpayers to be accountable and open with its activities. Such activities, especially involving the payment of large salaries or bonuses, may not sit easily with the public; such disclosure on fees or terms on private transactions may put the bank at a unfair disadvantage with competitors in making deals. The proposed merchant bank risks being politicized, as happens in public pension funds, such as when the California Legislature required CalPERS to restrict South African investments, harming the returns at the expense of other goals.
Bringing in other pension fund partners in the merchant bank would spread the risk. But it probably would also lessen CalPERS' control, presumedly the principal reason for starting its own bank.
By having its own bank, CalPERS may lessen its ability to deal with other merchant banks, which may think, whether fairly or not, the system would use information other bankers provide for its own bank to their disadvantage. CalPERS understandably may want to send as much business to its own merchant bank, even risking profitable relationships with other merchant banks. The performance or effectiveness of such a bank would be hard to measure and after the huge capital used to set up such a venture, the system may be reluctant to hold it to rigorous standards.
All in all, while CalPERS has the clout and money to establish such a bank, there is no compelling reason to do so. This proposal needs careful examination.