CalPERS Advisor: As Tech Startup Model Shifts, Direct Investment Model Makes Sense

Fewer IPOs mean operational efficiencies rather than leverage become more important for private equity portfolio company exits, Sonsini says.

A top advisor to the California Public Employees’ Retirement System (CalPERS) says the retirement plan’s proposed $13 billion direct investment organization makes sense because US tech companies are increasingly staying private, upending the traditional route of startup companies going public after a few years.

Lawyer Larry Sonsini’s comments came as CalPERS, the nation’s largest public retirement plan with more than $355 billion in assets under management, is finalizing plans for its $13 billion private equity direct investment program. Marcie Frost, CalPERS’s chief executive officer, said last month that the CalPERS board could vote on the program at its November meeting with the program operational by the end of 2018 or early 2019.

The CalPERS board is expected to pass the measure approving the program, with most of the 13 members supporting the direct private equity organization.

Sonsini, a founding partner of law firm Wilson, Sonsini, Goodrich & Rosati and a lead counsel in more than 250 IPOs, told the CalPERS board at a mid-July retreat meeting that the rules of the road have changed for startups.

He said 30 years ago, the route to success for startup technology companies and other ventures was a five-year incubation period with various venture capital commitments prior to an IPO. Today, the scenario is often different, he said.

“So, what has happened is these companies are staying private and these big conglomerate, industrial companies, technology companies, both in the US and China mainly, are buying these companies and getting bigger.”

Sonsini said 30 years ago, there were as many as 6,000 US public companies; now the number is half that or less, around 2,500 public companies.

Sonsini has helped companies such as Telsa, Netflix, Apple, and Google go public and is considered one of the top IPO lawyers in the world. He is also advising CalPERS on how to set up its private equity direct investment organization.

He told the CalPERS board that making direct investments in private companies made sense for CalPERS given the reduction in public companies. He also said the traditional private equity model has changed.

“You could agree that a lot of the key of early private equity was financial engineering, the ability to use leverage coupled with an equity check to maximize the cash flow and have an exit,” he said.

In a separate interview with CIO, Sonsini said technological disruption of traditional industries, globalization, and other factors have all made the traditional seven- to 10-year private equity cycle for a buyout fund—the time between buying and selling a company—not as relevant today.

“I would argue the traditional private equity model is stressed,” he said. “You can argue today that as we look at our private equity strategies, it has to be more long-term and have longer duration.”

Sonsini said as investments in portfolio companies are held longer term, operational efficiencies rather than leverage becomes more important for private equity portfolio company exits, so general partners can maximize profits of the portfolio companies they own.

CalPERS Chief Investment Officer Ted Eliopoulos’ plan for the private equity direct investment organization calls for CalPERS to become owners of income-generating corporations in a long-term buy-and-hold strategy.

The strategy is supposed to save on fees paid to private equity general partners and would be the first for a US pension plan on a large scale. But just how much it would cost CalPERS to hire top-notch investment talent, who potentially could receive multi-million-dollar compensation, has yet to be disclosed.

Eliopoulos has mentioned Warren Buffett’s income-generating long-term buy-and-hold strategy of owning companies as an example of what CalPERS wants to do, but it remains to be seen when a CalPERS-backed investment organization could be as successful as Buffet’s Berkshire Hathaway.

A second part of the CalPERS direct private equity plan calls for CalPERS to make venture capital investments in late-stage companies in technology, healthcare, and natural science companies. A company like Uber that is established but has yet to go public might be considered as an example of that kind of investment

Eliopoulos declined requests for a discussion on the planned private equity program at the retreat meeting.

CalPERS has $27 billion invested in private equity, mostly in buyout funds managed by a general partner. In those funds, CalPERS is one of a number of limited investment partners. It also has $14 billion in dry power, money that is scheduled to be invested by private equity funds but has not been called by the general partners. High valuations of potential portfolio companies have made it a difficult environment for private equity funds to buy potential companies at a discount necessary to turn a profit later.

Those traditional CalPERS private equity funds will continue, even with the new direct investment program. However, pension system officials are in the process of reviewing proposals from external managers including BlackRock to manage the traditional private equity program going forward,

CalPERS is one of several major US pension plans that is reviewing its private equity program in efforts to control fees. CalPERS typically pays a 1% to 2% management fee and 20% of the profits to private equity general partners.

With the direct investment program, CalPERS staffers envision a private equity program of more than $40 billion.

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