CalPERS CIO Says Pension Plan Must Create New Private Equity Organization

Plan is essential if CalPERS wants to avoid increasing its approximate $140 billion unfunded liability, Meng says.

Ben Meng, the new chief investment officer of the California Public Employees’ Retirement System (CalPERS), is not only unequivocal in his support for a new CalPERS-backed private equity investment organization, he has told state lawmakers that it is essential to help investment returns and prevent the system’s approximate $140 billion unfunded liability from growing.

Meng told a joint hearing of the Senate Labor, Public Employment and Retirement Committee and the Assembly Public Employment and Retirement Committee on Feb. 13 that achieving the retirement system’s 7% yearly expected average annual rate of return would be “a very tall order” without building new private equity investment capabilities.

Private equity is CalPERS’s best-producing asset class, long- and short-term. In the fiscal year ending June 30, 2018, it produced returns of 16.1%.

CalPERS has an existing $28 billion private equity program, consisting mostly of co-mingled buyout funds run by external general partners, but it makes up only 8% of the pension plan’s $345.7 billion portfolio. It also has been shrinking as the pension system competes with other institutional investors to become part of new funds.

Just eight weeks into his job, Meng has championed a plan first proposed by his predecessor, Ted Eliopoulos, in the summer of 2017. CalPERS would back two funds, Innovation, an investment vehicle that would invest up to $10 billion over a decade in late-stage venture capital investments, and Horizon, which would invest up to $10 billion over the next 10 years by taking buy-and-hold stakes in established companies.

Meng is not just pushing the plan before state lawmakers, who have no say in the actual decision to create Innovation and Horizon. On Feb. 21, Meng told the system’s investment committee, who will cast a vote on the expansion plan, that private equity is the only CalPERS asset class that is expected to generate a return above 7% in coming years, with an assumed average investment return of 8.3%.

He said stocks are only expected to produce a 6.8% average annualized return. Meng has made enacting the private equity program a major part of his eight-week tenure, first advocating his support for the program at CalPERS’s semiannual retreat meeting in January.

“If you are trying to achieve a 7% return—and there’s only one asset class that is forecasted to deliver more than 7% of return—you need that asset class in the portfolio, and you need more of it,” he told the investment committee.

Without an expansion of the private equity program, Meng told the investment committee that CalPERS could be forced to lower the expected rate of return under 7%, which would increase the system’s unfunded liability by billions of dollars, and raise contributions for the hundreds of cities, towns, special districts, and school districts that are part of CalPERS.

Those groups are already dealing with increased contributions from CalPERS investment committee’s decision to lower the expected rate of return in 2016 over three years to 7% from 7.5%

CalPERS, the largest US pension plan, is only around 68% funded.

A vote on the private equity plan could come as soon as next month.

Most board members have been supportive of the plan to create Innovation and Horizon, but its structure has become part of a controversy. Originally, in 2017, Eliopoulos proposed a direct-style private equity investment organization similar to Canadian pension plans, which often invest in private equity directly without external general partners.

That proposal has changed to making Innovation and Horizon CalPERS-funded, but actually run by external general partners who would invest solely for CalPERS. Compensation of the investment officials of the two funds would not be disclosed and they would not be subject to public disclosure laws.

Meng told the investment committee that eventually CalPERS might be able to run its own private equity organization, but not now. He said the pension plan does not have the in-house expertise and its location in Sacramento, which is not a global financial center, would deter world-class investment professionals from joining.

“I do not view that as a viable option,” he said of CalPERS running a direct private equity investment organization in the near future.

Former CalPERS board member and investment staffer J.J. Jelincic, a critic of the new private equity plan, told CIO that a lack of transparency about the planned organization is troubling. He also said CalPERS officials haven’t revealed enough specifics of the plan to make him comfortable.

“The fact that they have not defined the exact structure, makes me believe they have not thought it through,” he said.

Some CalPERS investment committee members have discussed similar concerns at public meetings, but the majority of the 13-member committee seem willing to let Meng call the shots. None have been as vocal as Jelincic, who has been a regular attendee at CalPERS meetings attacking the plan.

Jelincic also rejected Meng’s statement that CalPERS couldn’t attract the investment talent to run a direct investment program because it is located in Sacramento.

Jelincic said CalPERS investment teams could be located in cities other than Sacramento, a practice of other global pension plans, who often have offices in varied locations.

Meng rejects the transparency issues.

Meng told the investment committee and state lawmakers that the new program would be more transparent than CalPERS’s current legacy private equity funds run by general partners, and ultimately fees would be less, though he has not offered details. CalPERS generally pays a management fee of up to 2% to private equity general partners and gives up 20% of the profit.

In his discussions with the CalPERS investment committee, Meng conceded that the new private equity plans has risks and might not generate the investment returns that are anticipated. He said, however, that given CalPERS’s underfunded status and a slowing global economy that would impact investment results in a negative way, “doing nothing is not an option.”

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