The approval Monday by the investment committee of the California Public Employees’ Retirement System (CalPERS) creating two new private equity organizations came after a plea from the system’s chief investment officer calling for support of the plan.
“We cannot access private equity, access private equity exposure on the scale that we need, and then there are characteristics of the conventional private equity business model that are suboptimal in terms of our needs, namely the higher fees, lower transparency, and a relatively lower control,” CIO Ben Meng told the investment committee Monday.
The plan approves the concept of creating two new investment organizations for CalPERS to invest in late-stage venture capital and take buy-and-hold stakes in establishment companies.
CalPERS is the one of the largest private equity investors in the world—and its $27.8 billion portfolio is the largest in the US—but its program, made up largely of limited-partner stakes in buyout funds run by private equity firms, has been rapidly shrinking.
The private equity asset class made up 7.9% of CalPERS’s $351.1 billion portfolio as of January 31, down from around 12% six years ago.
Meng said competition from other institutional investors to participate in funds run by top managers has reduced CalPERS’s opportunities to be in prime funds with the best-expected returns. Fees are another issue. CalPERS paid more than $700 million in fees to private equity partners in the 12-month fiscal year ending June 30, 2018.
Private equity is CalPERS’s best-producing asset class, with a 10.5% average in a given year over the last 20 years. Without expanding the asset class, the pension system will not be able to make its annualized average annual return of 7%, Meng has said. He said this would decrease CalPERS’s funding level, estimated around 70%, even more, causing additional contributions from government units, many which are already seeing soaring CalPERS bills. Private equity is expected to earn an average 8.3% annualized over the next decade.
CalPERS investment officials see forming two investment vehicles, Innovation and Horizon, as a way to build the private equity program.
Innovation would make direct-style investments of up to $10 billion in late-stage companies in the venture capital cycle. Horizon would take buy-and-hold stakes, also up to $10 billion, in established companies, similar to what Warren Buffett does with Berkshire Hathaway.
However, the actual implementation of Innovation and Horizon, could still be months away, or even longer.
The plan approved by the investment committee on Monday gives CalPERS investment officials the power to negotiate contracts with investment teams for the new organizations.
The private equity plan would then come back to the 13-member investment committee for final approval. An outside investment consultant would also give the investment committee its prudent-person opinion before the vote.
Meng has not given a timetable as to when the new investment organizations could start but said before Monday’s vote that it “will help ensure CalPERS is able to bring potential (investment) partners to the table.”
Meng, who took over as CalPERS CIO three months ago, said finding the right investment talent is key to making the new program work.
There are still three skeptics on the 13-member investment committee: Margaret Brown, Jason Perez, and State Controller Betty Yee. Concerns raised by the three include the lack of transparency surrounding Innovation and Horizon. The two investment organizations would be funded by CalPERS but run by general partners who would control investment decisions.
In addition, the compensation of the general partners and their investment teams—which could run into the tens of millions of dollars—would not be disclosed to the public.
One irony is that the biggest critic of the plan is former CalPERS investment committee member J.J. Jelincic. He also worked as a CalPERS investment officer for several decades.
Meng, who also used to work at CalPERS as an investment official and knew Jelincic, said last month that it was Jelincic who helped convince him to take the CalPERS job. The two remain friendly, but continue to differ on the private equity plan.
Jelincic was at Monday’s meeting voicing his opposition to the plan. He questioned whether lower private equity fees would result from the plan and discussed the transparency issue regarding the lack of disclosure of compensation of the investment staff of the new organizations.
“Direct the staff to continue to explore and develop this plan,” he told the investment committee. At the same time, he urged a no vote against the plan, saying it kept changing, and was not ready to be voted on.
Meng maintains that the proposed structure, with general partners running the investment organizations and CalPERS serving as the sole limited partner, is the best way to launch the new investment organizations as quickly as possible. The CalPERS plan differs from what Canadian pension plans do, often making private equity investments directly without general partners.
He says CalPERS should ultimately over time save some of the fees it pays private equity partners through the new investment organizations. CalPERS currently pays external managers running its buyout funds management fees of up to 2% and 20% of the profits. Meng has not, however, offered specifics as to how much in fees could be saved. He also admits that fee savings might not be in the beginning years of the private equity investment organizations as they are getting off the ground.