Investment officials at the California Public Employees’ Retirement System (CalPERS) are moving quickly to implement a first for a US public pension plan: the creation of an independent investment organization that plans to make $13 billion in direct investments in private equity and venture capital.
The plan still needs approval of the $350 billion fund’s board, but CalPERS Chief Investment Officer Ted Eliopoulos told CIO in an interview on Thursday that the CalPERS board has already authorized beginning the search for investment leadership of the new organization as well as developing its organizational structure. He said that occurred at a closed session meeting on May 14.
Eliopoulos said that CalPERS is not planning to ask the state legislature for permission to create the new investment organization. “We don’t believe we need any outside approval,” he said
Eliopoulos sees the CalPERS board approving the plan in early 2019 with the new investment organization beginning the process of finding investments within a month after that.
Major pension plans in the US and around the world have been wrestling with what to do with their private equity programs in a higher-cost environment. It’s become more difficult for private equity funds to make oversized profits because of the high valuations of companies that are targets of private equty funds. Fees are another big issue; increased competition between institutional investors seeking deals means CalPERS and other pension plans are finding it hard to negotiate discounts from private equity general partners.
CalPERS paid more than $700 million in private equity fees and carried interest in the fiscal year ending June 30, 2017, giving around 20% of its profits to general partners who manage the investments.
Eliopoulos’s aim is to solve some of those problems, but critics warn that the plan is risky with no guarantee of success, as attracting top investment personnel experienced in venture capital and buying large equity shares in companies could cost tens of millions of dollars alone.
“Our investment team has spent months exploring options in order to design an approach to private equity that takes advantage of our size and brand,” Eliopoulos said. “We believe it will drive stronger private equity returns and help achieve economies of scale over time.”
The program, called “CalPERS Direct,” would consist of two separate funds run by an investment organization that would be set up by CalPERS, with not only its own independent investment staff, but its own board.
One fund would focus on late-stage venture capital investments in technology, life sciences, and healthcare, competing with the likes of Tokyo-based SoftBank that has been putting billions into later stage start-ups. Despite being headquartered in California, CalPERS is only a bit player in the Silcom Valley start-up scene. Its $27 billion private equity program, one of the largest pools of private equity capital in the US, contains only $1 billion in investments in venture capital.
The other fund would focus on long-term investments in established companies using a buy-and-hold strategy like that of Warren Buffett.
Eliopoulos said those two funds would operate alongside CalPERS’s existing private equity program, which is heavy on buyout funds.
While CalPERS would not have direct control of the new investment organization, Eliopoulos said ultimately the retirement plan will “always retain the right over how much capital we committed and how to wind down operations.”
“We would never give up that ultimate control,” he said.
Not all CalPERS board members are convinced of the need for the new organization. Board member Margaret Brown emphasized in her own press release that the CalPERS board has not given final approval to the program.
Brown said the board “cannot discharge its fiduciary duty” without seeing budgets, business plans, and an analysis of risks for the new private equity program. She characterized a CalPERS press release on Wednesday as misleading because she said it implied that the CalPERS board was further along in approving the program than it actually was.
Former CalPERS board member J.J. Jelincic, a CalPERS watcher who left the board last year, said he is concerned the new investment organization would not be accountable to the public or even CalPERS board members, being able to hide compensation of staff members and its expenses.
He said the program could actually potentially cost more than the current CalPERS private equity investment model because of huge multi-million dollar compensation packages that would have to be paid to attack top investment talent.
Eliopoulos told CIO that the creation of a separate investment organization will allow CalPERS to get the best staff necessary for the direct investment program.
“We need to find talent that perhaps won’t be located in Sacramento, will be in different geographies around the globe, and that we can compensate at market levels of compensation,” he said.
A hallmark of the direct investment model, which has been implemented by large pension plans in Canada, can be making investments without the help of investment partners.
Eliopoulos has acknowledged in the past that the CalPERS current private equity staff has the ability to source which private equity funds to become investors in as limited partners, but lack the ability to actually pick investments.
What CalPERS is planning is somewhat of a hybrid model between its current model and the Canadian model.
Eliopoulos told CIO the new investment organization would still have investment partners, known in the private equity world as general partners. He said while those partners would work for the CalPERS-created investment organization, they would still be classified as general partners. He said the new investment organization would be the limited partner.
This mean potentially that general partners in the new investment organization could still collect the 20% of profits that general partners usually in receive in private equity or venture capital deals, which can amount to millions of dollars when a fund winds down after a set period of time.
However, in a buy-and-hold strategy, which would be the hallmark of one of the CalPERS proposed funds, CalPERS would have to figure out other ways to compensate investment staff with lucrative bonuses, since investments would be keep for the long term, supposedly past the normal private equity cycle of seven to 10 years.
One CalPERS board member, who asked not to be identified, said the CalPERS trustees were told in a closed session this week that investment firms could be “raided” and entire investment teams could be hired away from venture capital and private equity firms to staff the new investment organization.
Eliopoulos said there have been some preliminary conversations with persons who could be managers of the new organization.
CalPERS is in the midst of lowering its return expectations to 7% from 7.5% because of lower projected future investment gains.
Private equity has been CalPERS’s best return-producing asset class. Over the 20-year period ending March 31, 2018, the private equity portfolio produced returns of 10.8% compared to 5.9% for the system’s stock portfolio. Despite that, the private equity portfolio has underperformed CalPERS’s custom benchmark over the years, never fully delivering the expected returns in part because of the fees paid to general partners.