The investment committee of the California Public Employees’ Retirement System (CalPERS) could approve the creation of an up to $20 billion direct investment-style private equity program in two weeks, part of a message to Wall Street that the nation’s largest pension plan is serious about building its private equity capabilities.
“We need to cast a wide net to the financial community to say we are serious about this,” CalPERS Chief Executive Officer Marcie Frost told CIO. She said the potential vote on the plan could come at the next investment committee meeting on March 18.
“It would be a signal to the financial markets that the investment committee is approving the concept and would then allow the [CalPERS] staff to continue the exploration of talent,” to run the new program, she said.
Frost said she is working with Bill Slaton, chairman of the CalPERS investment committee, to draft the resolution creating Innovation and Horizon. Innovation would invest in late-stage venture capital, and Horizon would take buy-and hold-stakes in established companies. The stakes are big: CalPERS plans to commit up to $20 billion to the new organizations over the next decade.
Most investment committee members, who are also CalPERS board members, support the plan, but this would be only the first vote.
Frost said a second vote would be necessary to put Innovation and Horizon in business.
Both Innovation and Horizon would be run by CalPERS-chosen general partners, with the pension plan being the sole limited partner. The concept is different than direct private equity investments made by some other global pension pensions. For example, in Canada, the pension organizations often make direct investments in private equity without a general partner.
Frost spoke to CIO after a California State Retirees Board of Directors meeting in Sacramento on February 28. The group represents some 38,000 CalPERS retirees. Frost and CalPERS Chief Investment Officer Ben Meng touted the planned private equity program at the meeting.
The CEO said it would be unclear how long it would actually take to implement the new private equity program following a positive vote by the investment committee.
“We don’t know that we can execute either six months, 12 months, two years, but … conditions have to be perfect for CalPERS, and if they’re imperfect, we will not execute on them,” she said.
Frost said finding top-notch investment teams are essential for the new plan to work. “We don’t know we can successfully find a team of talent,” she said. “We are not going to push it through.”
The new initative would be an addition to CalPERS’s traditional $28 billion private equity program, which makes up 8% of the system’s $345.7 billion portfolio.
Private equity is CalPERS’s best-producing asset class. For the fiscal year ending June 30, 2018, returns were above 16%, and the plan returned 10.5% on average annualized over the last 20 years. The problem, CalPERS officials say, is that they can’t expand the traditional program, made up mostly of co-mingled buyout funds. They say they face too much competition from other institutional investors, who also want places in funds run by top-rated external private equity managers.
At the February 28 meeting, several top officials of the California State Retirees expressed concern the new private equity plan was too risky, but they listened respectfully as Frost and Meng explained the program. The association has taken no official position on the new initiative.
Meng, who took over as CalPERS CIO in early January, told the retirees that Innovation and Horizon were “crucial for CalPERS’s success.”
He said officials of other public pension plans have told him privately they wish they could imitate CalPERS in its private equity initiative, but don’t have the size and scale of the Sacramento pension plan.
“We have a competitive advantage ahead of our competitors, who are smaller,” he said.
Meng has been touting the private plan for the last two months, arguing that it is a way to expand the private equity program and also pay lower fees. (Private equity firms normally take 20% of the profits from CalPERS and also charge management fees of up to 2%).
Private equity is the only asset class that is projected in the next decade to return over 7%, CalPERS’s expected annualized long-term rate of return. Private equity is expected to generate returns of 8.3% on an annualized basis over the next decade for CalPERS.
Meng said with CalPERS only having a funding level of 70%, building the private equity asset class is essential. “A lot of pension plans are in a similar boat,” he said.
Critics, including several and former CalPERS investment committee members, said they are concerned about transparency issues related to CalPERS’s foray into direct-style private equity investing. They note that under the initial plan, the compensation of the investment teams of Innovation and Horizon won’t be disclosed to the public.
The general partners of the two investment organizations are expected to earn millions of dollars a year but the compensation will be only known to CalPERS officials.
Meng told the retirees that some secrecy is necessary given the world of private market investments. He said information can’t be disclosed about potential investment teams before they are hired because they are now working at other private equity firms and don’t want their employer to know they’re negotiating with CalPERS.
CalPERS has already been negotiating with potential investment teams, but Frost said the resolution creating the new investment organizations would allow investment staff to go further, negotiating contracts.
Meng called Innovation and Horizon, “experiments” saying, “this may or may not work now.” He warned retirees that CalPERS must still proceed. “If we don’t get ready now, when the opportunity arises, we will not be ready.”
The CIO told the retirees that he was providing as much information as possible about the new private equity initiative without jeopardizing the potential investment opportunities.
“We tried to balance the responsibilities of being a public agency as well as our fiduciary duty to you all,” he said.