Exclusive: An Inside Look at CalPERS’s New Direct Private Equity Organization

Investments of $20 billion in two CalPERS-backed independent pension organizations would change the face of institutional investing in private markets.

As the California Public Employees’ Retirement System’s (CalPERS) direct private equity program begins to take shape, pension officials say they are planning two separate $10 billion investment programs for their forays into venture capital and a second initiative to make buy-and-hold investments in established companies.

The $20 billion won’t be fully funded at once, however, John Cole, a CalPERS investment director, told CIO. He said CalPERS is planning infusions of $1 billion to $2 billion a year separately for each of its investment vehicles and that full funding could take a decade.

The start of the program, known as “CalPERS Direct,” could also be delayed since it needs final approval from CalPERS board members. CalPERS CEO Marcie Frost said last month that investment officials hoped to have the final plan before the CalPERS board in November. Cole said while November is still possible,  it might be early next year before the board sees the plan.

Approval is likely for the program, given that the CalPERS investment staff has already received a go-ahead from the board to meet with potential investment personnel who would staff the new organizations and develop their structure. The two investment organizations already have names, Innovation and Horizon.

One thing is certain: As CalPERS lays out its plans for two private equity direct investment organizations—the first of a kind for a US public pension plan—all eyes in the institutional investment community are on the retirement plan.

With $352.8 billion in assets, CalPERS is the largest pension plan in the US. Its $27 billion private equity portfolio is also the largest in the US, but a shortage of investment opportunities has meant the portfolio only makes up 8% of the system’s overall portfolio instead of the 10% CalPERS wants to achieve.

The direct investment plan aims to change that, finding CalPERS additional opportunities in addition to  its traditional private equity fund program in which the pension plan invests as a limited partner in a fund structure with a general partner.

Ultimately, CalPERS’s success with direct investments will depend on its ability to attract top-notch investment talent to its new private equity investment organizations, says David Wessel, adjunct professor of finance, and a director of executive education at the University of Pennsylvania’s Wharton School.

“The biggest question is will [CalPERS] be able to attract the right investment talent to get the access to the big deals,” he told CIO.

Wessel said in Silicon Valley in particular, there are only 50 or so investment professionals who “can open the door” for CalPERS to find the top investment deals.

Cole said CalPERS plans to do just that—attract the top talent—matching private equity firms and paying the multi-million-dollar compensation packages that investment staffers can make in the outside world.

Cole says a budget for the organizations are still being developed but says one unique quality is the CalPERS-backed organizations will have a flatter structure than normal private equity organizations, meaning it won’t only be the investment leaders that get the bulk of the compensation.

CalPERS’s Innovation investment organization plans to focus on late-stage venture capital details in technology, life science, and healthcare companies, in what Cole says will be rounds four, five, and six of the venture funding cycle, also known as D, E, and F investment rounds.

“It would be more likely companies that are approaching $1 billion in market cap, the so-called unicorns, that we’d be interested in,” he said. Cole said the $1 billion number is not meant to be a “floor or ceiling” but just indicative of potential companies CalPERS might want to invest in.

CalPERS is far from the only institutional investor interested in the late-stage venture investments.

“The $100 billion Softbank Vin Fund made waves in the global VC investment community when it was announced in 2017,” notes a July report from consulting firm KPMG. “Since that time, other VC investors have announced large funds to try and compete for late-stage venture deals, including Sequoia, ($12 billion), Battery Ventures, ($1.25 billion), and General Catalyst, ($1 billion). Even the EU is getting on board the mega-fund trend, introducing Venture EU in Q2 18, a $2.6 billion fund intended to drive investment in the region.”

The report noted that even SoftBank has suggested that a second vision fund is coming, “a sure sign that mega-funds will continue to be a significant contributor to the VC market in the quarters and years ahead.”

Wessel said the CalPERS Innovation fund would be large enough scale to compete for deals in the later-stage venture cycle.

Cole said until now, CalPERS has been in effect shut out of venture capital investments. Only around 1% of the CalPERS private equity portfolio is in venture capital funds, which Cole attributes to a variety of factors, including the smaller nature of venture capital funds given CalPERS’s large size and California state transparency requirements which made funds reluctant to invest with CalPERS.

“It’s an irony with Silcom Valley in our backyard,” he said.

CalPERS’s second investment organization, Horizon, will invest in more established companies. Cole sees those investments as being “infrequent” and “lumpy.”

“We could conceive easily of going more than a year not investing in anything, and then once we do it, it might be large, it might be a billion dollars or more in a single company, if we find the right situation.”

Cole does not want to compare Horizon to the practices of Warren Buffett, who acquires companies through publicly traded Berkshire Hathaway and is considered one of the world’s top investors.

But there are many similarities as to what CalPERS wants to do, though it remains to be seen whether the CalPERS-backed organization can match Buffett’s investment record.

Cole said Warren Buffett’s model of buying a company without a specific intension to sell it by a specific date is what CalPERS wants to do. “We want to able to be unconstrained by an artificial date that says “this is the when a fund is going to end and therefore there has to be a sale or a distribution. That’s what we’re getting away from.”

Cole envisions investing in companies that are central to the core economy, companies “with an enduring business model.”

Not all Horizon investments may be traditional stakes in companies. Cole does see some potential special situation investing for Horizon. He cites as an example, when Buffett during the financial crisis poured $5 billion into then-troubled Goldman Sachs in exchange for preferred shares of stock.

Buffett was estimated to have made $1.75 billion, a 35% return on his investment, during the two and a half years he held the preferred stock.

CalPERS Direct is not without controversy. While the overall board supports the plan, some members have expressed concern over the lack of direct control CalPERS would have over the two independent investment organizations. They also said they are worried about the cost of funding the two organizations, a figure CalPERS has yet to disclose to board members.

CalPERS former board member J.J. Jelincic said in an interview that he thinks the term direct investing is misleading because both Innovation and Horizon, while being independent organizations owned by CalPERS, would still have the traditional limited partner (CalPERS) and general partner (investment leaders and staff of the new investment organizations) that make up CalPERS typical co-mingled funds.

What he said would be missing is transparency because the investment organizations would not report details of their financial transitions or compensation of staffers, even to the CalPERS board.

“There is no accountability,” he said. “It’s a con job.”

Cole said the two  organizations would be independent from CalPERS because that structure would allow the necessary compensation for its investment staff. Even in Canada, where Canadian pension plans do some direct private equity investments, he said, turnover of the investment staff occurs with some frequency because government pension system salaries can’t compete with those of private industry.

In fact, CalPERS as it develops the final plan for Innovation and Horizon, it is moving away from more oversight to less.

In June, investment staffers presented the CalPERS board members a plan for the organizational structure of the new investment organizations, showing an oversight advisory board overseeing both Innovation and Horizon. The oversight advisory board was in addition to individual advisory boards already planned for Innovation and Horizon.

Cole said the top layer oversight board has been eliminated in efforts to simplify the structure and remove an unnecessary layer of governance.

The CalPERS investment director stressed that the two advisory boards that remain, made up of investment professionals, would only act in an advisory fashion. Innovation and Horizon investment staffers will be in charge of making their individual investment decisions, he said.

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