Exclusive: CalPERS to Announce Direct Investment Program

‘CalPERS Direct’ would help largest US fund to bypass high fees.

Officials of the California Public Employees’ Retirement System (CalPERS) are expected to announce Thursday a $13 billion direct investment program that would give capital to start-up companies in the later stages of venture capital funding and also make direct investments in more established companies.

A CalPERs press release says the program, called “CalPERS Direct,” is aimed at bypassing the high fees the retirement system, the nation’s largest with nearly $350 billion of assets under management, pays when it partners with traditional private equity general partners or venture capital firms. 

Typically, CalPERS pays a management fee of 1% to 2% of invested assets to a private equity or venture capital firm but also has to pay around 20% of the profits made, known as carried interest, to the investment firm.

CalPERS officials aim to initiate CalPERS Direct in the first half of 2019 pending board approval, the release says.

If CalPERS officials succeed in implementing the plan, the retirement system would become the first US public pension to make large-scale direct venture capital and private equity investments without investment partners. Canadian pension plans have been making such investments for several decades.

The CalPERS plan called for a separate investment entity, independent of CalPERS with its own board, to run two separate investment funds: one for the later stage venture capital investments, the other investing in more established companies in a buy-and-hold strategy.

For venture capital, CalPERS would be following a playbook charted by Tokyo-based Softbank Group, which has been plowing billions of dollars into late-stage funding for Silcom Valley start-ups.

It’s not immediately clear how the $13 billion would be split between the two funds and whether CalPERS would need approval of the California legislature to create the independent investment entity.

The CalPERS press release says that up to $13 billion a year will need to be invested in private equity to achieve a ten percent allocation of the portfolio.

“We’re excited to move forward with this new approach for CalPERS,” said Ted Eliopoulos, CalPERS chief investment officer in a statement.  “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.  We believe it will drive stronger private equity returns and help achieve economies of scale over time.”
At least one CalPERS board member criticized CalPERS announcement of the new program, nothing that the press release stated the program was subject to final approval of the board, but in fact the board has never ever given preliminary approval to the new private equity effort.

“The May 17 press release at best was a premature characterization of CalPERS’ private equity restructuring plans, since the organization cannot adopt any plan of this magnitude without first receiving the board’s approval, and the board cannot responsibly consider any proposal such as the one described in the CalPERS press release,” said board member Margaret Brown.” At worst, the CalPERS press release might be seen as an attempt to force the board’s hand.”

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.

Eliopoulos, who discussed a portion of the direct investment plan back in July 2017, won’t likely be around to see the plan implemented, if the board approves it.

He announced earlier this week that he will be leaving the retirement plan by early 2019 and moving to New York City due to the health issues of one of his daughters, who will be attending college in New York.

CalPERS also does not have a private equty director. Réal Desrochers, managing investment director of the CalPERS private equity program, left in April 2017.  A replacement has not yet been named.

At board meetings over the last year, CalPERS investment staff and board members have discussed the advantages of creating a separate private equity investment entity. The entity in theory would exist to get around state civil service rules that limit compensation paid to investment staff, which typically amounts to several hundred thousand dollars a year.

In comparison, direct investment staff at Canadian pension plans can make more than $1 million a year.

Eliopoulos first discussed the direct investment program in an interview with reporters in July 2017 after a panel discussion on the merits of CalPERS running its own direct investment program.

At the time, Eliopoulos said the program would eschew the typical buyout fund private equity model. Under a typical investment fund, private equity companies buy portfolio companies, often using leverage, and then attempt to sell the company after a multi-year period to a higher bidder or prepare the company for an IPO.

Instead, Eliopoulos said CalPERS would buy controlling stakes in companies, but take a buy-and-hold approach, similar to that of Warren Buffett, looking for a steady stream of profits over the long haul.

In a separate interview in January 2018 after another CalPERS meeting, Eliopoulos expressed frustration about how private companies increasingly are staying private longer, leaving CalPERS without the opportunity to profit from those companies because they are not in its $170 billion stock portfolio.

“We think there is an opportunity for CalPERS to invest in private companies, perhaps at later stages of the venture cycle,” Eliopoulos said in the interview. “Companies that have gone through their first, second, third, fourth venture round but aren’t ready yet…to go public, that’s an opportunity.”

Eliopoulos said he hoped California could take advantage of its home state advantage as home of Silicon Valley in finding suitable VC investments. There is no shortage of later-stage venture companies seeking funding, but those investments can also be seen as speculative.

Only around $1 billion of CalPERS $27 billion private equity program is in VC funds. Eliopoulos has said traditionally CalPERS’s size has made it difficult to invest in smaller VC funds, that might only have several hundred million in AUM. He also said state transparency rules have made some VC funds reluctant to work with the pension fund.

The new plan comes as 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.

But Eliopoulos has said that he expects returns to fall because of high valuations of companies that are targets of buyout funds. Another issue: increased competition between institutional investors seeking deals. CalPERS paid more than $700 million in private equity fees and carried interest in the fiscal year ending June 30, 2017.

What’s unclear if the new private equity program goes though is what happens to the existing program.  With money from funds liquidating going potentially into the direct investment program instead of new buyout funds, CalPERS’s traditional private equity program could change drastically. 

Back in December, CalPERS asked money management firms to submit information requests for ideas on how they would run the program. The release says a review of those proposals is still in progress.

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