The California Public Employees’ Retirement System (CalPERS) manages the largest public pension fund in the United States. The pension fund’s investment committee voted 10-3 on March 18 (day one of its three-day board meeting), to move forward with a plan that could add another $20 billion in private equity investment into the portfolio as a means to improve investment returns and overcome increasing pension liabilities.
Monday’s vote isn’t binding and the plan still needs to clear one more board vote before CalPERS can move forward with the new investments. The new allocation, if granted final approval, is a large addition to the $27.6 billion in private equity investments currently held by the organization, but still a modest portion of the fund’s $356 billion in market value under management.
Private equity transactions involve a large variety of ownership arrangements like the outright purchase/buyout of an entire company, spin-off of a division, partial equity interest, funding growth initiatives, capital raises, balance sheet rebalancing, etc. While the returns can be a meaningful premium to equity investments, there is concern with liquidity and unwinding a position if needed. Further, some of the dissenting board members have voiced concern with transparency and control.
Under the plan, CalPERS would establish four distinct investment paths for its private equity holdings – emerging managers, a partnership model, CalPERS Direct Innovation and CalPERS Direct Horizon. CalPERS Direct Innovation would seek investment in late-stage tech, life sciences and healthcare entities, while CalPERS Direct Horizon would seek long-term investments in core economy established companies.
While a good portion of a private equity investment is done through a fund manager, some opposed to the asset reallocation at CalPERS are concerned with the lack of visibility into the real value of the underlying asset because there isn’t a daily closing price listed on an exchange. Additionally, private equity firms receive profit sharing in addition to investment expenses (up to 2 percent management fees and 20 percent profit sharing). This has raised concern that in addition to minimal visibility into the investment and its value, exactly what is paid for these investments to be managed would also not be known.
“We cannot access private equity 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,” CalPERs’ Chief Investment Officer, Ben Meng, conceded on Monday reported Chief Investment Officer.
Even with the noise around private equity transactions, the plan to create two new ventures to invest in private equity and hire a fund manager will likely be approved.
A common desire among investors of all levels of sophistication is the search for return. While the equity markets saw a meaningful run-up in late 2016 and throughout 2017, the markets have largely been range-bound for more than a year now. The recovery in equities has given pension funds a brief respite in their ongoing battle to properly fund their liabilities.
The battle ensues as many pension funds remain underfunded and often have more recipients than contributing participants. Moody’s Investors Service recently estimated that public pensions are $4.4 trillion underfunded, which is significantly higher than the aggregated data from state pension funds, which reported a combined $1.4 trillion in funding deficits in 2016.
Seeking higher returns is becoming the only lever that can cure pension fund balance sheets without reducing benefits payouts. However, most politicians aren’t jumping the line to advocate for riskier investment parameters.
State pension funds are typically governed by the legislature, which determine the percentage of workers' salaries that can be replaced in retirement and how much the government will contribute to the funds annually. From there, the legislature then delegates the operation of a pension fund to a board and oversees the risk parameters allowed to the money managers.
Investors in search of yield have turned to private equity transactions for sometime now. This is nothing new. What’s somewhat new is the willingness, likely spawned out of need, for seemingly large, risk-averse investment funds to tap into the private equity markets with more frequency and depth.
CalPERs’ Meng stated Monday, “As I said last month, we need private equity to be successful. We need more of it and we need it sooner rather than later,” reported The Sacramento Bee.
Marcie Frost, CalPERS chief executive officer, called out private equity in her November 2018 letter of transmittal in the fund’s fiscal year 2018 annual financial report. “I am pleased to report our earnings are above our 7 percent goal with an 8.6 percent net return on investments. Solid returns came from the private equity program, which generated a 16.1 percent net return,” outpacing the next asset class by more than 450 basis points (bps).
This isn’t a recent windfall either and she made it known that this asset class was required to help the fund achieve its return targets. “Since private equity is our highest returning asset class, averaging 10.5 percent over the past 20 years, we need a program that helps us achieve our 7 percent return target and hit our goal of investing 8 percent of our fund in private equity. We believe this proposed new model will help drive higher returns and allow us to take advantage of new investment opportunities.”
Other pension funds are moving to the private equity route as well. The Virginia Retirement System, or VRS, which manages the defined benefit and defined contribution plans for Virginia’s public sector employees ($80 billion in market value, 19th-largest pension fund in the U.S.), has seen increased growth in its exposure to private equity.
Private equity investment accounts for 11.6 percent of the fund’s investment strategy compared to just 5.1 percent in 2014. Further, this asset class sees returns higher than its other asset classes in every comparison (1-year, 3-year, 5-year and 10-year). The VRS Chief Investment Officer’s Letter penned by Ronald D. Schmitz noted the importance of the private equity group. “The Private Equity team had a strong year with a portfolio return of 15.8 percent,” he wrote. The next closest asset class trailed by 610 bps for fiscal year 2018.
It appears that private equity will continue to gain favor even among what had historically been viewed as a largely risk-averse group of investors.
For now, the CalPERS private equity plan will head back to the investment committee at a future date for a final vote and then an outside consultant needs to provide its blessing before implementation.