The $354.68 billion California Public Employees’ Retirement System’s new board members and recently appointed chief investment officer Yu Ben Meng spent a large portion of an investment committee meeting on Tuesday discussing private equity and progress on new programmes.
Here’s what we learned at the session.
- Dry powder and competition for access puts even large LPs at a disadvantage
The current environment of intense competition among LPs to get into the best funds, availability of dry powder and high valuations is leading to challenges in committing to private equity, even for large LPs like CalPERS.
With plenty of LP capital around, investors are at a disadvantage when it comes to fees; GPs can just roll over to the next investor who may not be so price-sensitive, said Andrew Junkin of Wilshire Associates, CalPERS’ investment advisor.
CalPERS has to write large cheques for its $27.8 billion private equity portfolio, and that creates capacity constraints, since many GPs are seeking a diversified LP base and come to market every three or four years for fundraising, he said.
Last year CalPERS committed $6 billion across 18 private equity managers.
“What would be a challenge, I believe, in the current structure of the programme is to take that from $6 billion to $10 billion by just making investments in funds,” said Steven Hartt of Meketa Investment Group, the pension system’s private equity advisor.
To hit that amount, the number of investments would need to increase from 18 to around 30, Hartt said.
“That would be a lot for this structure to be able to find 30 attractive investments per year that they can invest at that scale.”
Hartt suggested increased opportunistic, direct, co-investments and secondaries could help CalPERS reduce dependence on GPs and their fundraising cycles and allow it to continue committing in a consistent manner.
- Meng wants more PE
CalPERS’ private equity portfolio would deliver 8.3 percent in compound returns over the long-term, Meng said.
“[If] there’s only one asset class that is forecasted to deliver more than 7 percent of return, you need that asset class in the portfolio, and you need more of it,” Meng said.
Private markets will remain inefficient and skillful managers will continue to exploit the market inefficiencies in private equity, he said. What’s more, with more companies staying private for longer, CalPERS will need more commitments to private equity just to stay on par with the market opportunity shift, he said.
“We need private equity, we need more of it, and we need it now,” Meng said. “But we will do [private equity] in the most risk prudent way and in the most risk intelligent way.”
Private equity had a significant impact on total fund returns, according to Meng. A presentation he prepared showed having no allocation to private equity in CalPERS’ portfolio would generate an expected return of 6.7 percent and an employer contribution rate of 34 percent. An 8 percent allocation (CalPERS’ current level) would increase the expected rate of return to 7 percent and bring down the employer contribution rate to 31 percent.
But if the allocation to private equity were increased to 16 percent, the expected return would increase to 7.3 percent and the employer contribution rate would decrease to 29 percent.
CalPERS’ PE portfolio delivered 10.5 percent annualized returns in the last 20 years, Meng said.
- New programmes will bring more transparency to CalPERS, but not to the public
CalPERS staff clarified its previous statement on transparency for the two new proposed private equity vehicles – “innovation”, which would be dedicated to late-stage venture capital, and “horizon”, which will make longer-term investments. At the December meeting, Matthew Jacobs, its general counsel, had stated that too much privacy would defeat the entire purpose of the endeavour.
The general public would get the same information it gets now from the traditional model, but CalPERS would benefit from greater transparency in terms of partners and the types of businesses they invest in. That will help the pension system generate higher returns and make better investment decisions, Meng said.
- CalPERS has no plans to bring PE in-house – yet
The challenges of developing a direct private equity programme are timing and sequencing, Meng said. CalPERS does not have the expertise in house.
“Our current governance structure and also the fact that we’re not located in a global financial center seriously hinder our ability to attract the expertise in house,” Meng said.
But he’s not ruling it out entirely.
“I think we should test out an idea and prove the concept for a while. And if it works, then we can explore bringing it in-house,” Meng said. “We need to learn how to walk before we can run.”
- No decision yet on partners for the new programmes
Despite reports CalPERS is considering two Silver Lake alumni to lead the new programmes, the pension plan had no definite answer on implementation and details of the new programmes.
The challenge is finding the right partners for the programme and designing governance to ensure they are aligned with CalPERS’ objectives, Meng said, adding CalPERS staff had adopted a “trial and learn” approach with no outcome and no specific time line in mind.
“I do see the risk in the implementation: finding the right partners, and then having the right governance and economic terms in place to make sure the highly capable partners will be working for us, not themselves,” Meng said.