Walking into the headquarters of the California Public Employees’ Retirement System (CalPERS) in Sacramento, it’s easy to forget that you’re visiting a public pension fund. The front entrance to Lincoln Plaza East, the building that now houses the investments team, is a 90-foot tower of shimmering glass and steel that feels like it should belong to a super-rich private equity firm, not one of the LPs that bankroll them. Even if that LP does have $265 billion of assets under management.
The building is a relatively recent addition to the original CalPERS HQ; it only opened about eight years ago, a mere bagatelle for an organisation that’s been going since 1932. But they’ve been a fairly eventful eight years, at least as far as the investments team is concerned. First came the boom. Then came the worst financial crisis in decades, when CalPERS saw its returns and valuations plummet. Then, to add insult to injury, came the ‘pay-to-play’ revelations. By the time Joe Dear arrived as chief investment officer shortly afterwards, in March 2009, there was a substantial job to be done to restore CalPERS’ good name.
In late 2011, Dear (who has sadly been forced to take a step back from his role recently as he fights cancer) sat down exclusively with PEI to talk about some of the steps he had been taking to clean house. And perhaps one of the most significant was the recruitment of Réal Desrochers to head up the system’s private equity investments. Desrochers had previously done a similar job at CalPERS’ sister fund CalSTRS (the California State Teachers Retirement System), where his programme had delivered returns of 17 percent over a decade. In May 2011, Dear enticed him back to the Golden State from Riyadh, where he’d been working as CIO for the Saudi Arabian Investment Company (Sanabil), to try and perform a similar trick with CalPERS’ troubled programme.
On arrival, Desrochers was given a pretty blank slate by the board (some of whom were probably wondering whether the asset class was more trouble than it was worth). His official task was to “review and define the role of private equity in the portfolio” – and all options were on the table, he insists.
The answer he came back with, however, was simple. “Private equity should be producing 300 basis points above equities. That’s its role. It’s the alpha provider for the whole system.”
But if this basically meant more of the same for CalPERS in strategy terms – the allocation to private equity remained at 14 percent, with buyouts still accounting for the majority of the total – it was clear that big changes were required in the way that the pension’s investment team operated.
The first problem was that CalPERS was spending too much money on external consultants – which, as the ‘pay to play’ scandal showed, was a risky business.
Desrochers’ response was to start bringing core functions in-house. As part of this process, he has shifted the whole investments team from a generalist model – where an investment professional might be responsible for researching a fund investment, making the commitment and then tracking it afterwards – to a functional model, where the different parts of the process are managed by three different groups.
There’s a research group, run by Sarah Corr, which aggregates external research and synthesises it with portfolio data to inform the house view. There’s the investment management group, headed by Christine Gogan, which monitors the portfolio and feeds information back into the underwriting team. And there’s an underwriting group, led by Scott Jacobsen, which writes the cheques. The three group heads plus Desrochers constitute the investment committee.
This eliminates a potential conflict under the old regime, Corr points out. “An investment professional might do his or her own research and underwriting and portfolio management. So that person would have a longstanding relationship with a manager they were trying to objectively evaluate.”
Desrochers agrees. “There needs to be a separation between the people who monitor and the people who underwrite. It’s often a pain in the derrière for the GP, because they like to build a rapport with one person. But today their relationship is not with one person; it’s with CalPERS.”
It may have seemed like a pain in the derrière for existing staff, too, all of whom were suddenly told that they were being reassigned into different roles. Desrochers admits this process was not an entirely painless one. “Everyone likes to write 50 or 100 million dollar cheques. So if you say to people: ‘Tomorrow your job changes’ … This has been a big cultural change, and some people are not necessarily going to be happy about that.”
But the new structure has been helpful in attracting new staff, according to Gogan. “I think that opportunity to specialise and hone your craft in a sub-set was particularly attractive to a lot of the people who came to join us. One thing that’s really different is that the functional spec has allowed staff to go deeper within a vertical to build expertise.”
It’s certainly true that there are some impressive résumés among CalPERS’ recent recruits. Jacobsen himself, who joined in 2010, has degrees from Harvard and Stanford, plus 10 years’ investment banking experience with UBS and consulting experience at Bain & Co. A flick through the bios of the rest of the team reveals a healthy Ivy League contingent, along with experience at blue-chip financial names like State Street, Morgan Stanley, Pantheon, Neuberger Berman, Deloitte and McKinsey.
All these recruitment efforts might sound like a sure-fire way to increase costs. But according to Desrochers, the cost base has actually come down (which says a lot about how much CalPERS was spending on external consultants).
In addition, it substantially diminishes the likelihood of another pay-to-play incident, as Jacobsen points out. “[It’s] partly about cost-benefit analysis. But it’s also about having a risk-aware culture. By doing all this in-house, we can create more consistency across the platform and reduce our operational risk.”
As well as investing in people, CalPERS is also investing in technology, with a new accounting system intended to simplify portfolio analytics. “We’ll have much more visibility on where the value is being created in the portfolio,” explains Corr. “Right now, for example, we can’t tie cashflows to companies, so it’s hard to separate out EBITDA growth from multiple expansion and so on. When the platform is built out, we’ll have all that info in one place so we can use it to analyse performance.”
Manager costs have also been a big focus under the new regime. At the time he joined, says Desrochers, CalPERS was paying out total fees to fund managers of about $1.2 billion, and more than 50 percent of that went to private equity managers. “There was a big drive to reduce costs,” he admits. “It’s early days, but so far we’ve been very successful.”
This drive had a few interesting consequences for CalPERS’ investment strategy.
The first was that it branched out into opportunistic investing, via a $500 million separate account arrangement (or ‘customised investment account’, as CalPERS calls it) with The Blackstone Group’s Tactical Opportunities Fund, a vehicle that looks at non-private equity investments that target a 15-20 percent return.
This had other benefits too, explains Jacobsen. “It was a combination of focusing on the opportunity set, and also doing it in a way that optimised costs, because we could use our scale as an advantage to get reduced economics. But we also wanted more control over our capital. With all of these customised investment accounts we have the ability to turn it on or off whenever we want.” (This was a lesson learned the hard way in the aftermath of the financial crisis, when CalPERS, like many big LPs, suddenly found itself short of liquidity.)
The second consequence has been a greater focus on co-investment activity, which averages down fees. It’s done three in the last year, and Jacobsen says there’s no shortage of good opportunities coming their way. That’s partly because it’s taking a more systematic approach to sourcing: there’s now a programme in place to call key GPs regularly in order to get a heads-up on potential deals. “We’ve gone from being a reactive programme to being much more proactive, and we’re starting to see the results from that,” says Desrochers.
Jacobsen adds that the new structure allows CalPERS to be much more nimble in terms of how quickly it can analyse the merits of an opportunity and come to a decision. “All of [that] typically takes place within a three-week period, although we did one from start to finish in 10 days. I think some of the GPs we’ve coinvested with have been really impressed by how quickly we can execute and come to a decision.”
Nonetheless, Desrochers insists he will continue to take a fairly conservative approach to co-investment, in recognition of the fact that it’s a different sort of skill-set. “We realise that co-investment is a difficult business and a different business: it’s riskier, and we’re going to lose sometimes. So we wouldn’t bet the farm on a co-investment. I’m pretty defensive about what we do.”
As far as prospective GPs are concerned, there’s an important point here. Most discussion of manager costs tends to focus on headline fees. But for CalPERS today, that’s only part of the picture: it doesn’t actually mind paying full price, as long as it thinks that in return it can get outsized returns, or near-term coinvest opportunities, or even future separate accounts.
“We want to match price to the value being created,” says Jacobsen. “We will continue to invest with top managers on full economics – but we’re also really focused on our separate accounts and co-investment programme.”
THE GREAT GP CULL
But this increased focus on costs also has an important consequence for CalPERS’ primary fund investing: Desrochers is very clear that reducing the current number of GP relationships is a key priority.
“Currently we have 350 GPs. We don’t want 350 GPs, we want 80 or 100. We want to be more selective: we want to make larger commitments to a smaller number of managers. So how do you decide [which to keep]? It’s all about consistency of performance and good governance. We want to try and build a core portfolio of managers that are institutional quality, and be a long-term investor with them.”
Nothing unusual there; most LPs say the same. What is unusual, though, is the sheer scale of the challenge CalPERS faces to make this happen. “It’s a tough job,” he admits. “We can sell assets on the secondary market – and we’ve done that a bit – but it’s a big job to evaluate every asset before we sell, and the impact on the portfolio is often marginal.”
The numbers involved are stark. “Our top 40 managers are producing about 90 percent of the total gain,” says Corr. “So the value you’re getting from those incremental managers is not going to move the portfolio much.”
“And yet you still have to look after their distributions and capital calls and financial statements and updates,” Gogan points out. “So one of our focuses for 2013/4 is to encourage [my] staff to try and help restructure some of these funds.” In other words: expect CalPERS to start playing a more aggressive role with the zombie funds cluttering up its portfolio.
As for new fund investments, Jacobsen says this is another area where the system has become much more proactive. Gone are the days when a GP could turn up in Sacramento, ask for a meeting the same day, and then expect to get a commitment out of it. “We have a forward calendar. We know where we want to go, [and] I don’t anticipate us finding many new names that we don’t already know. We’ve been trying to instil a different mindset these past 12 months: we’re buyers of private equity now, we’re not being sold [to].”
It has also introduced a new Manager Assessment Tool, which is “designed to try to take subjectivity out of the decision”, according to Desrochers. And it looks to bring in external and/or opposing voices ahead of every investment decision. “I don’t like groupthink, so it’s useful to have outsiders present. And every deal we present has to have someone assigned to poke holes in the investment thesis.”
BIG IS BEAUTIFUL?
CalPERS wants to put about $6 billion to work across private equity in the next year – to include primary funds, co-investment and secondaries – and to keep investing at that sort of rate for the foreseeable future. (It’s invested about $5 billion in the last 12 months.)
But at the same time, it’s also looking to reduce its number of managers, write bigger cheques (in exchange for better economics) and open up more co-investment opportunities. Is the inevitable consequence that its portfolio will become increasingly weighted towards the biggest funds?
There’s already a sense that it has effectively pulled out of the lower end of the market: its venture capital portfolio now accounts for less than 1 percent of AUM, despite the fact that its home state is also home to most of the best venture firms in the world (some of which, to be fair, won’t take commitments from state pensions like CalPERS that publicly disclose returns information).
Then there’s the ongoing row over CalPERS’ emerging manager programme. CalPERS has historically been a big supporter of this segment, committing at least $10 billion to more than 300 of these smaller or minority-run firms over the last 23 years. But in recent years (in light, it must be said, of some underwhelming returns from its past programmes) the system has slashed its allocation: last year it committed $100 million over three years to a new programme, run by Credit Suisse. It has since been accused of turning its back on the segment; Centinela Capital Partners, which used to run CalPERS’ emerging manager programme, is currently suing it for breach of contract and racial discrimination.
Desrochers and co. won’t comment on the row, because it’s still the subject of an ongoing court case. But the direction of travel seems clear: CalPERS wants to reduce its commitments to emerging managers. It’s just about to launch a root-and-branch review of its emerging manager investment; and again, it sounds like all options are on the table, at least as far as Desrochers is concerned.
“There are two sides to every coin. And if this makes us stop and look at what we should be doing, that’s a big plus,” he says. “We’re setting up a taskforce to review what makes an emerging manager successful – and to understand why they fail. Once we know that, we’ll look at whether we should put more money in, and if so, how much. It certainly won’t be as significant as it was before.”
Some argue that this, too, is indicative of the system’s general move towards bigger managers.
“Réal just likes to have Kravis and Schwarzman and Bonderman on his speed dial,” says one mid-market European GP (who failed to get a commitment from CalPERS). “All he wants to do is back the big guys, just like he did at CalSTRS. I don’t see that much thought or analysis goes into it.”
Desrochers was also reportedly portrayed rather negatively in a spoof film played at last year’s annual investor meeting for Leonard Green, a US buyout firm that did not receive a CalPERS re-up for its latest fund.
Desrochers – a fairly genial sort – doesn’t sound like he loses too much sleep over disgruntled managers. “Sometimes a GP has taken [rejection] personally. But it’s not personal. We’re here to do a good job, and if you talk to good GPs they understand that. Our job is to negotiate the best terms – but we want to do deals that are win-win.”
The question is: can it be a win-win for anyone but the biggest managers? Say CalPERS wants to commit $6 billion a year, and roughly two-thirds of that goes to primary funds. If it commits to 10-15 new funds a year – as it plans to – that would still mean an average ticket size that’s too big for all but the larger funds. Over time, the danger is that it could end up with a lack of diversification by market segment and possibly even by vintage year.
CLOUDS ON THE HORIZON
That said, the current focus doesn’t seem to be doing any harm for the moment. CalPERS posted a 13.6 percent gain for its private equity assets in the nine months to March 31, up from 5.4 percent in the same period a year earlier. It fell a couple of percent short of its annual benchmark, due to the big rise in public markets, but its longer-term performance is looking a lot healthier.
Nonetheless, there is no shortage of things to worry about.
“Valuations are clearly of concern,” says Corr. “Distributions are far exceeding new investment activity, and the activity we are seeing is at multiples that are above historical averages. And the level of leverage available is shocking; people seem to have very short term memories.”
CalPERS is also “very cautious” on emerging markets, she says. “Valuations are high and exits are nonexistent. Also from a risk perspective, we want to be compensated for the risk – and our experience is that emerging markets haven’t performed in such a way that we’re compensated for the risk. So allocating a lot of capital there is challenging.”
Jacobsen worries about rate hikes. “We’re moving from an environment of declining interest rates and loose credit to one where rates will be rising and liquidity will be pulled back – which we’d expect to mean more challenging public markets. So the question is: what happens to distributions going forward? How are we going to get liquidity back from the portfolio?”
“If you look at the investments we’ve made over the last year… Everyone’s a bit uncertain about the economic environment. And in that environment, we’re more comfortable being more senior in the capital structure than equity. So we’ve done a lot of credit investing. We might have to give up a little upside if things come roaring back, but we have more protection on the downside. That makes me sleep a bit better at night.”
But CalPERS is also grappling with a problem specific to its portfolio: a lack of vintage year diversification, a consequence of its slow pace of investment in the wake of the financial crisis.
“If you think about the dynamics of what happens as distributions come off those 2006/7/8 funds, and there are no contributions to replace them because we made so few commitments in 2009/10/11, staying at 14 percent will become increasingly difficult,” admits Corr. “Impossible, in fact. And if you think about the entire portfolio, the danger is that if private equity falls too far below where it is now [currently below 13 percent], it will make it very hard for the portfolio to meet its overall return.”
The hope is that CalPERS will be able to rebalance its portfolio to some extent through secondary market activity – though this is clearly very difficult and market dependent – while the separate accounts and co-investments, because they tend to have a shorter J-curve, will fill in some of the contributions gap. But for a fund of this size, it’s going to be hard for either of these two approaches to make a substantive difference.
After all, last financial year, according to Desrochers, CalPERS received $9.9 billion in distributions, and paid out $3.2 billion in capital calls. “We were up $6.7 billion, cash on cash – we financed CalPERS last year!” he grins. Without a whole lot of portfolio rebalancing activity, this is not going to be the case for long.
So has Desrochers ‘fixed’ CalPERS’ private equity programme? It certainly seems to have taken steps in the right direction: as an organisation, it looks much more fit for purpose. But ask us again in five years.
CalPERS BY NUMBERS:
$42.5bn CalPERS’ total PE exposure as of March 31
$57.8bn CalPERS’ PE distributions since programme began
$9.9bn CalPERS’ PE distributions last year
$3.9bn CalPERS’ PE commitments last year
28 Headcount as of September 2011
52 Headcount as of August 2013
64 Expected headcount once all available positions filled