The California Public Employees’ Retirement System has long been a leader in the investment world, setting trends that other large institutions tend to follow.
Arguably, in recent years, the system’s influence on the private equity industry has waned as CalPERS has slowed its commitment pace and become very strict about what kinds of terms it will accept from managers, even those with the best performance.
However, one area within private equity where CalPERS continues to exert enormous influence is around emerging
manager strategies – managers on their first or second funds, who are often female or from ethnic minorities.
To be sure, this segment of the industry – an incubator for the next generation of top firms – is small. But it’s also significant. By fostering diversity within private equity, it helps the industry to better reflect the changing face of the US. For example, Hispanics are predicted to make up the majority of the population by 2043, according to the US Census.
The problem with most private equity emerging manager programmes at public pension systems in the US (and more are adding them every year) is performance. In other words: can these programmes really deliver the kind of returns these systems need to meet the obligations to their pensioners? And there’s still a widespread perception that investment strategies with a more socially responsible focus just do not provide the kind of performance demonstrated in past years by private equity more generally.
That perception continues to be challenged. Last year, the National Association of Investment Companies, which represents mostly diverse private equity firms in the US, published a study (with data compiled by KPMG) showing that its own members produced a median net internal rate of return from 1998 to 2011 of 15.2 percent – compared to just 3.7 percent for all US private equity and 7.1 percent for US buyout funds.
We don't know yet if the positive performance of diverse managers is wiped out by the extra layer of fees or not, and it will take time for us to figure that out.
CalPERS recently conducted a broad survey of its emerging manager programmes. It found that within private equity, it has been getting positive performance from diverse managers in the part of its emerging manager portfolio that is run by a funds of funds. However, the survey concluded, when the system has invested in diverse and emerging managers directly rather than through an external advisor, performance has been underwhelming.
This is an important distinction, and one that should help the system shape how it approaches emerging manager private equity going forward. The system is also examining whether the fee structure of the fund of funds through which it gains exposure to diverse managers cuts into that positive performance, according to Laurie Weir, a CalPERS portfolio manager who leads the system’s policy and programme development for emerging manager initiatives.
“We don’t know yet if the positive performance of diverse managers is wiped out by the extra layer of fees or not, and it will take time for us to figure that out,” Weir told me in March.
CalPERS has come under sustained attack because of a perception that it has been backing off from its support of private equity emerging managers. The situation escalated to such an extent that CalPERS skipped the annual Robert Toigo Foundation gala last year, the premier event for emerging managers. Tensions culminated last autumn in a hearing in front of two California State Senators, where CalPERS chief investment officer Joseph Dear defended the system’s dedication to emerging managers. Over the years, CalPERS has committed $10 billion to 300 emerging managers across asset classes, and $3 billion of that amount went to diverse managers, the system has said.
It has the figures to back up its claims. Between 2006 and 2008, CalPERS committed about $7 billion to private
The fear is that in the future, CalPERS wants to commit to a handful of the biggest managers who can offer the system separate accounts, or lower fees.
equity, about 18 percent of which went to emerging managers. Following the collapse of Lehman Brothers in 2008, CalPERS has committed about $1 billion to private equity from 2009 to date; again about 18 percent of that commitment total went to emerging managers, according to a CalPERS spokesperson. Numbers don’t lie: the system has been one of the largest supporters of this segment across asset classes, and has maintained its level of support even after the financial crisis.
The fear is that in the future, CalPERS wants to commit to a handful of the biggest managers who can offer the system separate accounts, or lower fees. But this could mean that it misses out on the kind of returns it can get from the smaller, more successful managers. And it also undermines the growth and vitality of the emerging manager community, which has come to rely on its hefty ally to keep pumping in the capital required to keep the incubator machine well oiled.
The good news is that CalPERS appears to have no intention of abandoning the strategy; in fact, it’s putting a lot of time and effort into studying exactly how to get emerging managers right. Let’s just hope the approach that emerges is one that works for the system, its pensioners, and the managers in question.