The twenty billion dollar man

Investors in private equity funds come in all shapes and sizes, ranging from the high net worth individual, often gravitating towards the roller coaster that is venture capital investing, to the large institutional investor looking to spice up its performance with a discreet allocation to alternative assets.

This latter group is interesting because, as GPs, other LPs, placement agents and advisors all agree, they are the part of the private equity buy side who will determine the ultimate size and evolution of the asset class. These heavyweight institutions have the heft and the profile amongst the rest of the investment community to do this. And it is the investors within this group who are not only committing significant percentages of their investment capital to private equity now but also actively engage in the key issues facing it who are the most interesting ? and arguably the most influential. There are not many of these exemplars around. If you're looking for a heavyweight investor who is wanting to make a fundamental engagement with the asset class, sooner or later you end up looking at the California Public Employees Retirement System, CalPERS for short. ?They,? says one who knows the institution well, ?are the gorilla in the park.?

The numbers are a key part of this story: CalPERS has $160bn under management in total with more than $20bn committed to private equity ($10bn of which is as yet undrawn); it makes average annual new private equity commitments of over $3bn, has relationships with 125 private equity firms and investments in over 300 funds, which in turn are invested in 5000 companies; the average portfolio age is just 2.9 years? you get the picture.

Thinking long term
Talk to Rick Hayes though and you soon realise that the numbers are backed by something with broader implications. Hayes, who is the senior investment officer for CalPERS' Alternative Investment Management (AIM) programme, and his team are clearly thinking hard about the long-term evolution of the private equity industry as well as their own portfolio. This is in part driven by the fact that CalPERS manages pension and health benefits for more than 1.2m California public employees, retirees and their families: there is a long-term fiduciary duty to uphold and this helps determine CalPERS' attitude with regard to private equity as much as it does to other asset classes the fund invests in. Safeguarding these people's capital and delivering substantial returns on it is a responsibility which they take very seriously.

CalPERS now invests in the private equity industry throughout the world. ?I'd estimate that at any time there's around 100 people working on the CalPERS portfolio,? says Hayes. The vast majority of these people are with external advisory firms: as a public agency CalPERS is not in a position to run a big team itself so instead has developed close relationships with between eight and twelve firms who help throughout the investment process ? be it for due diligence, reporting or accounting tasks. But at the centre sits a group of seven investment professionals based at CalPERS' offices in Sacramento. This team is headed by Hayes.

?There's around 100 people working on the CalPERS portfolio?

At present CalPERS' allocation to private equity is broadly diversified, with some 35 per cent allocated to both buyout and growth capital, 25 per cent to venture and between five and ten per cent allocated to distressed and other special situations. This allocation is monitored closely, with the seven managers meeting every Monday morning to review developments within the portfolio. ?We make decisions by consensus,? Hayes comments, ?and these Monday meetings can last around five hours.?

At the moment Hayes is excited by what some might see as the wake-up call private equity (and venture in particular) has received in terms of lack of exit options, the slump in portfolio valuations and performance declines. This harsh new world is a land of opportunity in CalPERS' estimation. ?I think the contraction you're going to see over the next couple of years in this industry is going to be a healthy one,? says Hayes. ?As the market gets tougher a couple of things will happen: there's going to be a real shakeout as there's a huge number of funds that have not exited, have big funds and will have big problems raising their next fund. And you'll see a real return to the highest quality. We think this is healthy.?

Finding the best
CalPERS clearly prides itself in selecting only the highest quality private equity managers and goes to considerable lengths to evaluate a new firm as well as a particular fund being presented to it and its advisors. For GPs hoping to win a piece of business from the fund this can be quite a taxing process. One GP who preferred not to be named said that presenting to CalPERS had its downside: ?It's a marathon. You think there can't possibly be more hoops to jump through and you find there are. And all the time you're trying to get to a close and it just drags on and on. You're left thinking that they [CalPERS] expect you to dance to their tune come what may.?

But those succeeding in winning CalPERS as a limited partner are aware that they have won more than just another financial commitment. It is a tremendous reference: having CalPERS join your list of confirmed investors is certainly news that you're going to share with other prospective buyers.

Candover, the European buyout specialist that closed its 2001 fund at €2.7bn last month, received a €160m commitment from CalPERS and also had the Californians in its previous 1997 fund. Colin Buffin, joint managing director at the firm, is clearly a fan of the institution. ?They've been extremely supportive, and their organisation and management is now much more efficient.? Buffin sees Hayes as having been instrumental in advancing CalPERS' professionalism, although it was Hayes' predecessor running the AIM programme, Barry Gonder (now at Grove Street Advisors, the gate keeper that helps to manage

CalPERS' venture investments), who started this process off. Buffin also makes a point about Hayes that many others make too: ?Rick could readily get a job at an investment bank.?

Hayes' background, according to people like Grove Street founder Clinton Harris, is a key factor in determining his ? and CalPERS' – approach to private equity. Whilst some of the investment professionals at the fund have been longstanding CalPERS employees and have passed through numerous different divisions within the institution, Hayes is a relatively new recruit, having joined in May 1998. He was appointed senior investment officer for the AIM programme in July 2001.

Prior to joining CalPERS, Hayes had spent six years working at AT&T Wireless Services, where he was ?involved in the ups and downs of trying to operate a business,? as he himself puts it. He was vice president for marketing and new product development and then became corporate director of marketing at the AT&T unit. This first-hand operational experience (in a sector which at the time was breaking new ground) is important when it comes to understanding who in Hayes' mind will survive the current upheavals in the private equity and venture fund communities. Hands-on operational experience in running a business in down as well as up times is vital and in his estimation there is ?a generation of people in this business who don't have this experience.? The implication is that it is this generation whose private equity and VC firms are going to find it hard to survive.

To Hayes this is a necessary, natural stage for the industry to pass through, and he doesn't expect to be missing any of the funds that will be forced to quit the industry. Hayes predicts that for CalPERS ?the next couple of years are going to be very good as we have $10bn committed but undrawn with what we consider to be the best [general] partners in the world.?

But what makes the best GP? Grey hairs and track record clearly matter but a look at CalPERS' broader investing activities quickly tells you that quality of disclosure is also a fundamental criterion. Transparency matters hugely to this investor which has what some would call a fearsome reputation in the public equity markets for shareholder activism. If CalPERS is unhappy with a company's management, the world soon knows about it.

An investor with attitude
Just take a look at www.calpersgovernance. org to get a better sense of what this means. The mission statement on the homepage says that ?CalPERS' Board of Administration has concluded that ?good? corporate governance leads to improved long-term performance. CalPERS' also strongly believes that ?good? governance requires the attention and dedication not only of a company's officers and directors, but also its owners. CalPERS is not simply a passive holder of stock. We are a ?shareowner,? and take seriously the responsibility that comes with company ownership.?

?The next couple of years are going to be very good?

?Activism comes down to transparency?

Unsurprisingly, the revelations at Enron and now Worldcom have prompted CalPERS to urge for deep-rooted changes to take place in corporate reporting practices. These have been codified in its Financial Market Reforms Principles: five basic reform proposals that it sees as a return to the basics of transparency, ethics and accountability. And here, closer to home, is Hayes on what it means to be a shareowner of a private equity fund: ?If you're not willing to communicate the question is ?why not?? We don't expect perfection but we do expect good partner communication. Whether its Tyco or Global Crossing or a private equity fund, the investors want to know what's going on.?

Which makes that episode of July last year, when the media discovered on CalPERS' website an IRR league table ranking private equity firms that it was invested in, a point of debate still. Was it a deliberate ploy to encourage more open reporting of performance? Hayes won't be drawn: ?It was just an accident. People misused the rankings ? so the lesson we had was that until there's better industry standards and until people have better ways of looking at these things it serves nobody ? GP or LP ? to have information flying around the Internet.? Interestingly, when CalPERS withdrew the information from its website, it also issued a statement that said: ?Based on feedback we got from the market, we concluded that posting per fund performance might hurt our competitive position? It might have meant some parties no longer wished to let CalPERS into their funds or might do so on less favourable terms. This was the exact opposite of what we intended.? Which suggests that the private equity firms were quick to signal to CalPERS that they would respond to unilateral disclosure by freezing it out from future funds.

Sources close to the protagonists take a similarly pragmatic view: ?I wouldn't say it was premeditated but I think CalPERS' could see the upside of what happened. The press coverage was a bit of a pain but kind of necessary,? says one. And as Hayes himself says: ?It has increased our communication with our best partners.? So it was not a name and shame exercise but nonetheless a useful instance of how a more transparent private equity community might be expected to disclose performance data. Because in Hayes' estimation, ?activism comes down to transparency.?

Building an LP network
Information flow and transparency are also highly relevant themes to another initiative involving Hayes that GPs are following with great interest, and sometimes with concern. The Institutional Limited Partners Association (ILPA) has been set up by a group of senior limited partners who, combined, have over $1 trillion of capital allocated to private equity and in 2001 committed around $80bn to private equity funds. Hayes has been elected Chairman and clearly is excited by the prospect of helping to grow a network of like-minded investors who can share information and ? tellingly ? speak with one voice via the Association. Hayes is cautious about predicting how much influence ILPA will have ? ?you won't see ILPA coming out with big pronouncements for now? he comments ? but like the doctor who wants to reassure the nervous patient he declares that ?the asset class will benefit from more LPs talking to each other.?

Hayes already spends significant amounts of time talking to other LPs as he garners intelligence about particular firms and markets. Because private equity remains a network business: one where a successful LP needs to tap into a wide circuit of other LPs, gatekeepers, consultants and GPs to capture the latest market trends. Although the aim is to have ILPA formalise parts of this network, at present Hayes is happy to work that 100-person team to gather the information he needs. ?The thing I'm most proud of here at CalPERS is the partnership we've built,? he comments.

Within the external network there are several key relationships, including McKinsey & Company, KPMG, State Street and Grove Street. This last alliance is of especial importance when it comes to CalPERS' relationship with the VC community, as it makes possible for an investment programme the size of CalPERS' to continue to make small allocations to new generations of venture capital boutiques. Grove Street's Clinton Harris points out that his company now manages all new relationships for the investor.

CalPERS has already allocated some $2.4bn to around 120 venture funds, although only $700m has been drawn down thus far. Importantly, only around $250m of this allocation is in 1999/2000 vintage funds which are the ones enduring the most pain as their portfolio companies plummet in value or, worse, go under.

VC investing (typically running at a 25 per cent allocation within AIM) plays a key role in CalPERS' private equity thinking for a number of reasons. Critics will reference it as more distraction than return generator, suggesting that CalPERS' role as a public sector institution within California state means that it invests in funds for reasons that are more social than profitable. CalPERS rejects such criticism. For instance, when it invested $475m in eleven Californian VC firms (such as the Garage California Entrepreneurs' Fund) in May 2001, William D. Crist, President of CalPERS' Board of Administration, insisted this was by no means a philanthropic gesture. ?Investments in underserved areas hold potential to deliver superior returns for our Fund and its members while fuelling the growth of jobs, businesses, and stronger communities in our state,? Crist said at the time.

?We are always trying to think 20 years out?

Hayes too sees the fund's commitment to VC as paying very real dividends, describing it as an ?apprentice? part of the asset class where talented GPs can be spotted and nurtured. He is also mindful that it is going to be VC money that will help new companies transform ground-breaking technologies into profitable businesses over a twenty to thirty year term. The biotech sector is one field where CalPERS sees huge potential over this kind of period. Says Hayes: ?We are always trying to think 20 years out as to where we should invest to get outsize returns over that term.?

Getting results
Mention of returns leads inevitably to a discussion about what private equity can deliver as part of the allocation mix. Hayes says that the broad aim is to achieve 500 basis points over public market returns but ?the question is, what will the public markets return?? At present it's easy to presume that the depressed state of the stock markets is serving as a useful counterbalance to the markedly lower returns coming out of private equity, but the message back from Hayes is that the fund's results, even very recently, have been good.

To date the AIM programme has delivered $4bn cash profit and Hayes uses May's figures to illustrate what kind of net return they are seeing now. ?On average we get between $75m and $200m capital calls each month – and over $1bn a year – and every month we look at distributions. We got a gain of $40m in May.? And this is the fundamental benchmark: ?When evaluating performance, we're looking at cash,? says Hayes. What about IRR? ?When people say that last year the IRR on VC was 30 per cent, I don't know what that means. We have a toolkit of performance measurements: one of them is realised IRR, one is the absolute cash in / cash out and there are softer measures such as how the private equity team is adding value to portfolio companies.?

Hayes is an interesting mix of enthusiast and analyst: he clearly enjoys the closely knit world of private equity, and is keenly aware of the size of the footprint CalPERS leaves within it. He also wants to see the industry achieve a credibility amongst institutional investors that's based on the quality of disclosure besides the quality of returns. Today, practitioners monitoring CalPERS can already see much of what this evolved private equity asset class is going to look like. Private equity is still at a stage where one institution can make a difference. ?You can take a lot more control in private equity,? says Hayes. ?This is an opportunistic asset class? – whether you're an LP or a GP.