Mega on mega

How does CalPERS evaluate the opportunities that large private equity funds present as they grow ever larger?

CalPERS today has a $30 billion private equity programme. The challenge for us and for a lot of large investors in private equity is, how do you invest that much capital in private equity without becoming an index? Our view is that not all of the megafunds will be successful. They've been very successful raising their funds, but the question is, will they be as successful in investing and realising value? We've made a conscious decision not to back every mega-buyout fund.

We look for firms that have the operational expertise because we think the value-add component will be more and more important in this environment. Clearly, some firms are better equipped to do this than are other firms of equal size and stature. The alignment of interests is key. There are a lot of investors that tend to focus on getting management fees down by ten basis points, or something like that. We tend to focus a little bit more on alignment of interests and some of the operational features of these agreements. And of course, in the teams, what we look for are groups that have been through cycles before, investment professionals that have historically been able to see around corners. That gives us comfort.

A lot of people say, boy, these funds have just become too big. That's not necessarily our view. These firms have incredibly talented investment professionals that have been through multiple cycles and have in some cases extraordinary vision and discipline.

Are you not doubtful that, for example, a $20 billion fund can find as many quality investment opportunities as a $200 million fund?

How do you invest that much capital in private equity without becoming an index?

I think you can find good opportunities at the small end as well as at the big end. At the big end, private equity has become a greater component of the overall investment landscape here as well as abroad. Deals have been getting larger. We don't see anything necessarily that is going to get in the way of that trend. There are a couple of things that could happen that would slow down activity at that end. One would be a significant continued bull market in the public market that raises public market prices to levels that are just not attractive for major acquisitions. That said, if that happens, other areas in our portfolio will do very well.

At the smaller end, we think it's attractive as well. The ability to earn 2.5 to 3 times your money is probably more feasible there than it is at the bigger end.

CalPERS is one of several large institutional investors that is seeking to place more capital with fewer GPs. Is this driven by a desire to focus on the top performers, or is there an administrative aspect to this as well?

I think it's a little bit of both. Our strategy is writing larger cheques to fewer groups that we believe are the best. But if you did just that, you'll be overweighted toward the big end. We've decided that the smaller end of the market is attractive, but you have to ask, how does an entity like CalPERS invest there in a meaningful way? What we've done is set up investment vehicles that are customised for us. They target niche opportunities – for example, clean energy and technology, emerging markets. These are areas in the private equity market that we believe are attractive, but difficult to do ourselves directly because of the resources involved.

Have you been able to evaluate the risk posed by club deals, where several of your GPs might be buying the same large asset?

There are a couple things for investors to be thinking about regarding that issue. Given the size, scale and diversification of CalPERS' portfolio, the fact that more than one of our general partners is investing in any one deal doesn't create as big of an issue for us as might be the case for a smaller investor. But it's something that we do monitor.

Our view is that not all of the megafunds will be successful

The other issue is the fact that there are pros and cons to clubbing in general. Having multiple skill sets available to work a deal is good. The downside is, if a deal goes sideways, are the parties going to be aligned? We haven't seen that yet.

Have you been able to track a trend whereby a stock owned by CalPERS is acquired by a private equity GP in a buyout, and then goes public again and is bought back by the CalPERS public equities team?

We see this happen routinely. It's not something we've really studied in depth. I think as long as our asset classes are achieving their performance objectives, I don't necessarily see a problem with it.

Do you see megafund returns coming down?

I can tell you at the very large end – and “large” has varied over the last three years – the largest of the large have delivered anywhere between 30 and 50 percent rates of returns. That is, as we all know, not sustainable. That said, the best megafund managers will continue to outperform the public market by a pretty significant amount. And by that I mean by 1,000 basis points or more.

Let's talk about management fees. As you are well aware, a number of LPs feel that traditional management fees charged as a percentage of enormous capital commitments is the wrong approach. Is this an issue about which you think LPs should exert more pressure?

We do negotiate hard on fees on every deal. But I'd say generally fees are in the ballpark of where they ought to be. Would we like to see them lower? Sure. Do LPs have the leverage right now? Probably not.

The one thing I would mention is that as investors, we need to be mindful of an extremely competitive market for talent. Private equity firms are competing against hedge funds, who offer incredibly lucrative compensation packages.

Are budgeted fees a real option?

In a perfect world, that would be an approach that would seem to make sense. But we live in a very competitive world.

CalPERS owns stakes in Carlyle and TPG, among other firms. Those have turned out to be great investments. What advantages do these stakes bring CalPERS, other than value creation in their own rights?

The stakes that we took allowed CalPERS to provide enabling capital to groups like Carlyle to go out and recruit investment teams, expand their businesses globally, and roll out new and innovative products. What I think these firms give us other than financial performance is this – Carlyle, for example, is a global organisation, they give us a view of the world that is truly unique. They've got global intelligence. Other advantages would be, we can pick up the phone, call Carlyle and tell them we're interested in getting up to speed in a particular area like energy or infrastructure. They can put a team on it and really help us. This is something you might not get if you were just an LP in a fund.

When will CalPERS monetise these stakes?

These are very long-term strategic relationships. But I won't say we wouldn't entertain an exit. There will eventually be liquidity events, and to what extent CalPERS participates in those is not known today.