CalPERS’ emerging manager problem

In private equity’s emerging manager community, there is no bigger event than the Robert Toigo Foundation’s annual gala.

Toigo, which was founded in 1989 (originally under a different name) by Robert and Sue Toigo, provides MBA fellowships to select minority students each year, and its gala is a celebration of the “spirit of diversity”, according to its website – and more importantly for guests, the best networking event around for emerging managers.

No single institution has been as important to the growth of the emerging manager segment as the California Public Employees’ Retirement System. The $236 billion pension system established its private equity emerging manager programme, called the Capital Link funds, in 2006 with its first commitment to Centinela Capital Partners, the fund of funds it chose to run its $1 billion portfolio. It has seeded some of the most successful young managers in the business, including the likes of Vista Equity Partners and Clearlake Capital Partners. Since then several other institutions, such as the Teachers’ Retirement System of Texas, have followed suit and built their own programmes focused on young, often diverse firms.

Across the various asset classes, CalPERS now has almost $10 billion invested with more than 300 emerging managers as of 30 June 2011, according to the system’s five-year emerging manager plan released in August – of which about $3 billion is managed by ‘diverse’ female- and minority-led firms.

No wonder, then, that the pension system has always played a big role in the Toigo Foundation. For example, former board member Charles Valdes served as president of Toigo’s governing board, while Anne Stausboll, CalPERS’ chief executive officer, currently sits on the foundation’s advisory board.

“For more than 20 years, CalPERS has been a national leader in advancing Toigo’s mission – creating opportunities in finance for minorities and women. CalPERS’ continued commitment to emerging managers and its support of Toigo’s work is the basis for a dynamic and growing partnership,” Toigo said in a statement emailed to Private Equity International.

For more than 20 years, CalPERS has been a national leader in advancing Toigo's mission — creating opportunities in finance for minorities and women.

Toigo Foundation

This year, CalPERS’ chief investment officer Joe Dear had been invited to speak on a leadership-focused panel at the gala moderated by legendary broadcast journalist Ted Koppel.

But as the June date of the gala approached, Toigo’s executive director Nancy Sims was contacted by several emerging private equity managers, all long-time supporters of Toigo, who suggested the foundation should remove Dear from the programme if it wished to retain their support.

Because of the close relationship between the organisations, this was a shocking request. CalPERS staff did not attend the event.

The episode may have seemed sudden. But in fact, it was the culmination of tensions that had been boiling under the surface for months, numerous sources have told Private Equity International. Many emerging managers believe CalPERS is withdrawing its support for the segment – preferring instead to write bigger cheques for the larger, top-performing managers who can offer a better deal on fees.

Changing strategy

One of the key factors in an emerging manager programme is that the best performers “graduate” into direct commitments from the system. However, CalPERS has not re-upped with any manager in the private equity emerging manager portfolio for 18 months, sources say.

Performance is clearly a key concern for CalPERS at the moment. The pension system reported a lacklustre overall return of 1 percent as of June, and while private equity was one of the better performers in the portfolio, it only beat its benchmark by 0.34 percent.

So what of the emerging private equity manager programme? CalPERS’ website reports that Capital Link I was generating a 7 percent internal rate of return and a 1.2x multiple as of 31 December, 2011, while the second fund, which was about 50 percent drawn as of early September, was producing a .6 percent IRR and a 1x multiple.

However, according to Centinela’s audited results (as of 31 December 2011), the first fund is showing an 8.53 percent net IRR and a 1.23x multiple, and the second fund a 2.07 percent IRR and a 1.04x multiple.

“We exceeded expectations with the historically challenging mandate in emerging managers,” Centinela’s co-head Robert Taylor told PEI in a recent interview.

Overall, CalPERS has not been happy with the performance of its emerging managers. The system sent a letter to California state Senator Curren Price recently showing that over a three year period, CalPERS’ emerging private equity managers had generated a 12.3 percent return, compared to an about 20 percent return produced for the total asset class. Over five years, the emerging manager number drops to 3.93 percent, compared to 7.24 percent for the asset class.

But it’s not just about performance. According to some emerging private equity managers, the system is even ending relationships with firms that have enjoyed better returns than other managers in its portfolio.

This is where the distress comes in … [CalPERS] is saying they're supporting emerging managers, yet the ones they have supported and who have returned quite well are not being funded.

Robert Smith

Take Vista Equity Partners, which closed its fourth fund earlier this year on $3.5 billion, well oversubscribed but without a commitment from CalPERS. Vista’s third fund, which is part of the Capital Link funds, was generating a 2x multiple and a 28.6 percent internal rate of return as of 31 December, according to CalPERS’ performance numbers – so it would appear to be a perfect candidate to ‘graduate’ from the emerging manager portfolio. But CalPERS didn’t like the fund’s 30 percent carried interest rate that would kick in if the fund achieved a 3x multiple, according to Vista’s head Robert Smith.

“This is where the distress comes in … [CalPERS] is saying they’re supporting emerging managers, yet the ones they have supported and who have returned quite well are not being funded,” Smith says.

Ed Dandridge, CEO of trade body the National Association of Investment Companies, which represents minority-led private equity firms, agrees. If performance was the decisive factor influencing CalPERS’ investment decisions, why would it not re-up with top-performers like Vista, he asks?

Further, NAIC earlier this month published, with the help of KPMG, a study showing that NAIC member firms — mostly minority and women-led — have outperformed the general private equity industry, generating median net IRR during the time period from 1998 to 2011 of 15.2 percent, compared to 3.7 percent for all US private equity, and 7.1 percent for US buyout funds. The study also shows that upper quartile net IRR was 20.9 percent over the time period for NAIC firms, compared to 11.8 percent for the US private equity industry, and 14.7 percent for US buyout firms.

Managers in the programme also believe CalPERS’ commitment to the strategy is waning. Earlier this year, the system allocated $100 million to Credit Suisse for a private equity emerging manager programme, to be spent over three years. Some emerging managers argue that this amount is insignificant compared to the $1 billion it has entrusted to Centinela via the Capital Link funds since 2006, and to the fund’s total assets, which are currently valued around $236 billion.

The Centinela fall-out

The suspicion that CalPERS is less committed to its emerging manager programme has been fostered by the gradual breakdown of its relationship with Centinela.

In 2010, Centinela came back to CalPERS for a re-up to the Capital Link programme. At the time, CalPERS was in the process of investigating alleged pay-to-play activities among some of its managers and pursuing a full review of its alternative investments programme.

The system did offer Centinela a $100 million commitment – but made it contingent on the firm removing its chief, Cesar Baez. CIO Dear said Baez had a “fitness issue”, according to documents PEI obtained earlier this year through a public records request.

Centinela claims officials were worried about Baez’s relationship with certain “Latino” placement agents. However, Baez and Centinela were not accused of any wrongdoing.

Cesar Baez

Eventually, Centinela agreed to remove Baez, and expected to receive the $100 million commitment to keep running the programme.

However, CalPERS hired Réal Désrochers as the new head of its private equity programme last year, and he decided that “it would not be in keeping with CalPERS’ fiduciary duty to award Centinela Capital Link III as previously contemplated”, according to the documents.

Désrochers argued that Centinela had not achieved “market validity” by attracting other LPs, according to a letter the

In the current market environment, we have had to make some tough decisions about our partners to improve the long-term performance of our fund.

CalPERS spokesperson

firm sent to CalPERS investment staff (which was part of the record release).

Centinela filed breach of contract and racial discrimination claims with the California Victim Compensation and Government Claims Board earlier this year, arguing that CalPERS has “reneged” on its promise to re-up with the firm. However, the board rejected the claims and recommended Centinela take its claims to court. The firm says that it is keeping all of its options open.

Either way, the relationship appears to have broken down irreparably: in July this year, CalPERS fired Centinela from managing the Capital Link portfolios, giving the job to Credit Suisse instead (which was already running CalPERS’ most recent mandate).


Attracting attention

Meanwhile, tensions have been escalating between CalPERS and its existing private equity emerging managers. Many of the latter have grown frustrated with what they see as CalPERS ignoring them, i.e. not even returning phone calls or emails, according to sources.

“In the current market environment, we have had to make some tough decisions about our partners to improve the long-term performance of our fund,” a CalPERS spokesperson said.

The system has acknowledged the break down of relations. In the recent letter, CIO Dear asked state Senator Price for help in improving relations: “We have concerns that the continued focus and breakdown of performance by segment or fund will only lead to further mistrust and divisiveness. We would appreciate your help in trying to find a mutual understanding with the emerging manager community on these issues.”

But according to NAIC, CalPERS has rejected re-investments in emerging managers in the Capital Link portfolio without appropriately explaining its rationale, or offering them suggestions on how to improve.

“Attempts by these NAIC managers to solicit constructive feedback resulted in a pattern of avoidance by CalPERS,

Joe Dear in an interview earlier this year

followed by non-specific concerns about firm performance in some cases, and no reply in others,” Dandridge said at a special hearing in California in September, which was convened by state Senators Price and Gloria Negrete McLeod in part to investigate the perception that the pension system has been inequitable in its manager selection.

“CalPERS’ recent actions and lack of transparency in its assessment of NAIC firms has led to significant concern among association members, and, more broadly, confusion in our industry,” he continued.

NAIC believes the system is pursuing a strategy of committing capital to the biggest firms in the market, who “are able to provide significant management fee discounts because of their size”, according to Dandridge (its $500 million commitment earlier this year to The Blackstone Group’s Tactical Opportunities fund being a prime example). This strategy appears to be ruling out even the best-performing emerging managers, he says.

We're in the state of California — the nation's largest state, the nation's most diverse state, ethnically and culturally … It is in our economic interest to have as wide a pool of talent as possible available to us so we can achieve our investment target.

Joseph Dear

However, at the same hearing, CalPERS’ CIO Dear restated the system’s “unequivocal” support for emerging managers – and explained that each of the managers who submitted proposals got fair consideration, plus explanations if they were rejected. At least two of them may receive a commitment from the system, he added.

“We’re in the state of California – the nation’s largest state, the nation’s most diverse state, ethnically and culturally… It is in our economic interest to have as wide a pool of talent as possible available to us so that we can achieve our investment target,” Dear said.

Another hearing is scheduled for this month, at which time several emerging managers have said they hope to find some resolution to what they think is an “imprudent” shift away from a strategy that they believe has actually been helping to boost CalPERS’ returns.

It’s also, of course, a strategy that has been instrumental in helping young and minority managers get a foot in the industry door.

On the other hand, although there’s an argument that CalPERS’ bench of investment managers ought to be reflective of its home state, the pension system would say that its primary responsibility must always be to its pensioners – which means that issues around performance and fees may always need to take precedence over any social goals. CalPERS now needs to play quite a balancing act. 

Subscribers to Private Equity International magazine can also read this article in our October issue.