Dear & Ailman: Smashing 2-and-20

The climate may still be challenging for private equity. But the chief investment officers of the two largest US public pension plans – the $255 billion California Public Employees’ Retirement System (CalPERS) and the $167 billion California State Teachers’ Retirement System (CalSTRS) – have no intention of pulling back from the asset class. 

“It’s necessary to achieve our return objectives,” says CalPERS CIO Joe Dear, during a conversation with PEI and CalSTRS CIO Chris Ailman on the sidelines of the Milken Institute’s annual ‘Global Conference’ in Los Angeles in May. “Different strategies are working at different degrees; different-sized firms are performing different ways. The basics are still important; who you do business with is still fundamentally important.”

Ailman agrees, saying he’s “totally bullish” on private equity at the moment. 

The only exception, he says, is the mega-deals. “I’m worried about some of the EBITDA multiples that are crawling up again.” Historically, he adds – “all the way back to the great RJR [Nabisco deal]”– very large transactions haven’t exactly been private equity’s best performers. “But like Joe said, when you look at the range of investment options other than equities, private equity still should be able to offer returns with some consistent growth. It’s got to be organic, they’ve got to grow the companies.” But GPs need to act prudently, he insists – as once again “leverage is very, very inexpensive”.

A number of GPs at the conference suggested the smartest among their peers were watching cautiously from the sidelines and sticking to deals in sectors with idiosyncrasies. 

Apollo Global Management’s Josh Harris, for example, is worried about market over-exuberance. “What you’re seeing now is the high-yield market at 570 [bps] and then you’re seeing companies put 6.5 even 7 times debt to EBITDA to consummate transactions,” Harris said on-stage during a panel. “When you see the high-yield market below 6[00 bps], run – do not walk, run – the other way.”

The Apollo co-founder warned against ‘drunk driving’ on cheap credit. “The bar is open, the bartender is serving lots of drinks,” Harris said – in part because central banks have been pumping trillions of dollars into the system.

“You’re seeing that lowering of rates and liquidity reverberate into the high-yield market.” But he also suggested that unlike the last credit boom, most GPs were “sitting this one out sensibly”. 

That’s largely in line with what Dear and Ailman say they’ve observed. “The GPs are talking to us, telling us they are going slow [agreeing new transactions] and checking to make sure that we don’t think they’re going too slow,” confirms Dear. 

CalPERS’ main objective going forward is to be mindful of history, Dear says – “not forgetting that you have waves of optimism and waves of pessimism, but [trying] to keep up a relatively steady amount of capital at work at any given time”.