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Reassuringly expensive

Half a billion dollars of carry may seem like a lot for a public pension to pay external managers, but while CalPERS’ direct investment portfolio has performed well since inception, returns data available for the past 10 years suggest it would be better off sticking with GPs.

It was a week of headline-grabbing numbers on the West Coast.

The California Public Employees Retirement System revealed it had paid $539 million in carried interest to private equity general partners in the last year, with the big winners in the portfolio being Advent International, CVC and TPG. This is the total carry paid across the 118 funds that have given CalPERS the data; the pension has commitments to 408 funds in total.

The California State Teachers’ Retirement System, meanwhile, said it paid $851 million in private equity fees and expenses in 2015, $516 million – or 60 percent – of which was carried interest.

To put these numbers in context, CalPERS committed $4 billion to the asset class in the last fiscal year and is budgeted to do the same in the fiscal year 2016-17. CalSTRS’ private equity portfolio is valued at more than $16 billion.

CalPERS’ chief investment officer Theodore Eliopoulos asked its private equity team to explore options to change the $299.5 billion pension fund’s programme, including cutting out GPs and making private equity investments directly, according to a person familiar with the matter. “It’s not a game of chicken,” Eliopoulos reportedly said, noting a potential review could take several years.

Eliopoulos is merely considering different ways of investing in the asset class; he is not attacking GPs, but putting the focus on making CalPERS’ private equity programme as cost-effective as possible, adding that other options include increased co-investments and use of separate accounts.

While PEI understands the co-investment and direct investment portfolio has performed well since inception, providing a 9.48 percent return according to a source familiar with CalPERS' PE portfolio, when looking at the performance of CalPERS’ existing private equity investments for the past 10 years only, the direct route might not be the best to follow.

CalPERS’ $1.8 billion co-investments and direct investments bucket – yes, the pension has made some direct investments at some point, although it wasn’t available to confirm what those were – has returned a mere 1.8 percent on a 10-year basis.

Over a one-year period, the direct portfolio actually declined 4.4 percent, which CalPERS attributed “to the continued underperformance of large direct investments”, in its 2016 first half private equity performance report released in August, adding that “co-investments and direct investments have lagged the overall portfolio over all time periods”.

This compares with a 1.7 percent one-year return and a 10.2 percent 10-year return for investments in private equity partnerships: the bulk of its programme in the asset class.

“Partnership investments have been and will continue to be the largest contributor to performance over all time periods,” CalPERS wrote in its first-half report.

Separately managed accounts fared better, but only in the short term, returning 12.9 percent on a one-year basis and 4.1 percent on a 10-year basis.

One bucket that typically has a lower cost of capital, presents less risk, and has been proven to offer robust and stable returns is secondaries. The strategy delivered a 5.6 percent one-year return, a whopping 39.6 percent three-year return, and 10.9 percent on a 10-year basis, the strongest return on that timeframe.

Additionally, while going direct may cut fees and expenses to GPs, it would increase internal costs as they attempt to lure investment professionals in-house with competitive salaries; something that is not a viable option for US public pensions in the same way that it is for their Canadian counterparts.

The industry has watched with interest as CalPERS has streamlined its private equity portfolio, reducing its number of manager relationships from 100 to 30 in five years. If it were to cut out managers altogether it would be seismic, but we don’t expect this to happen any time soon.