Wednesday, January 15, 2014

CalPERS Revamping its PE Portfolio?

Randall Smith of the New York Times DealBook reports, Stung by Scandal, Giant Pension Fund Tries to Make It Right (h/t, Suzanne Bishopric):
After a pay-for-play scandal tarnished its reputation, the nation’s largest public pension fund turned to a courtly native of Quebec to help it restore order and improve performance in a crucial investment sector.

One of the main tasks for Réal Desrochers, the Quebecer who has been head of private equity investments at the pension fund, the California Public Employees’ Retirement System, since 2011, is to reduce the number of outside management firms, which now stands at 389. The portfolio is “overdiversified,” hurting its ability to generate above-average returns, he told fund board members last month.

In an effort to achieve returns that exceed those of the overall stock and bond markets, many large public pension funds like California’s, which is known as Calpers, turn to so-called alternative investments like private equity, real estate and hedge funds. Private equity firms, for example, acquire companies, make changes outside the spotlight of public ownership and then profit by either selling them or selling shares of their stock to the public. While such investments usually carry higher fees and may often be less liquid, their long-term returns can be lofty.

Because Calpers uses stock index funds, which aim to mirror overall market performance, for more than one-third of its investments, it depends all the more on alternatives like private equity, which accounted for $31.2 billion, or 11 percent, of the fund’s $272 billion in assets as of Sept. 30. That percentage has more than doubled in the last decade.

Calpers aims for the private equity category to beat stock market returns by three percentage points annually. For the 10 years that ended Sept. 30, the category returned 12.9 percent a year. While that was well above the stock market’s performance of 8.5 percent, it still slightly trailed a custom Calpers benchmark that changed twice during the period.

In a progress report to the investment committee of the Calpers board on Dec. 16, Mr. Desrochers (pronounced day-row-SHAY) said the fund should have only 100 to 120 private equity managers, implying drastic plans to cut the number by two-thirds or more. But winnowing the field takes time because, as he noted, private equity funds typically have a life of 10 years, often with extensions of two to three years. The plan to cut managers was first reported by the publication Pensions & Investments.

Mr. Desrochers, 66, previously was the head of private equity investments at the California State Teachers Retirement System and also managed private equity at Caisse de Dépôt et Placement du Québec, a giant Canadian pension fund manager. He joined Calpers in the wake of a scandal over fees paid to placement agents for certain private equity investments.

In May 2010, the California attorney general brought a civil fraud case against Calpers’s former top executive, Federico R. Buenrostro, and a former board member, Alfred J. Villalobos, accusing them of sharing in more than $47 million in undisclosed fees. The Securities and Exchange Commission filed a related case in 2012.

Last March, the United States attorney in San Francisco charged the two men with criminal fraud, accusing them of falsifying documents for $14 million in fees paid by one of Calpers’s private equity managers, Apollo Global Management. Apollo was not accused of any wrongdoing. All three cases are pending, with a trial set for March in the federal criminal case.

Mr. Desrochers’s predecessor at Calpers, Leon Shahinian, resigned in August 2010 after it emerged that, in connection with a Calpers business trip, he had accepted travel on a private jet and perks including attendance at a black-tie event honoring Apollo’s founder, Leon Black, according to a report on the placement agent issue by a Calpers outside counsel, Steptoe & Johnson.

In all, four private equity managers, including Apollo, agreed in 2010 to cut their fees for Calpers by $215 million over five years as part of the Steptoe legal review. Without going into detail, Mr. Desrochers says his own restructuring program has saved fees of $90 million to $250 million.

Joseph A. Dear, Calpers’s chief investment officer since 2009, said that the placement agent imbroglio had injected “undue influence into the investment decision process” without necessarily affecting the outcomes and that the large number of managers had tended to drive performance “toward the median.” (Mr. Dear announced last week that he was taking a new medical leave to battle a previously disclosed prostate condition.) Mr. Desrochers has also had to contend with political pressure to hire “emerging managers,” which include many firms owned by minorities and women, as well as managers who invest partly to create jobs and promote economic development in “underserved” California areas.

“When you have that many managers, you’re going to wind up with average performance,” said J. J. Jelincic, a Calpers board member elected by the pension plan’s participants. Calpers has a stake in 741 private equity funds. Generally speaking, if each fund had investments in 20 companies on average, the resulting stakes in more than 14,000 companies would “act like an index fund,” and each individual commitment “wouldn’t move the dial” in delivering outperformance, said Michael McCabe, a pension fund consultant at the firm StepStone in New York.

Other big public funds have also sought to cut manager head counts for similar reasons. Lawrence Schloss, former chief investment officer of the $148 billion New York City Employees’ Retirement Systems, said he tried to trim the manager ranks during his nearly four years at the fund. Results for smaller commitments of $100 million or less “really have no impact on a fund that size,” said Mr. Schloss, who is now president of Angelo, Gordon, an alternative investment firm.

In his December report, Mr. Desrochers made several comments that seemed to point to a few underperforming areas where some managers may be cut. One is in so-called funds of funds, which make dozens of smaller investments that drive up the manager head count. Another is venture capital, where fund sizes may be too small to move the needle on returns.

Funds of funds are expensive because they charge two layers of fees but do not outperform, Mr. Desrochers said, and do take control of manager selection away from Calpers’s own staff. With long-term annual returns of just 4.1 percent, he called them “a drag on the portfolio.” The dozen funds of funds listed on the Calpers roster have among them more than 200 different managers, so eliminating them could trim the managerial ranks by more than half.

Many of the funds of funds managers are in venture capital. Calpers has already mapped plans to cut its venture allocation to 1 percent of the portfolio from the current 5.4 percent. Venture returns have also lagged, at 4.3 percent annually over 10 years. By comparison, buyouts, which represent three-fifths of the portfolio, have returned 17.2 percent.

While the going may be slow so far for Mr. Desrochers, he “is doing a good job getting hold of a program that is quite frankly out of control,” Mr. Jelincic, the Calpers board member, said.
And Randy Diamond of Pension & Investments reports, CalPERS plans to cull 269 private equity managers to boost performance, oversight:
CalPERS wants to cut the number of private equity managers to less than a third of the 389 managers now participating in the $42 billion program.

Real Desrochers, senior investment officer, private equity, for the $277.3 billion California Public Employees' Retirement System, Sacramento, told the CalPERS investment committee Monday that a future goal is to reduce the number of managers to around 120.

Mr. Desrochers did not detail a timetable for the reductions.

In an interview, Mr. Desrochers said reducing the number of private equity managers is keeping with the private equity program's focus on managers with strong long-term performance. He said reducing the number of relationships would also enable to CalPERS to better monitor managers.

The number of managers and private equity funds has slightly decreased since Mr. Desrochers began a strategic plan in September 2011 to revamp the program. The number of managers has declined since the plan began to 389 from 398, while the number of private equity funds has gone down during that same period to 741 from 762, CalPERS statistics show.

The plan also included adding risk and investment review units to the private equity program and increasing investment staff to 58 currently from 28 in September 2011.
The articles cover a lot of information so let me walk you through it. Basically CalPERS has way too many private equity relationships which is why it's delivering index performance.

But in private equity, you're taking on illiquidity risk, and don't want index performance, you want to be handily beating the median return of funds or else you're better off investing in the S&P 500 and having no liquidity risk.

I've known Réal Desrochers for years. He is a standup guy with a very interesting background. His approach in private equity is akin to Warren Buffett's approach in the stock market, ie., take a few concentrated bets with well-known funds and outperform the index by a substantial margin over the long-run. They are not interested in being closet indexers or relying on useless investment consultants (CalPERS does use many consultants, some are a lot better than others).

You read the article above and think what the hell is CalPERS doing investing in 389 outside managers and a bunch of funds of funds that are raping them on fees, drastically hindering their private equity performance. It's a joke and there is no way Réal Desrochers or anyone else can clean up this mess in a timely manner.

That's the thing with illiquid private equity, real estate or infrastructure, once you're invested, you're pretty much stuck with that investment for many years. Sure, pension funds can unload some of their private equity portfolio to secondary funds who are always looking to purchase private stakes at a deep discount but this isn't a smart strategy.

What else struck me from the article above. Over 5% of CalPERS PE portfolio is allocated to venture capital. What a disaster that has been. I can tell you from my experience working at the Business Development Bank of Canada that venture capital is a total disaster and very few LPs have made money in this space (OMERS Ventures CEO John Ruffolo, a very decent guy, is trying to change this but it won't be easy).

In fact, I remember when I was working at PSP helping Derek Murphy set up private equity, I got him and Gordon Fyfe to meet Doug Leone, one of the founders of Sequoia Capital. In the VC world, Sequoia Capital are gods. They are part of a handful of elite VC funds and they command respect because they seeded Apple, Google, Oracle and many other successful technology powerhouses.

Anyways, I don't know where I got Doug Leone's name, probably from one of the many books I bought, but I just called him up and asked him if he would meet with Derek and Gordon. At first, he refused and told me straight out: "Don't bother investing in venture capital funds unless you want to lose all your money. We're not interested in meeting PSP or any public pension fund. We're fighting amongst partners as to whether to allocate more money between Yale or Harvard's endowment fund."

I kept pleading with him to meet Derek and Gordon. I even called him three times in one day until he finally gave in: "Ok kid, I like your persistence, tell them they got thirty minutes." Gordon and Derek loved that meeting and realized venture capital isn't a space PSP will ever invest in. They both told me "we never felt so poor in our lives." Of course, wealth is all relative as they're both doing just fine at PSP, collecting millions in comp beating their bogus benchmarks (they finally got the PE benchmark right!).

Ah benchmarks, one of my favorite subjects and the one topic that makes Canada's pension aristocrats extremely nervous. It's all about the benchmarks, stupid! If you don't get the benchmarks right in private equity, real estate, infrastructure, hedge funds, stocks, bonds, commodities or whatever, then you run the risk of over-compensating pension fund managers who are gaming their benchmark to collect a big fat bonus. And as we saw with the scandal at the Caisse that the media is covering up, things don't always turn out well when pension fund managers take stupid risks, like investing in structured crap banks are dumping on them.

A few months ago, Réal Desrochers called me to work on fixing CalPERS private equity benchmark. I can't consult CalPERS or any U.S. public pension fund because I'm not a registered investment advisor with the SEC and they got all these rules down there which make it impossible for a Canadian to work for them.

Anyways, I remember telling Réal their PE benchmark is too tough to beat, the opposite problem that many Canadian funds encounter. I told him I like a spread over the S&P 500 and even though it's not perfect, over the long-run this is the way to benchmark the PE portfolio.

Andy Moysiuk, the former head of HOOPP Capital Partners and now partner at Alignvest  has his own views on benchmarks in private equity. He basically thinks they're useless and they incentivize pension fund managers to take stupid risks. He raises many excellent points but at the end of the day, I like to keep things simple which is why I like a spread over the S&P 500 or MSCI World (if the portfolio is more global).

Should the spread be 300 or 500 basis points? In a deflationary world, I would argue that many public pension funds praying for an alternatives miracle that is unlikely to happen will be lucky to get 300 basis points over the S&P 500 in their private equity portfolio over the next ten years. To their credit, CalPERS has updated their statement of investment policy for benchmarks, something all public pension funds, especially the ones in Canada should be doing (don't hold your breath!).

Below, Patrick Siewert, managing director for Asia consumer and retail buyout at Washington-based private-equity firm Carlyle Group, talks about the company's investment strategy in China. He speaks with Rishaad Salamat and Angie Lau on Bloomberg Television's "Asia Edge."

And Roy Kuan, Managing Partner, Asia at CVC Capital Partners, says the goal for private equity against a backdrop of rising interest rates is to ensure stable returns.