Thursday, February 20, 2014

CalPERS Strikes Fear Into PE Firms?

Matthew DeBord wrote a comment for Southern California Radio O89.3KPC, CalPERS strikes fear in the hearts of private equity firms:
Yesterday, CalPERS, the huge California public employees pension fund, announced some good news: the $248 billion colossus made a 13.26 percent return on its investments in calendar year 2012. They're dancing with their spread sheets in Sacramento, because that's a vast improvement over the 2012 fiscal year performance, which ended on June 30.

How bad was the fiscal year performance? One percent.

Yep, one percent. It was bad.

CalPERS has targeted a rate of return for its investments of 7.5 percent — a target that it reduced from 7.75 percent last year. So that 13.26 percent return, if it holds up through the fiscal year, will go a long way toward helping CalPERS make up what it lost last year.

However, as CalPERS Chief Investment Officer Joe Dear pointed out and Pensions & Investments reported, that 13.26 percent wasn't as thrilling as it sounds. It was "117 basis points below the retirement system's custom benchmark for the calendar year."

Translation: CalPERS expected 14.43 percent (a basis point is 1/100th of a percent, so the math is 1326 + 117). The problem child was private equity:
Mr. Dear attributed the below-benchmark results to disappointing returns in the private equity portfolio, which had a 12.24% return in the period, compared with the custom benchmark's 28.4% return.
That's a pretty hefty expectation on CalPERS' part, and it highlights a challenge facing big pension funds. The 2012 annual return on the S&P 500 was about 13 percent, so money passively invested in that index would have beaten CalPERS private equity portfolio by...76 basis points! (0.76 percent).

Obviously, it's an uncomfortable situation to be a pension fund manager and see that putting state workers' retirement money into an index that runs on autopilot is a better strategy than investing in sexier, riskier alternatives.

But CalPERS can't take its chances with more passive investments, because the bond and equity markets are going to have down years. In order to achieve that (reduced) 7.5 percent benchmark return — which it's only beating, barely, on a ten year basis, according to Dear — CalPERS had to construct a portfolio of alternative investments, including private equity, which can meet a benchmark annual return of nearly 30 percent.

It currently has $45 billion locked up in private equity, and in many cases, those funds are truly locked up — invested for long time frames.

What CalPERS calls "private equity" is actually an amalgam of "sub-asset classes," in the system's language. Of these, venture capital and "buyout" are two of the most familiar, because we hear so much about venture capitalists and their high-tech investments, as well as buyout shops, a good example of which was Mitt Romney's old firm, Bain Capital.

CalPERS, as I wrote last year, has been reviewing its venture capital allocation, in light of the meager returns that VC has generated. That looked like good news for buyout firms:
If CalPERS does greatly reduce its VC investments — and the writing is on the wall that it will — it will have to redeploy those funds in its private-equity portfolio. CalPERS calls everything that isn't "typical" in the portfolio "private equity," combining leveraged buyouts, VC, and other alternatives into one group. What most people now think of as private equity — leveraged buyouts of companies, the kind of thing Mitt Romney did when he was at Bain Capital — has been performing much better than VC.

So while CalPERS' change in investment philosophy may strike fear in the hearts of VCs, it will likely bring a smile to faces of private-equity players. And that could be good for Los Angeles, where private-equity is more entrenched and VC is just beginning to be competitive with Silicon Valley.
But CalPERS' big miss for 2012 on the entire private equity portfolio means that buyout firms, which represent the biggest chunk of investments, aren't doing so well, either. The Economist's Free Exchange blog tackled this problem last year, pointing out that private equity firms invested in by pension funds haven't lived up to outsized expectations.

I reached out to CalPERS for comment — specifically, whether they've broken out returns for VC versus buyout in the private equity portfolio. But according to a spokeswoman, CalPERS hasn't generated that breakdown yet.

A number of state pension funds are starting to seriously question their commitment to alternative assets in their portfolios. CalPERS isn't totally there yet — so far, it's only had major issues with VC. But if private equity continues to miss its marks, there could soon be a day of reckoning in Sacramento.
I thank Andy Moysiuk, the former Managing Partner of HOOPP Capital Partners and now partner at Alignvest, for sending me the article above.

I've already covered why CalPERS is revamping its PE portfolio but think it's important to go over some points again so that everyone understands their reasoning. First, over 5% of CalPERS PE portfolio is allocated to venture capital and it's been a total disaster.

In my humble opinion, Doug Leone of Sequoia Capital is right, pension funds shouldn't be investing in venture capital. In fact, I question whether anyone except for the very best VC funds should be investing in venture capital (I saw how disastrous these investments were at the Business Development Bank of Canada and even though they're doing better, I have my doubts as to whether the BDC should be investing in VC).

Second, CalPERS has way too many private equity relationships, almost 400 in all. That's ridiculous and basically a testament of how Réal Desrochers' predecessor didn't have a clue of how to construct a proper private equity portfolio. With so many goddamn relationships, CalPERS was literally a big private equity cash cow, funding pretty much anyone. It's hardly surprising the returns are mediocre. CalPERS private equity portfolio is one giant PE index, which isn't what you want when you invest in illiquid asset classes that are suppose to deliver absolute returns and handily beat your public market benchmarks over a long period.

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.

Third, Réal Desrochers' private equity strategy is the same one he had at CalSTRS.  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 (Buffett bets on a few stocks) and outperform the index by a substantial margin over the long-run.

However, Réal doesn't really care how good a fund's past performance and treats each new fund the same way. And if the terms aren't right, he has absolutely no problem walking away, no matter how well-known the private equity funds and its managers are. In fact, he even told me about one popular fund where the decision making power is concentrated in the hands of two partners and he decided not to invest in their new fund, irritating its superstar manager. "I didn't like the governance so I walked away. Still, the fund was oversubscribed because a lot of pension funds just look at the pedigree."

Fourth, as I stated in my comment on CalPERS is revamping its PE portfolio, CalPERS' PE benchmark is ridiculously tough to beat and a lot of that has to do with the allocation to VC:
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!).
On the issue of benchmarks in private equity, Andy Moysiuk shared these words of wisdom with me:
I tend to be a bit more diplomatic than you have suggested in regards to benchmarks. Public index based benchmarks tend to direct activities towards more cyclical investments that move in sympathy to the public markets, defeating some of the purposes of having private equity be a lower correlation investment activity in an overall equities mix.
Further, risk adjusted investment structures can be a highly valuable part of an overall private equity portfolio, and a public benchmark implies there is no value to these critical risk control tools that are often uniquely available in private equity investing. And when one considers the hurdle rates embedded in virtually every private equity partnership contract, the underlying general partners are operating on an incentive model completely unlinked to public market relative performance.
The historical public market biases within institutions are at the root of public market benchmarking, indeed it is public market people that coined the term “alternative investments”, i.e. an alternative to public markets. Alternatives have evolved more broadly to be non-index tracking investment approaches, not necessarily illiquid, and generally investments geared towards making a profit in absolute terms.
A modern approach to benchmarking would evolve as well. I had used an absolute return approach since 1999 in my institutional investing, using the actuarial return for the pension fund as whole as a hurdle rate as a starting point to measure whether the asset class was serving a useful purpose (and this was disclosed in annual reports, along with actual performance).
Really, I was adopting more of a corporate capital allocation model, and I found that this approach was aligned with the incentive models within the general partners, and more closely aligned with how underlying operating companies actually allocated capital and seemed to support the seeking of risk adjusted returns in sympathy with reasonable expectations.
In the end, specific organizations benchmarking approaches can simply reflect the culture and intentions/expectations of a firm, which could appropriately change over time. What matters is the benchmark choice be thoughtfully considered, including the business and behavioural implications, and transparently disclosed.
Andy is one of the nicest and sharpest minds I've had the pleasure of meeting in the course of writing this blog. He really knows his stuff when it comes to private equity and he raises excellent points as to why traditional "public market" benchmarks in private equity will direct activity to more cyclical investment activity, defeating some of the purpose of having private equity in the portfolio.

But I remain undeterred knowing full well that no matter what, private equity is intrinsically tied to public markets. There is no way around this and that's why the correlation between private equity and public equities is a lot stronger than what most risk models lead you to believe. These risk models consistently underestimate the real correlations between public and private investments.

Also, I'm an economist by training. I see things in terms of "opportunity cost." The opportunity cost of taking on too much illiquidity risk in private markets is investing in good old public market benchmarks. Over the long run, you most definitely hope the private equity, real estate and infrastructure portfolios at your large public pension funds are handily beating public market benchmarks or else what's the point of investing in private markets, getting raped on fees?

One thing I will tell you about private markets, the time to invest heavily is when everyone else is selling them to shore up their liquidity. In that sense, PSP and CPPIB have a "liquidity advantage" over most of their competitors because they can pounce when market dislocations occur, buying up private market assets on the cheap and sitting on them for a long time waiting for their values to increase.

But other more mature pension funds that do not have PSP or CPPIB's liquidity profile can still invest wisely in private markets but they need to be smart and control liquidity risk a lot tighter. And they need to carefully consider the opportunity cost of making such investments. For example, blowing billions in the wind might sound sexy but in my opinion, it's a really dumb investment.

Hope you enjoyed this comment and once again let me remind all of you, this is the best blog on pensions and investments so pay up and show your appreciation by subscribing using the PayPal buttons on the top right-hand side (I don't really need your money but will keep harping on all of you, especially those ridiculously overpaid and cheap pension plutocrats that have yet to show me the love I deserve!).

Below, David Rubenstein, CEO at Carlyle Group, discusses philanthropy, income inequality and the state of private equity from the World Economic Forum’s annual meeting in Davos, Switzerland on Bloomberg Television’s “Market Makers.”

And the DLD Munich conference hosted WhatsApp co-founder Jan Koum. A month later Facebook purchased the messaging app for $19 billion. The forum was moderated by David Rowan of Wired UK. There is no bubble in private markets? Yeah right! Short Facebook and go long Twitter over next five years and please pay me a nice slice of your profits!!!