Tuesday, June 19, 2018

CalPERS Gears Up CalPERS Direct?

Arleen Jacobius of Pensions & Investments reports, CalPERS gears up for private equity portfolio changes:
Private equity was a big theme at CalPERS' investment committee meeting on Monday.

The $356.5 billion California Public Employees' Retirement System, Sacramento, adopted a new investment policy statement that includes lowering the benchmark return for its private equity portfolio. The committee also discussed a proposal to change its private equity investment structure that includes creating an outside corporation to make direct investments, and it reviewed the first draft of a new private equity investment policy.

Chief Investment Officer Theodore Eliopoulos kicked off the meeting by stressing the importance of private equity to the system's total portfolio.

Private equity has had the highest return of any asset class and that is expected to continue, Mr. Eliopoulos said. He said the private equity portfolio has added $11 billion over public equities. Private equity also expands the investible universe and has exhibited the most growth in the capital markets, he said.

"There's no obvious public markets substitute for the private equity portfolio," he said.

This is important because CalPERS is 71% funded and has an expected rate of return of 7%, which is "relatively high" and could be difficult to achieve, especially with a lower interest-rate environment, Mr. Eliopoulos said.

"Private equity is the only asset class projected to provide more than 7% return over the next 10 years," he said.

CalPERS' new investment policy for the entire plan lowers the private equity benchmark to FTSE Global All-Cap index plus 150 basis points, lagged by a quarter, from a custom benchmark of 67% FTSE U.S. Total Market index and 33% FTSE All-World ex-U.S. index plus 300 basis points, also lagged one quarter. The new policy also requires prudent person opinions by an outside firm for private equity co-investments and customized separate accounts.

During the discussion of its new private equity structure, Mr. Eliopoulos noted that CalPERS would have to commit about $10 billion to $13 billion a year to get to and maintain a 10% private equity allocation. Currently, the private equity target allocation is 8% plus or minus 4 percentage points, with a 7.7% actual allocation.

"This strategy reflects our conclusion that CalPERS needs to substantially add to our current business model and to our internal resources to achieve our objective of a substantial and successful private equity portfolio over time," he said.

The structure has four pillars: the partnership model; emerging managers; and two strategies that would be run by a separate corporation, CalPERS Direct — private equity and venture capital. CalPERS' investment staff will now begin researching industry best practices regarding the makeup of both the independent advisory boards for the private equity and venture capital direct investment strategies and the management teams for CalPERS Direct.

CalPERS executives would like to invest more capital in its emerging private equity manager fund-of-funds program and add co-investments with the managers, Mr. Eliopoulos said. CalPERS currently has $350 million in two private equity emerging manager funds-of-funds portfolios.

During the discussion on the new private equity structure, Ashby Monk, executive and research director at Stanford University's Global Projects Center, told the committee it was not the only asset owner considering establishing an "arms-length" entity to invest in private equity.

Investors are stuck with private equity, even if they don't like the alignment of interest or the fees, because it is likely to produce better returns than the public markets, Mr. Monk said.

"So, you need it but the challenge is that everybody else has realized they need it too," resulting in a flood of money into the asset class, Mr. Monk said. "We need to be innovative," he said.

A few committee members noted that time is of the essence and that CalPERS needed to create a new structure soon or it would be left behind.

"The fact that it's not going to get better where we are today ... we have a lot of choices in how we design this, how we construct it," said Bill Slaton, board member. "I don't think we have a lot of choice doing it. I think we'll be compelled by the marketplace to do it."

Mr. Monk agreed. "You're not alone," he said. "You guys are on a journey I can think of probably 20 or 25 plans like you right now are saying, 'how are we going to do this?'"

CalPERS' investment committee also had a first look at a new private equity investment policy proposal that removed direct investments in private equity firms as a transaction type. The current policy includes direct investments "including independently sourced investments." However, during the investment committee meeting, Sarah Corr, interim head of CalPERS' private equity program, explained that "direct investments" referred to investments in private equity general partnerships.

The only direct investments CalPERS has made in private equity are stakes in general partnerships, said Megan White, spokeswoman.

CalPERS invested in private equity firms only a few times on an opportunistic basis and hadn't taken a general partnership stake since 2007, she told the investment committee. In that year, CalPERS took minority stakes in Apollo Global Management and Silver Lake. CalPERS had also taken a minority stake Carlyle Group in 2001.

In an interview, Ms. Corr said the new private equity investment policy, if adopted, would remove the strategy as a simplification measure. The new policy also expresses staff's authority to make investments without board approval in dollar terms from percentage of the total private equity assets.

The policy would also remove the requirement that staff obtain board approval for private equity funds of managers that are not at least second quartile. However, CalPERS staff would need to obtain a prudent person opinion for commitments to funds of managers that are not at least second quartile.

The private equity policy would also lower staff's authority to make commitments to top-quartile investments without investment committee approval, while increasing that authority for second-quartile funds. The managing investment director authority to commit to top-quartile funds without investment committee approval would be reduced to $500 million from 4% of the private equity portfolio, and the CIO's limit would be reduced to $1 billion from 8%. But the managing investment director's authority to invest in second-quartile funds would be increased to $500 million from 0.75% of the portfolio and the CIO's authority would increase to $1 billion from 1.5%.

Impact investing

Separately, CalPERS staff and Pacific Community Ventures, a impact investing consultant, gave the final report for its $2.1 billion California private equity investment initiative, a program it has been winding down since 2013, Mr. Eliopoulos noted. The only portion of the program that will be kept are co-investments, which will be part of CalPERS' new private equity structure, he said. CalPERS is winding down the program to which it committed $1 billion since its 2001 inception in order to move "side programs" into the main private equity investment program.

The program which was established to invest private equity in traditionally underserved markets, primarily but not exclusively in California, and has been successful in investing in underserved markets and in women and minority-owned businesses, he said. CalPERS will support women- and minority-owned businesses as an ancillary benefit of its emerging manager program. Staff is studying whether investing in emerging managers also has an impact on investing in underserved areas, Mr. Eliopoulos said.

Board diversity

Also, the investment committee plans to enhance its definition of what it means to have a successful board diversity program so that staff can file shareholder proposals and vote against directors at U.S. companies that lack diversity. The so-called "key performance indicators" would change to require all public companies in which CalPERS invests have a level of board diversity that reflects each company's business, workforce, customer base and society in general. Currently, the key performance indicator showing success is that the companies in which CalPERS invests has "a dimension of board diversity."

"I think many of us on the board and staff are concerned about how long it's taking to improve board diversity, particularly in the U.S., when we see it could benefit performance," said Beth Richtman, managing investment director of the sustainable investment program.

At the July 16 off-site meeting, staff plans to provide a session on innovations in board diversity, including technology and new practices. In response to committee member questions, Simiso Nzima, investment director, global equity and head of corporate governance, told the committee that staff is talking to a number of institutional investors about mandatory diversity data disclosure, but that building coalitions of investors takes a long time.

"Our approach really is multipronged and we don't want to wait to build the coalition," Mr. Nzima told the committee. "We want to be able to start moving in that direction."
You can review the material from Monday's Investment Committee here.

I bring your attention to the update on private equity busines model alternatives where is specifically states:
Background

In relation to the announcement of CalPERS Direct, the new strategic model for private equity, this item focuses on the next steps regarding the implementation of this direct investment vehicle with independent board governance. After more than a year of planning and discussion, the Investment Office is ready to move into the next phase of development. CalPERS’ Investment Office staff will now begin its research into industry best practices regarding the makeup of both the independent advisory boards and the management teams.

Analysis

In order to leverage the strength of our portfolio and increase scalability and long–term sustainability, the proposed plan for CalPERS Direct involves the creation of two separate funds. The first would be focused on late-stage investment in technology, life sciences and healthcare, and the second on long-term investments in established companies. CalPERS Direct would be governed by a separate independent Board made up of members from subsidiary Boards and other independent Board members, to advise on allocation. The proposed timeline calls for CalPERS Direct to launch in the first half of 2019, following final approval by the Board.
Not surprisingly, Yves Smith of the naked capitalism blog jumped all over CalPERS Direct over the weekend, claiming a leaked memo by Larry Sonsini shows Sonsini and CalPERS are violating their fiduciary duty with the proposed private equity outsourcing scheme.

Yves ends her long diatribe with some very serious and wild accusations:
Last week, highly respected Sacramento columnist Dan Walters also wrote about the whiff of corruption coming from CalPERS’ private equity restructuring scheme. Even for those like Walters who don’t know much about private equity, there is too much that is obviously wrong here, from CalPERS not dropping or at least suspending its plans now that its cheerleader in chief is quitting, to CalPERS branding and too many other claims being obviously demonstrably false, to the scheme going firmly against the positive steps other large limited partners are taking, that of building staff skills and bringing more deal-makgin and management in house.

The only two explanations are utter incompetence or rank corruption in the form of Ted Eliopoulos trying to curry favor with BlackRock and other influential players in order to bolster his future employment prospects. And before allies of Eliopoulos in and outside CalPERS act outraged, this suspicion is widespread among the journalists and limited partner community. You are only shooting the messenger.

The more and more CalPERS sticks to this plan in the face of deservedly critical press, the more it looks like dirty dealing. And with CEO Marcie Frost having amassed decision-making authority in her office, she will have nowhere to hide if this scheme blows up on her watch, as we fully expect it will.
So, Ted Eliopoulos is trying to buy himself a cushy job at BlackRock by moving ahead with CalPERS Direct?

God damn Greeks! They're all crooked little weasels! God forbid Ted Eliopoulos put this idea forward because it actually makes sense for CalPERS and its stakeholders over the run.

And those BlackRock guys! They too are little weasels in the eyes of Yves Smith and her followers who think she's an authority on private equity (quite the opposite). The nerve of Larry Fink going out to recruit Mark Wiseman from CPPIB, André Bourbonnais from PSP and a couple of Goldman stars to beef up this PE group. Who does he think he is, Warren Buffett? How dare he ask CalPERS to outsource part of its PE program to BlackRock?

First of all, it's not a done deal yet (as far as I'm aware). BlackRock is competing with a few big players like Neuberger Berman Group and others. The key here is "big" players which will help ramp up direct investments (co-investments) at CalPERS relatively quickly.

You need experienced players who know what they're doing to ramp up CalPERS Direct. And you need an independent board to move things along quickly and diligently. There is no fraud going on here, just good old fashion hard work to ramp up CalPERS Direct.

Why CalPERS Direct? Look at the success of Canada's large pensions in ramping up direct investing (co-investments) with their private equity general partners. Co-investments are a form of direct investing where general partners (GPs or funds) approach their limited partners (LPs or investors) to invest alongside them on larger transactions.

In order to gain access to co-investments, LPs first have to invest in private equity funds but once they do that, they can ramp up co-investments to lower overall fees (pay no fees on co-investments). This can only be done if pensions have an experienced private equity team to quickly evaluate co-investment opportunities as they arise.

I recently spoke about how PSP Investments is ramping up direct private equity. The Caisse's private equity group led by Stephane Etroy is also going direct in PE.

Ontario Teachers' started this trend years ago under the watch of Jim Leech who hired Mark Wiseman to ramp up the fund and co-investment portfolio. Mark took that experience over to CPPIB where he did the same thing with the help of André Bourbonnais.

"It's a big club and you ain't in it. You and I aren't part of the big club," as George Carlin once noted in his famous American Dream skit.

Nope, people like Mark Wiseman and André Bourbonnais are operating on another level and they're now part of the big club. By the way, so is André Collin who arguably did buy his position at Lone Star and then worked hard to convince John Grayken to make him president of his fund.

Collin is part of the big club and now enjoys compensation that makes his old PSP bonuses look like chump change.

Good for him, good for all these guys, but there's something you need to remember, you don't get invited to the big club because of your good looks and once you're in, you need to produce results or you'll find yourself out of a job fairly quickly.

It's easy sitting in a nice chair at CPPIB or PSP, ordering people around, much tougher when a John Grayken or Larry Fink are on your ass constantly to produce results. In short, the big club has big paydays but it's brutal work.

I mention this because unlike Yves Smith, I actually think it makes a lot of sense for CalPERS to outsource part of its PE program to BlackRock because Mark Wiseman, André Bourbonnais and others in that group have great experience and can help CalPERS ramp up their co-investments quickly and efficiently.

Moreover, I know for a fact that tight governance rules forbid any investment staff at CalPERS to join a fund they invest in for a period of three years after the initial investment takes place (there were no such rules at PSP when Collin collected his million dollar bonus and then hopped over to join Grayken at Lone Star where he now runs the fund).

Ted Eliopoulos is just doing his job and he already signalled he's stepping down for family reasons.

More importantly, what if Yves Smith is wrong and CalPERS Direct turns out to be a great success over the next ten years, not a "bomb"? Is she going to praise Eliopoulos then? I highly doubt it.

As far as the PE benchmark at CalPERS being changed to FTSE Global All-Cap index plus 150 basis points, lagged by a quarter, from a custom benchmark of 67% FTSE U.S. Total Market index and 33% FTSE All-World ex-U.S. index plus 300 basis points, I'm not surprised.

Go read a recent comment of mine on private equity going public where I note the following:
Clearly, these are good times for private equity titans. They are raising multibillions for their megafunds and most of that money is coming from global pensions and sovereign wealth funds.

Given the amount of money pouring into private equity, it's not surprising to see PE giants increasingly focused on taking public companies private. And there is no doubt that private companies have better alignment of interests with their shareholders who typically focus on long-term added value.

But increasingly playing in public markets raises concerns too. In particular, as Javier Espinoza of the Financial Times reports, Valuations for private and public companies are narrowing:

Valuations for private and public companies are narrowing, data by the Boston Consulting Group show, prompting concerns that investors could be overpaying for privately held assets (click on image).


The narrowing of the gap has been driven partly by private equity investors paying record multiples for assets as they come under pressure to deploy capital, according to industry analysts.

This could eventually lead to investors finding better value and more liquidity in publicly traded companies if economic conditions were to change dramatically, these observers warned.

“Buyout funds have historically valued private companies based on their historical averages,” said the private equity head of a multibillion fund in London. “But private equity investors have raised a lot of capital and to get deals done they are having to pay full price. Many are starting to ignore their traditional metrics.”

The person added: “It’s like 2006 and 2007 all over again.”

Yield-starved investors have been under growing pressure to deploy their capital in a low-interest rates environment. As a result, demand for private equity has risen in recent years, which in return has led buyers to pay record multiples for assets.

In 2017, investors paid on average 12.5 times multiples for private companies compared with 9.5 times multiples a year earlier. This compares with 16.8 times multiples paid for public companies last year versus 19.5 times multiples a year earlier, the data showed.

Industry observers also said that a narrowing of the gap would lead some to reassess their exposure to private equity. “If you want to re-calibrate your portfolio, you can take instant action in the public markets. While you can’t with private equity exposures. You can try and sell your stake in the secondary market but at huge discounts.”

However, Antoon Schneider, senior partner and managing director at the BCG, said that investors were still paying less on average for private companies than for listed companies.

“Private equity investors are not paying more than if they bought shares in the stock exchange and they hopefully get superior governance and better returns,” he said. “The private equity boom is still less than the stock market overall.”
Again, it's confusing but as private equity funds get bigger and bigger, they are forced to take public companies private in order to deploy the capital, so I'm not shocked to see valuations are narrowing between public and private companies.
All this to say a spread of 300 basis points might be too tough to beat in this environment (I remember when pension funds were using a spread of 500 basis points but those days are long gone as money pours into private equity).

Anyway, those are my thoughts on CalPERS gearing up for changes to its private equity portfolio. The most important thing to note is private equity remains the most important asset class at CalPERS and if they can bring on experienced people to help run CalPERS Direct, they will also enjoy a well-run co-investment portfolio which helps them scale up quickly and lower overall fees.

That's it, that's all, there is nothing remotely shady going on here.

Below, I embedded CalPERS's Investment Committee meeting from May 14th. Take the time to watch this clip and if they post the one from Monday's meeting, I will edit this comment and add it.

Update: Arleen Jacobius of Pensions & Investments reports, CalPERS’ staff to refine private equity investment model for board vote in fall:
CalPERS' staff plans to return to the board in the fall for a vote on a revised version of a proposed private equity investment model, CEO Marcie Frost told the board at Wednesday's meeting.

The new investment model proposal includes creating an outside corporation to make direct investments in private equity. In addition to the outside corporation, the model would include an expanded emerging manager investment program and a partnership program in which the $356.5 billion California Public Employees' Retirement System, Sacramento, would hire a strategic partner to make co-investments, Ms. Frost said.

"We will also refine this proposal as additional information comes in with a go, no-go decision expected later this fall," she said.

After the board meeting ended, CalPERS sent out a written "For the Record" statement by Ms. Frost outlining her views on why CalPERS officials are considering the new approach, which echoed statements made by CIO Theodore "Ted" Eliopoulos at Monday's investment committee meeting. She noted that private equity is CalPERS' highest-returning asset class and that the pension plan is 71% funded. CalPERS' most recent investment performance and risk report showed that its $27 billion private equity portfolio outperformed its benchmark with a 10.7% annualized internal rate of return for the 20 years ended April 30 but that the portfolio has underperformed its benchmark for all other time periods including one year at 16.6% IRR; five years, 12.1% IRR; and 10 years, 8.7% IRR.

Ms. Frost did not address concerns raised Tuesday by former board member J.J. Jelincic at the performance, compensation and talent management committee meeting.

During the public comment period, Mr. Jelincic noted, "there is a lot of dry powder out there." He added, "If you want more private equity (investments), you would have to pay up," which he said he wouldn't recommend because it would drive down returns.

Separately Wednesday, the board approved substantially increasing the compensation of the next chief investment officer who will replace Mr. Eliopoulos when he leaves at the end of 2018.

The board approved a motion by the performance, compensation and talent management committee to pay the new CIO a salary range of $424,500 to $707,500 per year in addition to incentive pay of up to 150% of total salary. This would amount to a maximum of $1.8 million annually. Currently, the CIO's salary range is $408,000 to $612,000, with an incentive of up to 75% of salary for a maximum of $1.1 million a year. At the same time, the board delegated to the CEO the authority to select an incentive target for the CIO. The current incentive target is 50% of salary.

Two board members voted against the proposal: Margaret Brown and Richard Gillihan.

"I want to say again for the record that we're making adjustments to salary ranges when we have zero evidence that we're going to have any issues recruiting qualified individuals for this position," Mr. Gillihan said at Tuesday's performance, compensation and talent management committee meeting.

The committee deferred until August proposals on an incentive plan for the CEO.
So we will wait till the fall to here more news on CalPERS Direct. As far as CIO compensation, I think the new incentive program is much better and more aligned with industry standards.

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