CalPERS Goes Canadian in Private Equity?

Robin Respaut of Reuters reports, CalPERS says considering making own private equity investments:

The California Public Employees' Retirement System (CalPERS) on Monday said it was considering making direct investments in private companies, a potential major shift in strategy that would be the first such action by a U.S. public pension fund.

The change, discussed at a meeting of CalPERS board in Monterey, would be closely watched by other U.S. public pensions as they look to improve returns on their investments, in part by cutting fees.

The $323 billion pension fund, the largest in the country and a trend setter, has been under increasing pressure to achieve returns closer to the fund's assumed rate of return of 7 percent by 2020.

In the fiscal year ended June 30, private equity investment returned 13.9 percent, the second best performer behind public equities, or stock portfolio. The asset class helped to boost the fund's total year-end returns to 11.2 percent, exceeding expectations for the first time since 2014.

Private equity has been CalPERS' best performing asset class in the past two decades and accounts for about $26 billion of its portfolio. But CalPERS mainly invests in private equity funds and has been criticized for accepting the high fees and limited disclosures typically associated with the asset class.

The shift in strategy, if adopted, is likely to require a considerable investment in staff and expertise in the years ahead to handle the strategic shift.

CalPERS Chief Investment Officer Ted Eliopoulos told Reuters he would recommend CalPERS "explore setting up a separate vehicle" for direct investments and expand the current co-investment program.

Eliopoulos suggested CalPERS focus on opportunities that do not compete with its current private equity investments, such as owning companies for longer than 10 years, and investing in technology and life science companies.

"CalPERS has a unique opportunity to be a leader in the co-investment space," Sandra Horbach, U.S. buyouts co-head at The Carlyle Group, told the board on Monday.

CalPERS' massive size would make it a formidable player and allow the fund to dictate some investment terms, Horbach said.

Most U.S.-based funds shy away from such investments, while Canadian pension funds are considered leaders in the strategy.

By its own account, CalPERS has developed somewhat of a negative image among private equity firms as being difficult to work with and slow to make decisions, John Cole, CalPERS investment director, told the board at Monday's meeting.

A number of funds "have told us that we have become too unpredictable to do business with, and many larger general partners are cutting back the amounts that they are willing to allocate to us in their new funds", Cole said.

So, CalPERS is going Canadian, or at least attempting to by exploring the creation of a separate vehicle for direct investments and co-investments with top private equity funds.

The key passage in the article above is this:

"The shift in strategy, if adopted, is likely to require a considerable investment in staff and expertise in the years ahead to handle the strategic shift"

Why? Because in order to attract and retain qualified individuals to do direct lending (private debt), purely direct investing and co-invest with top private equity funds, they need to compensate these individuals properly or else this venture will be a failure.

This is why CalPERS' CIO Ted Eliopoulos told Reuters he would recommend CalPERS "explore setting up a separate vehicle" for direct investments and expand the current co-investment program.

Unlike Canada's large pensions, CalPERS doesn't have the governance to pay people to come to its pension fund to engage in these direct investing activities and therefore needs to create a separate vehicle to pay them properly.

Canada's large public pensions have the right governance to pay people properly to bring these activities in-house but they too have seeded specialized platforms when they need the expertise of people they cannot pay internally.

But the difference is Canada's large public pensions are way ahead of the game, having developed their fund investments and co-investments and entering private debt in a huge way.

Go read a comment I posted last week on whether pension funds are displacing private equity, where I wrote this:

So, are pension funds displacing private equity funds? Yes and no. Where they can compete effectively, they will and this is most notable in Canada where large public pensions have the right governance which allows them to higher industry experts and pay them properly.

But in the buyout world, large private equity funds reign supreme, and there's not a pension in the world that will ever displace them from their bread and butter. It won't ever happen, ever, and the reason is simple, when there's a major deal on the table, the first phone calls bankers make is to Schwarzman et al., not the CEO of a major pension fund.

In other words, while Canada's large pensions can compete with private equity funds in private debt, ramping up their operations in the US and Europe and pretty soon Asia, they will never compete with private equity titans on major deals and still need them to generate returns in the traditional buyout space where they invest and co-invest with top private equity funds.

But there is no question that large Canadian pensions are increasingly muscling into private debt an they are delivering stellar results in this area which was once dominated by top PE funds. Just look at the resuts of CPPIB and PSP Investments in fiscal 2017 to underscore this point.

Is private debt foolproof and the pinnacle of all asset classes? Of course not. I worry about public an private debt as the US and global economy slow over the next year but if the principals at large Canadian pensions can still originate great deals, they will be able to weather the storm ahead.

I have no worries that the individuals doing private debt at PSP and CPPIB know what they're doing, I am a little more worried about how CalPERS is going to engage in direct lending, direct investments, and co-investments.

Can it be done? Of course, it can. Should it be done? You bet as long as they get the governance right. If not, it will be doomed from the get-go.

Below, I embedded all three parts of the CalPERS' Investment Committee (June 19, 2017). Listen carefully as CalPERS' CIO Ted Eliopoulos attacks critics of their private equity program, stating that CalPERS is way ahead of its peers when it comes to transparency of fee disclosure (Part 1).