CalPERS's New CIO on Private Equity?

Randy Diamond of Chief Investment Officer reports, CalPERS CIO Says Pension Plan Must Create New Private Equity Organization:
Ben Meng, the new chief investment officer of the California Public Employees’ Retirement System (CalPERS), is not only unequivocal in his support for a new CalPERS-backed private equity investment organization, he has told state lawmakers that it is essential to help investment returns and prevent the system’s approximate $140 billion unfunded liability from growing.

Meng told a joint hearing of the Senate Labor, Public Employment and Retirement Committee and the Assembly Public Employment and Retirement Committee on Feb. 13 that achieving the retirement system’s 7% yearly expected average annual rate of return would be “a very tall order” without building new private equity investment capabilities.

Private equity is CalPERS’s best-producing asset class, long- and short-term. In the fiscal year ending June 30, 2018, it produced returns of 16.1%.

CalPERS has an existing $28 billion private equity program, consisting mostly of co-mingled buyout funds run by external general partners, but it makes up only 8% of the pension plan’s $345.7 billion portfolio. It also has been shrinking as the pension system competes with other institutional investors to become part of new funds.

Just eight weeks into his job, Meng has championed a plan first proposed by his predecessor, Ted Eliopoulos, in the summer of 2017. CalPERS would back two funds, Innovation, an investment vehicle that would invest up to $10 billion over a decade in late-stage venture capital investments, and Horizon, which would invest up to $10 billion over the next 10 years by taking buy-and-hold stakes in established companies.

Meng is not just pushing the plan before state lawmakers, who have no say in the actual decision to create Innovation and Horizon. On Feb. 21, Meng told the system’s investment committee, who will cast a vote on the expansion plan, that private equity is the only CalPERS asset class that is expected to generate a return above 7% in coming years, with an assumed average investment return of 8.3%.

He said stocks are only expected to produce a 6.8% average annualized return. Meng has made enacting the private equity program a major part of his eight-week tenure, first advocating his support for the program at CalPERS’s semiannual retreat meeting in January.

“If you are trying to achieve a 7% return—and there’s only one asset class that is forecasted to deliver more than 7% of return—you need that asset class in the portfolio, and you need more of it,” he told the investment committee.

Without an expansion of the private equity program, Meng told the investment committee that CalPERS could be forced to lower the expected rate of return under 7%, which would increase the system’s unfunded liability by billions of dollars, and raise contributions for the hundreds of cities, towns, special districts, and school districts that are part of CalPERS.

Those groups are already dealing with increased contributions from CalPERS investment committee’s decision to lower the expected rate of return in 2016 over three years to 7% from 7.5%

CalPERS, the largest US pension plan, is only around 68% funded.

A vote on the private equity plan could come as soon as next month.

Most board members have been supportive of the plan to create Innovation and Horizon, but its structure has become part of a controversy. Originally, in 2017, Eliopoulos proposed a direct-style private equity investment organization similar to Canadian pension plans, which often invest in private equity directly without external general partners.

That proposal has changed to making Innovation and Horizon CalPERS-funded, but actually run by external general partners who would invest solely for CalPERS. Compensation of the investment officials of the two funds would not be disclosed and they would not be subject to public disclosure laws.

Meng told the investment committee that eventually CalPERS might be able to run its own private equity organization, but not now. He said the pension plan does not have the in-house expertise and its location in Sacramento, which is not a global financial center, would deter world-class investment professionals from joining.

“I do not view that as a viable option,” he said of CalPERS running a direct private equity investment organization in the near future.

Former CalPERS board member and investment staffer J.J. Jelincic, a critic of the new private equity plan, told CIO that a lack of transparency about the planned organization is troubling. He also said CalPERS officials haven’t revealed enough specifics of the plan to make him comfortable.

“The fact that they have not defined the exact structure, makes me believe they have not thought it through,” he said.

Some CalPERS investment committee members have discussed similar concerns at public meetings, but the majority of the 13-member committee seem willing to let Meng call the shots. None have been as vocal as Jelincic, who has been a regular attendee at CalPERS meetings attacking the plan.

Jelincic also rejected Meng’s statement that CalPERS couldn’t attract the investment talent to run a direct investment program because it is located in Sacramento.

Jelincic said CalPERS investment teams could be located in cities other than Sacramento, a practice of other global pension plans, who often have offices in varied locations.

Meng rejects the transparency issues.

Meng told the investment committee and state lawmakers that the new program would be more transparent than CalPERS’s current legacy private equity funds run by general partners, and ultimately fees would be less, though he has not offered details. CalPERS generally pays a management fee of up to 2% to private equity general partners and gives up 20% of the profit.

In his discussions with the CalPERS investment committee, Meng conceded that the new private equity plans has risks and might not generate the investment returns that are anticipated. He said, however, that given CalPERS’s underfunded status and a slowing global economy that would impact investment results in a negative way, “doing nothing is not an option.”
Doing nothing isn't an option? What about doing something and sinking further into deficit because it blows up spectacularly over the next ten years?

Alright, let me be quick in my analysis. I agree with Ben Meng, with only a 68% funded status (it's actually 65% now), CalPERS is in a bind and it needs returns to lower its ever-widening pension deficit and private equity is the place to look for those returns it needs over the long run.

The problem? Too much money flowing into private equity, returns have come down considerably over the last few years.

Bain & Company came out with its much anticipated Global Private Equity Report 2019. Take the time to read it here.

Here is the state of the market in 2018 (click on image):

I quote: "Chronically heavy competition has driven deal multiples to historic highs, and growing jitters about an eventual economic downturn are affecting decision making, from diligence to exit planning. For general partners (GPs), putting record amounts of capital to work means getting comfortable with a certain level of discomfort when investing. They are paying prices they swore they would never pay and looking to capture value that may prove elusive post-close. The most effective GPs are stepping up their game to identify targets and sharpen diligence, while simultaneously planning for the worst. "

Even the GPs are warning you that it's as good as it gets for private equity and returns are going to come down.

Still, even if they come down to 10% instead of 16%, that's good enough for Meng, but my advice is to get the risk-sharing of the plan right and do this as fast as possible.

CalPERS and other US public pensions experiencing a deficit need to raise contributions and cut benefits for a period to restore their funded status. Looking for a PE solution isn't a long-term plan, CalPERS needs to adopt conditional inflation protection and tackle its deficit on both ends: better, more consistent returns and lowering liabilities by increasing contributions and decreasing benefits.

Relying on investment returns to lower future liabilities is never going to work, Canada's large pension plans figured that out years ago.

And 7% is better than 8% but it's still too high in my opinion. CalPERS needs to reduce its discount rate to 6%. Yes, cities, counties and public-sector employees will complain because they will all need to contribute more but this is the responsible thing to do on top of adopting conditional inflation protection.

What about J.J. Jelincic's criticism? If you recall when I last went over CalSTRS and CalPERS beefing up their private equity, J.J. shared this with me after reading this comment:

There is a difference between CAN'T and WON'T  (when it comes to setting compensation):
California Government Code


(a) The board shall appoint and, notwithstanding Sections 19825, 19826, 19829, and 19832, shall fix the compensation of an executive officer, a general counsel, a chief actuary, a chief investment officer, a chief financial officer, a chief operating officer, a chief health director, and other investment officers and portfolio managers whose positions are designated managerial pursuant to Section 18801.1.
J.J. has been a stickler for tranparency and he rightfully notes that CalPERS's board can pay private equity employees at CalPERS higher compensation, open up an office in San Francisco like CalSTRS and OMERS are doing, it just chooses not to (for political reasons, optics or who knows).

Well, in this business, you get what you pay for. If you're not willing to attract and retain qualified staff through a very competitive compensation scheme, then you will never compete with the pensions that do. It's that simple. You can outsource it but what you're paying in fees is going to end up being a lot more than had you just hired a qualfied staff to begin with.

Below, CalPERS's new CIO Ben Meng discussed his review of the portfolio at the Board offsite which took place on January 22nd and offered many great insights. Listen carefully to Ben, he's a very sharp guy who understands the issues CalPERS is facing very well.

I also embedded the Investment Committee meeting which took place during the February Board meeting on February 18, 2019. Fast forward to minute 3:15 to listen to agenda item 7 c) on ptivate equity. Again, this is a great discussion but it's not enough to rely on Private Equity to get the plan back to fully-funded status. Ben Meng knows this but he's operating under major constraints.