CalPERS Chief Yoga Master Talks PE and More

Peter Smith of the Financial Times reports on CalPERS investment chief talking about private equity and yoga:

From his home in Sacramento, Ben Meng starts the day with yoga and Bloomberg TV.

“It’s frustrating because I’m watching TV and I can’t do meditation,” says the investment chief of Calpers, the Californian fund which is the largest state employee pension scheme in the US. “My mind is on the TV but physically I’m stretching.”

The 49-year-old China-born US citizen, who was educated in Xi’an and California, is used to switching hemispheres.

He returned to Calpers in January after three years as deputy chief investment officer at the State Administration of Foreign Exchange (Safe), the agency that manages China’s capital account and the “largest asset owner in the world”, according to Mr Meng.

“I thought we were big [at Calpers] with nearly $400bn, but seeing how $3tn works, that definitely helps my job here,” says the tall, smartly groomed and engaging executive on a recent visit to the Financial Times’ London headquarters.

He knows asset management, too. After stints at Morgan Stanley and Lehman, he spent four years as a portfolio manager at Barclays Global Investors in San Francisco but left after BlackRock bought the business. He moved to Sacramento about an hour and half away to join Calpers as its investment director for asset allocation in 2008.

When asked about how to best navigate the choppy waters stirred by US-China tensions, including the detention of executives from both countries and trade spats between Washington and Beijing, Mr Meng is deft.

“My approach is very simple. I was hired to do a purely technical job, be an investment professional. Before Safe hired me, they knew I was an American citizen. They knew everything about me, the background check, everything.”

Now back at Calpers, he reiterates his role is purely about investment. “I am apolitical. Of course, my loyalty belongs to the United States of America,” he says.

“My personal interest and professional career is in investment management. If you stay focused on that, most likely different political factions wouldn’t bother you. But occasionally real extremists try to make a case out of it.”

Closer to home, Mr Meng has specific challenges as one of the most powerful executives in the US investment industry. Calpers is also an industry bellwether.

“Once [your size is] beyond $100bn, the challenge is roughly the same. From an asset manager’s perspective, the sweet spot is about $100bn-$150bn. You are not too small to be ignored by the market but you are not too big to be your own enemy,” he says.

Calpers’ total assets represent just 71 per cent of what it needs to pay future benefits to the 1.9m police officers, firefighters and other public workers who are members of the scheme. It invests in more than 10,000 public companies.

The fund has been hacking back its discount rate, its assumed rate of return, which is down to 7 per cent compared with 7.75 per cent in 2011. Lowering the discount rate means that California’s government employers need to make larger contributions to the scheme.

But even hitting the reduced number is tough in a low-return era.

“Let’s call the 10-year yield at 1.5 per cent, and the long-run equity premium, depending on which market and which time period you look, at 4 per cent; that only gives me 5.5 per cent. I still need another 150 basis points of additional return on the $400bn portfolio.

“So, I need to look at all corners of the world where I can earn that additional 1-2 per cent.”

Mr Meng says investments in faster-growing economies such as India, and private markets, mostly private equity, are where Calpers can generate juicier returns.

Soon after returning to Calpers, Mr Meng demonstrated an almost messianic zeal for private equity where valuations are at nosebleed levels. Of Calpers’ $385bn of assets, nearly $28bn or 7.3 per cent is in private markets. But Mr Meng wants to grow that to 10 per cent or higher.

It seems odd that a giant investor such as Calpers should so publicly signal its ambitious private equity growth plans when that risks prices moving against it. The fund has also attracted criticism for the amount it has spent on fees to private equity managers.

After investing in a new reporting system, Calpers revealed in 2015 that it had paid $3.4bn in carried interest to private equity managers over 25 years. That estimate was incomplete because nine managers had refused to provide historical data and Calpers was also unable to recover details of carried interest paid to private equity funds that had already matured.

Even so, he says private equity is the best-performing asset class for Calpers. “Over 20 years, net of the fees, our private equity delivered 10.5 per cent per annum.”

But generating strong returns from private equity owes much to getting access to the best managers. Mr Meng agrees that some academic studies have found that private equity, on average, does not beat public equity. “Depending on which data source you use or what time period you use, you get all different kinds of results,” he says.

Calpers, which has cut back its partnerships with private equity to about 100, recently stumped up $750m to one of Blackstone’s latest funds. “We regard Blackstone as one of the best private equity investors,” Mr Meng says.

In his spare time, he enjoys reading. Mastering The Market Cycle: Getting the Odds on Your Side by Howard Marks is on his table, and he rues the day airlines allowed WiFi on flights. “Just give me that uninterrupted block of 12-hour time. I can finish a book,” he says.

“Sometimes, I go to a coffee shop, don’t bring my computer or phone, just a book or research report for half a day, a day. I call that a really good day.”

His message to the nearly 2m Californians who are members of Calpers?

“They can rest assured that their retirement security is with good stewards, even though what the market does is out of our control,” he says. “But if we can focus on the long term we have a meaningful chance of success, of achieving the 7 per cent return.”

On Sunday, I received an email from CalPERS CIO Ben Meng telling me he will be in Toronto on Monday and asking me if we can meet.

I would have taken that meeting in a second if I lived in Toronto but explained to Ben I'm based in Montreal and invited him here one day.

This reminds me, I wouldn't mind putting together an annual "Pension Pulse Conference" where I invite top CEOs and CIOs to discuss important topics. I don't particularly like conferences -- in fact, I dread them -- but it would be a half day event where we can really get into the thick of it.

The only thing I would ask is this conference be sponsored entirely by large pension funds, not asset managers, so the focus, invitations and topics can all be restricted and catered to the pensions sponsoring the event. I'd be happy to moderate a panel discussion and keep it short and sweet.

One more thing on conferences. In April, I attended the CFA Society Toronto's 2019 Annual Spring Pension Conference because KPMG sponsored me.

In September, I attended the CAIP Quebec & Atlantic conference at Mont-Tremblant because Geoffrey Briant, President & CEO of G2 Alternatives, and Gordon Power, Founder & CIO of Earth Capital, sponsored me to attend that conference.

My point being if you want me to attend a conference, please sponsor me, and that includes all expenses or else I simply will not attend. I take conferences seriously so when I attend, I actually listen, take meticulous notes and ask tough questions. I enjoy networking too but that's not why I attend these conferences (again, for me, they are all dreadfully boring but some are much better than others).

Anyway, back to Ben Meng. Last time I spoke with Ben was back in March when he assumed his new role. Also in March, I discussed why private equity was so instrumental to CalPERS's new CIO.

In October, I discussed whether CalPERS is ready to ramp up its in-house PE which now falls under the purview of Greg Ruiz who is in charge of the asset class.

Ben is right, he needs to expand private equity at CalPERS to attain their 7% target rate-of-return over the long run.

And as I have stated in the past, 7% is better than 8% but it's still too high and 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.

Ideally, Greg Ruiz and his team would be expanding co-investments with top private equity partners, much like Canada's large public pensions have done over the last decade.

In fact, unlike US public pensions, the co-investment portfolios at Canada's large pensions are now much larger than the fund investment ones and they perform better over the long run because a) there are no fees on co-investments and b) they can keep these investments longer on their book without the churning that typically goes on in PE funds.

More importantly, Canada's large pensions are able to reduce overall fees by co-investing and maintain their allocation to private equity (typically around 12%) by investing large sums through their co-investments with their general partners (GPs).

I would go as far as stating developing a strong co-investment program is critical for any large pension fund looking to maintain a healthy allocation to private equity.

The catch? You need to hire qualified people to analyze co-investment opportunities quickly and turn around fast to invest in a timely manner. And unlike US public pensions, Canada's large public pensions operate at arm's length from the government and have all implemented strong compensation packages to attract and retain qualified personnel across all their private markets.

Of course, even some US public pensions are catching on. In June, Private Equity International published an article on how the California State Teachers' Retirement System (CalSTRS) is looking to add a 15 member team that only does co-investments (this might be due to the fact that it saw a big drop in carried interest).

Take the the time to read this entire article here because it highlights how developing a solid co-investment program also allows you to be a better fund picker.

But the article also questions whether co-investments generate alpha because of their concentrated nature (they do if you have the right partners and team analyzing them).

Anyway, I'm not sure how CalSTRS is going to compensate this 15 member co-investment team but these are the structural issues that all US public pensions face and they represent serious roadblocks to developing a good private equity program that is well aligned with members' interests.

Ben Meng knows all this. He reads my blog and gets advised by the best private equity funds and advisors in the world.

He also knows that private equity is booming (while hedge funds are waning) and he needs to take his time with Greg Ruiz to develop a sound program that takes advantage of opportunities as they arise.

On that note, I've been sort of bearish on private equity citing how performance is deteriorating, secondaries are no longer selling at a discount and volatility is often underestimated even if the alpha is there over the long run.

However, this morning I read a great comment by Ben Carlson of A Wealth of Common Sense putting private equity "record" dry powder into perspective. You should all take the time to read this comment carefully here. I just note the following:

At my previous firm we had a substantial allocation to private equity and it was my job to manage the cash flows into and out of those funds. Here’s how I explained this process in Organizational Alpha:

Cash Flow Magnitude Matters. Let’s say your pension fund makes a $10 million commitment to a private equity fund. It’s highly likely that just $6-$7 million of that capital will ever be invested by the private equity fund over the life of the investment period. This is because, on average, private equity funds only call roughly 60 to 70 percent of committed capital. This means that while investors may be receiving decent returns on their private investments, it’s being earned on a smaller capital base than they may realize, thus diminishing the impact of the returns on the overall portfolio.

So that $800 billion of dry powder isn’t sitting in a money market or checking account at all of these private equity firms. It’s sitting in the portfolios of the endowments, foundations, sovereign wealth funds and wealthy LPs of these PE funds.

Private equity funds don’t invest all of your money the first day you sign up for their fund. They slowly invest the capital over a number of years when opportunities arise. So investors are more or less dollar-cost averaging into the buyout deals the PE firms are executing on their behalf (granted, this is a much riskier style of DCA because it’s typically a concentrated portfolio of private companies).

That money has to come from somewhere in the portfolio.

Many funds equitize their capital commitments and keep some combination of stock ETFs and cash to be ready when those calls come in. That’s exactly what we did at my old fund, selling down the ETF stock holdings when a large capital call came in (they typically give you around a month of lead time to come up with the cash before they’re going to make an investment).

So this dry powder is really just money that’s either sitting in cash or other investments in the portfolios of the LPs who invest in the PE funds. And depending on the size of the deal, those capital calls can sometimes be funded partially or solely from the distributions from current fund holdings that have some sort of liquidity event or dividend payout.

That $800 billion stockpile of commitments isn’t going to rush into the market all at once. It’s going to take time. We often modeled anywhere from 3 to 10 years for a fund to become fully invested. And there were cases where the fund would actually come to the investors and ask for an extension in the investment window they originally promised.

All that money is never always invested at the same time because PE funds make investments at different times, thus making the contributions and distributions of cash flows irregular and impossible to precisely plan for.

Ben Carlson is right to point this out, just like he's right to end that comment on this note:

The secondary PE market was actually more vibrant during the crisis from my perspective because investors in PE funds needed to dump them because their allocations to PE became too large relative to the rest of the portfolio. It wasn’t out of the ordinary to see 50% discounts on these fire sales.

However, I caution everyone, during the 2008 crisis, CalPERS and many other pensions were forced to sell stocks during the rout to meet their capital calls and that was the wrong thing to do. This is why CalPERS is looking to leverage up its portfolio not to be caught in another predicament like 2008.

Lastly, while I noted in September that CalPERS's $50 billion bet on factor investing paid off handsomely, more recently, there has been a change of heart.

Chief Investment Officer reports that CalPERS has fired most of its equity managers:

In a major investment move, the California Public Employees’ Retirement System (CalPERS) has terminated most of its external equity managers, slashing their allocation to $5.5 billion from $33.6 billion. Only three of 17 external equity managers have been spared in the reduction, shows a memo by Chief Executive Officer Marcie Frost.

The Oct. 21 memo to CalPERS board members also reveals that CalPERS Chief Investment Officer Ben Meng has restructured the pension plan’s emerging manager program, reducing the allocation to $500 million from $3.6 billion and cutting the number of managers to one from five.

The memo, which has not been publicly discussed, says the moves are necessary because of long-term underperformance. The memo obtained by CIO says that Meng is putting a “renewed focus on performance and our ability to achieve our 7% assumed rate.”

Meng, who took over as CalPERS’s CIO in January, has repeatedly expressed concerns, not only about CalPERS achieving the 7% assumed rate of return, but of its underfunding. CalPERS is only around 70% funded.

The memo notes that the move terminating emerging managers, who are often minority-owned or women-owned enterprises, “could receive media or legislative attention.”

The $380 billion pension system, the largest in the US, has faced criticism going back more than a decade by some legislators for not having enough diverse money managers on its roster.

In response, CalPERS launched new initiatives to hire a more diverse base of managers, including hosting diversity conferences with the California State Teachers’ Retirement System (CalSTRS).

However, the Frost memo indicates that emerging managers, which also included some newer managers who were not women or minorities, underperformed their benchmark on an even greater basis than the traditional equity managers.

“Over the last five years, traditional managers have underperformed their benchmarks by 48 bps and emerging mangers by 126 [bps],” the memo says.

The traditional equity managers, generally larger firms, will have no sway with the legislature. But some emerging equity managers have given campaign contributions to legislators who, at least in the past, have put pressure on CalPERS to hire more diverse managers.

Meng and other CalPERS officials have their own dagger to rise this time in defense, since the white-male owned investment firms favored by CalPERS over the years to manage a large chunk of its equity portfolio have also been fired.

Over the last decade, CalPERS has moved to managing most of its $187 billion in equities in-house, the majority of the strategies index-based. Still, just a few months ago, almost $34 billion in equity exposure was still managed by external managers.

CalPERS officials had debated over the course of the last decade whether it should fire external equity managers since they had almost universally underperformed stock index benchmarks. Until recently, investment officials had only selectively terminated managers, and gave most of its external partners a pass, with the assumption that stocks pickers would rise once again.

CalPERS documents from the system’s Nov. 18 investment committee meeting show that $9 billion was transferred recently into various in-house equity strategies. It’s likely that more money will be transferred into those accounts over the next few months since the liquidation of CalPERS accounts with the external managers will occur over several months.

CalPERS spokeswoman Megan White did not offer any immediate comment. CalPERS has not disclosed which managers it terminated.

The memo advises board members who receive questions about the changes to notify CalPERS’s office of public affairs. It says the terminations of the traditional external equity managers began three months ago and the emerging managers the day of the memo, Oct. 21.

Back in 2016, CalPERS officials pledged spending $7 billion more to expand its emerging manager program, but it’s unclear if any new managers were hired in the equity arena.

In the memo, Frost said the review of the external active equity managers began 18 months ago, before Meng started in office. She noted that the new CIO fully supported the efforts.

“This is a key part of Ben’s focus on risk and on making investments that can hit [a] 7% assumed rate of return,” she said. Frost noted that returns by external equity managers “haven’t contributed enough to achieving [the] 7% target.”

The CEO also noted that the pension plan will see “very significant savings” in fees from the manager terminations: $80 million from traditional equity managers and $20 million from the emerging managers.

The emerging manager program was particularly expensive for the pension plan since almost all of CalPERS emerging managers were part of manager of manager programs. CalPERS hired an overall manager, who was paid fees. That manager then hired a group of money managers, who were also paid fees from the pension plan. CalPERS did not hire the money managers directly because most were too small to receive a CalPERS allocation on their own.

Frost in the memo said that CalPERS was “not stopping” its emerging manager program. Without offering specifics, Frost said the pension plan will continue to engage with emerging managers across all asset classes.

All I have to say is welcome to the Canada Club CalPERS, this should have been done ages ago.

Ben Meng is right to fire most active equity managers as they struggle to beat their benchmark and he's also right not to cave to the politics of the day and divest from fossil fuel companies:

Meng said that 60 cents of every dollar to pay the retiree benefits comes from investment returns. “We need those investment returns now and in the future,” he said. “If the market fails us, or we miss our targets, the hard-working people of California and the employers take on the financial burden.”

Meng said that outside groups, referring to the environmental advocates, need to be mindful of CalPERS’s financial condition and challenges.

“For non-stakeholders, such as outside parties, who do not bear the financial risk of our fund, but advocate using our fund to take actions beyond the scope of our fiduciary duty, and advocate using our fund to advance their agenda, we ask that they respect our fiduciary duty,” he said.

Meng’s statement comes as CalPERS is expected to issue, as soon as today, a report on climate-related risks in its investments and how the pension plan’s engagement activities are altering those risks.

The new report is required to be released by CalPERS by Jan. 1 under legislation signed into law by former California Gov. Jerry Brown in 2018.

CalPERS takes climate change very seriously but as a fiduciary, it cannot bow down to environmental groups and divest from traditional energy companies if it's not in their members' best interests:

As a long-term investor, we work to address risks and opportunities that can impact our returns. We have banded together with other investors to urge action against global warming @UN’s #COP25 conference on #climatechange: https://t.co/NfND7pWMEv -via @naumanbilly @financialtimes

— CalPERS (@CalPERS) December 9, 2019

That's all from me, if Ben Meng or anyone else wants to add something, you know where to find me.

Below, I embedded Part 1 and 2 of CalPERS November Investment Committee. Take the time to watch both clips, they are full of great information.

Also, Bruce Flatt, chief executive officer at Brookfield Asset Management, discusses his view on China and partnership with Oaktree Capital Management. When you invest in Asia and Latin America, make sure you have the right partners, and I can't think of a better one than Brookfield.

Update: The Wall Street Journal examines how CalPERS CIO Ben Meng is taking hard look at the portfolio, re-examining everything, and taking action where needed to achieve investment performance. You can read this article here.