A Webcast With CalPERS' CIO Ben Meng

This afternoon, I spoke with CalPERS's CIO Ben Meng for almost an hour. It was the second time we spoke except this time, we did it through Webex, which was pretty cool as we finally met over the web. It was once again an incredible conversation full of great insights.

Let me begin by thanking Ben Meng for taking the time to speak with me and Wayne Davis, Chief, Office of Public Affairs, for setting this up. Both of them are very busy so I do appreciate it.

It was the first time I used Cisco's Webex and for some reason, I had audio issues even though I can see them, so I dialed in to chat using my cell (technology is amazing but annoying sometimes).

You'll forgive me, I took a screenshot to remember the moment as I was feverishly scribbling down notes and caught Ben looking a bit surprised.

Anyway, to situate my audience, I recommend you read my recent comment on CalPERS's $80 billion leverage plan.

I wish I had spoken to Ben before publishing that comment because the media and I got a lot of things wrong. I did however get the key points about using leverage right.

Anyway, let be briefly go over the key points from my conversation with Ben Meng:
  • CalPERS is not leveraging its portfolio by $80 billion to invest in private equity. "Even if we wanted to do this, you know as well as I do that it's impossible to commit that much money to private equity all at once."
  • Ben told me the most important message he wants to get across is leverage will only be used "gradually, prudently and opportunistically" across private and public markets to take advantage of dislocations while keeping the overall portfolio highly diversified (like I stated, stop reading nonsense on other blogs on how "CalPERS plans to blow its brains out", it's sensational drivel, total nonsense!).
  • He told me they spent all of last year "preparing for a market correction" and laid the groundwork for their "enhanced liquidity management program" exploring all sources of liquidity. "We were able to identify 15 additional pathways and tap an additional liquidity of up to $20 billion."
  • He spoke about striking the right balance between too little and too much liquidity. He went into great detail about "contingency liquidity when we want it" and referred me to a paper he wrote for the Journal of Investment Management back in 2013 on a topic he called "Liquidity at Risk" (the only paper I found online is a 2016 paper he co-authored on mean variance optimization with public and private asset classes which is available here). 
  • Ben said they will not be issuing commercial paper like Canada's large pensions to leverage their portfolio. Rather, it's balance sheet leverage by borrowing securities (bond repos) and other "internal pathways". He kept referring to "balance sheet liquidity framework" and said they manage their liquidity needs very tightly planning for the next 7, 30 and 90 days.
  • He said not all sources of extra liquidity are the same in terms of their "negotiability, reliability and costs". For example, cash & cash equivalents, contributions, coupons and dividends, are more reliable than private equity distributions (all sources of liquidity he referred to are cash and cash equivalent, contributions, coupons and dividends, assets that can be liquidated for cash and borrowed liquidity or “liquidity on demand”)
  • He referred to "Total Fund Level Risk" and said in 2008 they got caught when they had to sell liquid assets assets at the wrong time to make their capital call commitments to private equity funds. "The whole point of using leverage and managing risk at a fund level is not to get into that predicament again."
  • But again, he emphasized that leverage will only be used "gradually, prudently and opportunistically" to take advantage of market dislocations and remain highly diversified across public and private markets. He added: "We aren't the first to do this, Texas Teachers' and Wisconsin Retirement System have been doing this for years."
Now, in private equity, he said they are taking a four-pronged approach:
  1. Larger allocations to top funds. "We were able to approach many top GPs and communicate what we are looking for. In many cases, we went from zero to significant allocations."
  2. Ramping up co-investment program. "We are doing more co-investments with our GPs" but he didn't go into detail about how advanced this program is.
  3. Large managed accounts with top GPs. "Where we negotiate details and economics, akin to what Texas Teachers has done with KKR".
  4. New vehicles (Pillars III and IV). "To improve our ability to deploy assets in private equity opportunities, so we can invest more in private equity, and over time, to lower costs as well as improve both CalPERS' level of control over and the transparency concerning our private equity exposure"(see this article).
On those Pillars III and IV, Ben stressed "they are still experimenting, taking a measured approach" and haven't made any commitments yet.

In terms of risks, he stressed they need to take risks to achieve the 7% bogey which he believes is achievable over time. "When Treasury notes are yielding 70 bps and your target is 700 basis points, you need to take risks and capitalize on the structural advantages you have: long investment horizon, scale, certainty of assets, internal expertise, external partners, and a total portfolio approach".

At one point he was talking about using leverage to remain diversified across stocks, bonds and private assets and I said: "It's like Bridgewater's all-weather approach, better known as risk parity."

Ben replied: "Yes, but Bridgewater only invests in public markets, we invest across public and private markets and have a much longer investment horizon."

I did ask him about their decision to exit hedge funds and whether he thinks they will get back into them.

He said their analysis validates the decision they made as it saved them billions in losses and added this: 
"Structurally speaking, public markets are very efficient and the high fees and low returns of hedge funds don't make them a right fit. This might change in the future but for now, our focus remains on private equity to generate the long-term returns we are looking for."
I totally agree and told him its very difficult to scale into hedge funds whereas you can scale significantly into private assets and that alignment of interests are better in private equity.

He said: "We can take on illiquidity risk and get compensated for it. We don't have to sell when assets are marked down, we can wait for the cycle to turn and sell them at the right price."

In terms of getting flack for ending its tail-hedge risk-mitigation program in favor of a traditional diversification strategy because of the high costs of tail hedging, Ben was adamant:
"I got a lot of flack but these tail-risk strategies aren't scalable and using leverage to remain diversified while investing opportunistically as opportunities arise costs us nothing compared to investing in these tail-risk strategies."
I've already discussed CalPERS's "untimely" tail-hedge unwind here. With all due respect to Ben Meng's critics, they aren't experts on managing billions in pension assets and don't understand (or don't want to understand) why it doesn't make sense for a pension with a long investment horizon to invest in these tail-risk strategies.

We spoke briefly about how CalPERS switched to working remotely and here Wayne Davis told me: "Ben was prepared for COVID and spoke to the IT department. The switch happened over night and it was seamless."

In fact, Ben told me they had a couple of operational issues with counterparties which weren't prepared when the pandemic initially hit and couldn't do transactions with them so they went to another bank.

He also praised the "entire team" for being ready and working very hard over the last year.

Lastly, we spoke about the pandemic and markets. I told Ben I see this bounce off March lows as nothing more than the mother of all bear market rallies fueled by the Fed's massive $3 trillion balance sheet expansion and when insolvencies start piling up, markets will head south again.

Ben said the nature of this crisis is very different from the tech crash in 2000 and the credit crisis of 2008. "It's a health crisis and the forced lockdowns created massive unemployment and uncertainty."

He said the Fed and Treasury responded massively and swiftly which was the right thing to do but "they only bought time".

Importantly, unless something changes on the health front (vaccine, virus dies out), then there will be what Ben calls "tertiary effects" which will impact markets.

Anyway, I will stop there, I wish CalPERS had a detailed paper on their Balance Sheet Liquidity Management but for now, I will refer you to Ben Meng's comments below which you can also read here.

Once again, I thank Ben Meng for taking the time to talk to me this afternoon, I really enjoyed our conversation and wish I recorded it somehow but I'm not that technologically advanced. I also thank Wayne Davis for setting up this webcast.

Lastly, CalPERS CEO Marcie Frost recently joined "Squawk Box" to discuss how she approaches ESG investing. Take the time to listen to her comments below.

Update: Arleen Jacobius of Pensions & Investments wrote a great article, For CalPERS CIO, revolution is now:
CalPERS CIO Yu "Ben" Meng has been conducting a slow-moving campaign to boost the $386.9 billion pension plan's returns by centralizing management and making comparatively revolutionary changes to the fund's governance along the way, adding the ability to leverage the entire fund up to 20%.

Use of leverage has attracted a lot of attention for the California Public Employees' Retirement System, Sacramento, after its investment committee signed off on that in September. The new leverage limit is another step in CalPERS' move since the financial crisis to govern the plan as a whole, rather than each asset class operating independently with its own leverage limit and leverage definition.

Currently, the Sacramento-based pension plan has 4% to 5% leverage, Mr. Meng said. In September, the plan had less than 10% leverage.

"We don't plan to leverage to 20%," Mr. Meng said in an interview. "We will deploy leverage gradually, prudently and opportunistically."

He called the 20% limit "moderate" leverage that is needed to offset lower return expectations; CalPERS currently has a 7% expected rate of return.

Before the 20% total fund limit was set, the leverage allowed in each asset class totaled about 23%.

However, not all leverage is counted as such. Leverage in both capital commitments and direct debt are considered as contingent liabilities, according to CalPERS' investment policy. And leverage in currency derivatives used for hedging or risk management purposes likewise isn't counted as leverage.

The 20% total fund leverage limit applies to the total leverage in which staff exercises direct control of the exposure. Direct control means leverage where staff has authority over a manager or limited partnership's use of leverage or staff applies debt to in-house portfolios.

"If you can't control it, you can't manage it," said Eric Baggesen, CalPERS managing investment director, trust level portfolio management, in a separate interview.
You can read the rest of the comment here, it goes into more detail on governance, leverage and liquidity.

I also embedded a podcast where Amanda White of Top 1000 Funds talks to Ben Meng on leverage, liquidity and inflation.You can read more here.