CalPERS' $80 Billion Leverage Plan?

John Plender and Peter Smith of the Financial Times report that CalPERS aims to juice returns via $80bn leverage plan:
Calpers is to move deeper into private equity and private debt by adopting a bold leverage strategy that the $395bn Californian public sector pension fund believes will help it achieve its ambitious 7 per cent rate of return.

In a presentation to the Calpers board, Ben Meng, chief investment officer, said the giant fund would take on additional leverage via borrowings and financial instruments such as equity futures. Leverage could be as high as 20 per cent of the value of the fund, or nearly $80bn based on current assets. The aim is to juice up returns to help the scheme, the largest public pension in the US, achieve its growth target.

The move comes after a 2019 investment strategy review that found Calpers needed greater focus on the excess returns potentially available from illiquid assets compared with public equity and debt. Under Calpers’ previous asset allocation strategy it was estimated to have a less than 40 per cent probability of achieving its 7 per cent return target over the next decade.

Calpers’ 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.

The US stock market slide this year has increased the long-term structural problems across the entire US public pension system, particularly for the weakest plans that have ballooning unfunded liabilities. The weak funded position of these funds poses a huge long-term risk for millions of US employees and retired workers.

Mr Meng hopes Calpers’ deeper push into illiquid assets over the next three years will help it exploit its structural strengths. Its perpetual nature allows it to make longer-term investments, while its size gives it access to top managers in private equity markets where performance is widely dispersed.

“Given the current low-yield and low-growth environment, there are only a few asset classes with a long-term expected return clearing the 7 per cent hurdle. Private assets clearly stand out,” Mr Meng said. “Leverage will increase the volatility of returns but Calpers’ long-term horizon should enable us to tolerate this.”

He added that leverage would not “be tied to any specific strategy, asset, fund or deal”.

Mr Meng has terminated relationships with more than 30 external fund managers since 2019, redeploying $64bn of capital with savings of more than $115m in annual fees. Holdings of global equities are now 95 per cent internally managed, while 80 per cent of the total fund is managed in-house. It invests in more than 10,000 public companies.

Mr Meng has faced criticism this year for abandoning a hedging strategy for tail risk, the risk of low probability but highly costly events, before the market crash in March.

He countered that Calpers had developed ways of raising cash at short notice to meet unexpected demands on the fund, an approach that was less expensive than high-cost hedging strategies.

Calpers’ portfolio has also been de-risked by increasing its holdings in longer-dated US Treasuries and switching more assets from capitalisation-related equity indices to factor-weighted equities. These use indices that focus on investment styles such as price momentum or volatility.

According to Mr Meng this strategy protected the fund from losses of $11bn in the pandemic-induced market slide, which far outweighed the $1bn profit forgone on tail risk hedging. He said that unlike in the financial crisis of 2008 Calpers was not forced to sell assets into a depressed market in March. “Too little liquidity can be deadly but too much is costly,” he said.
So Ben Meng passed his plan to leverage up CalPERS' portfolio. And not by a little, it can go up to 20% or $80 billion if needed.

Exactly one year ago, I covered the topic of what I thought about CalPERS leveraging up its portfolio and shared this:
So why is CalPERS considering to add leverage now? Ben Meng, CalPERS's CIO, explains why above: " of the undesirable outcomes during a drawdown is we don't have money to deploy to take advantage of a market dislocation, and one of the ways to generate additional liquidity is put on leverage on the total fund. So, we borrow money."

Remember what happened to CalPERS during the 2008 crisis, it was unloading stocks in a falling market to make sure it has enough cash to meet its private equity and real estate obligations:

The pressures come as the California Public Employees' Retirement System has had to raise cash to fulfill commitments to private-equity firms and real-estate partners. The giant fund's predicament is another sign of how the market selloff is tightening the screws on pension funds nationwide. Many other pension funds have similar partnerships and could also confront liquidity strains.

Members of the board investment committee at Calpers held a closed-door session on Monday and discussed ways to raise more cash, according to people familiar with the matter. The issue was brought to the attention of the committee after members of the investment staff expressed concern, a person with knowledge of the matter said.

Typically, Calpers keeps less than 2% of its assets in cash, but the recent demands have forced it to raise that level.

"Calpers receives more than enough cash from employers and members to cover its monthly benefit obligations" to retirees and other beneficiaries, a Calpers spokeswoman said Friday.

Under normal conditions, pension funds count on some private-equity partners to distribute investment gains, while pensions owe some partners more capital. During the recent market selloff, however, distributions have dried up while capital calls continue. That's created a mismatch and a cash strain.

Since the credit markets have tightened up and real estate and alternative investments aren't very liquid, Calpers has been compelled to sell off stocks to raise large sums quickly. Those sales are turning paper losses into realized losses.

Calpers said it had $188.8 billion under management as of Wednesday, down 21% from the end of June. The fund, which said it had about 63% of its assets in global stocks at the end of August, has been punished severely by the stock-market selloff.
That was October 2018, a lesson for all mature pension plans that need liquidity when a crisis strikes.

If CalPERS was able to borrow back then, it would have made its capital calls to private equity partners without selling stocks at the bottom of the market.

This is what I call the intelligent use of leverage, a hot topic at pension funds these days. Most critics don't understand the use of leverage at a large pension fund like CalPERS which is why they're quick to criticize it.

CalPERS isn't the first US pension fund considering the use of leverage. In 2010, the State of Wisconsin Investment Board said it was considering leveraging its then $67.8 billion core fund to achieve an asset allocation equivalent to 120% of total assets over the next three years:
The groundbreaking move — believed to the first effort to adopt an approach that a number of pension funds are weighing — would enable the board to reduce its equity exposure and increase allocations to lower-returning and lower-risk assets that offer greater diversification benefits while seeking to meet the board's expected actuarial return.

SWIB officials discovered that, like many pension funds, Wisconsin's exposure to equity risk comprised 90% of the fund's volatility. The pioneering change also would position the fund to endure a period of high inflation and low economic growth, a scenario of growing concern for many investors.
Wisconsin's big public pension cheese basically adopted Bridgewater's all-weather approach which is one of the reasons why it's one of the few fully-funded US public pension plans.

The main reason Wisconsin's public pension is fully funded, however, is it adopted a shared-risk model like most of Canada's fully funded public pensions.

Canadian pensions have also pioneered the use of leverage and have the requisite sophistication to do this properly and intelligently using a broad array of instruments and strategies.

CalPERS might not be there yet but in my opinion, its CIO Ben Meng is smart enough to understand he doesn't want to get caught in another 2008 scenario where CalPERS is unable to meet capital calls without selling equities (at the bottom).

The main message I want to convey here is leverage isn't a bad thing, you need to use it wisely at the right time, so ignore CalPERS's critics who simply don't understand the use of leverage at pensions.
I still stand by these views, however, I want to point a few things out:
  • Unlike Canada's large pensions, CalPERS isn't fully funded, so if using leverage on illiquid assets doesn't pan out for any reason, they will exacerbate losses and worsen its funded status considerably.
  • Also, Canada's large pensions have unbelievable balance sheets, so I suspect their cost of borrowing is significantly cheaper than that of CalPERS which will be low but not as low.
  • Canada's pensions use leverage in different ways. They use it by implementing a risk parity approach internally on their portfolio by leveraging up their bond portfolio (repo trades), to implement derivatives strategies which typically pan out but sometimes blow up, and to borrow money to invest in green bonds, hedge funds, private equity, real estate, infrastructure and private debt.
  • CalPERS is basically taking a page from Canada's large pensions and using its structural advantages -- long investment horizon, certainty of cash flow, etc -- to use leverage and invest in private markets, waiting for the cycle to turn and profit when it's the right time to sell.
The most important thing to understand is if used intelligently, leverage can be a godsend to CalPERS and other large pensions because it allows them to stay the course without having to sell at the wrong time.

Truth be told, leverage has been a key factor behind the long-term success of Canada's large pensions but it's not the only one. To be successful using leverage, you need to hire smart people who know what they're doing, so here are the elements of success at Canada's large pensions:
  • Good governance: Allows them to attract talent, pay and retain them, to do more investing internally.
  • Shared risk: Typically through conditional inflation protection so when the plan has a deficit, they can partially remove full indexation until the plan's funded status is fully restored.
  • Leverage: To take advantage of dislocations in the market and invest across public and private markets at the right time.
Now, I don't know of any Canadian pension that has ever leveraged its portfolio by 20%, so CalPERS will be setting a new bar here. Typically Canadian pensions leverage up to 5% max of their total assets but I could be wrong about this (doubt it).

What else? There is a lot of controversy surrounding private equity these days. I recently wrote two comments:
There are many critics of the asset class and still lots of confusion out there as to why pensions invest in private equity.

Some of the criticism is legitimate, like how IRR is bullsh*t and I always say it's best to look at net IRR and take all the costs associated with the performance of any private equity fund into consideration:
In 2014, the Securities and Exchange Commission (SEC) began investigating whether private equity fund managers were correctly disclosing their own invested capital into their own funds when performing net internal rate of return calculations. Including that sum—known as a "general partner commitment"—could artificially inflate fund performance because such capital infusions do not have fees attached to them.
How net IRR calculations are performed (whether they include general partner capital or not) varies among private equity firms, Reuters found. The SEC expects private equity firms to clearly report both average net IRRs and gross IRRs on all fund prospectuses and marketing material.
I also think a lot of private equity managers have never had it so good:

But I am not going to get into a huge debate about private equity and its merits.

I'm clearly in favor of more private equity when the approach is right, and let me be clear about what I mean:
  • Invest in top funds and co-invest with them on large transactions to reduce fee drag.
Are the top funds only brand name funds? Not necessarily but there is evidence of performance persistence in private equity, albeit it has been attenuated in recent years.

Are private equity returns coming down? Absolutely, there's way more money chasing fewer deals and as rates hit record low levels, the performance has been coming down across all asset classes, public and private.

Does this mean pension shouldn't invest in private equity? Absolutely not as long as the approach is right, it makes sense for a lot of reasons:
  • They will generate their target rate-of-return over the long run
  • They will diversify their public equity holdings which are marked to market and have less marked to market volatility which is beneficial because it will mean less volatility for the contribution rate of plan members.
  • Over the long run, private equity remains a great asset class for a pension with a long investment horizon.
Now, don't get me wrong, there is volatility in private equity, it's very understated in theory, but for a pension with a long investment horizon, it's criminal not to invest in private equity.

So stop reading nonsense on other blogs how "CalPERS plans to blow its brains out", it's sensational drivel, total nonsense!

There's a reason why Ben Meng is the CIO of CalPERS, not Yves Smith aka Susan Webber. Let the pros manage pensions and let Ms. Smith take ridiculous potshots at them without offering any valuable insights.

Again, CalPERS can go as high as 20% leverage doesn't mean it will, so take a deep breath everyone!

CalPERS is holding its board meeting today via the internet and I embedded it below (click here to view it as well). I also embedded a clip from April where Ben Meng discussed liquidity and managing total fund risk and addressed criticism on their decision to unwind their tail-risk investment (in my opinion, much ado about nothing regardless of what Nassim Taleb thinks).

Update: Please take the time to read my follow-up conversation with Ben Meng here.