CalPERS Sets Marching Orders for Next CIO?

Mary Williams Walsh of the New York Times reports that CalPERS' next chief investment officer has their marching orders: more private equity:

Ben Meng got the job of chief investment officer of CalPERS by convincing the trustees of the nation’s largest public pension fund that he could hit their target of a 7 percent annual return on investment by directing more of the fund’s billions into private equity.

Now, Mr. Meng is gone — only a year and a half after he started — and CalPERS, as the $410 billion California Public Employees’ Retirement System is known, is no closer to that goal. The fund is consistently short of the billions of dollars it needs to pay all retirees their pensions. And it continues to calculate that it can meet those obligations only if it gets the kind of big investment gains promised by private equity.

The strategy involves putting money into funds managed by firms such as the Blackstone Group and Carlyle, which buy companies and retool them with the goal of selling them or taking them public. Even as some of the fund’s trustees have misgivings — they say the private equity business is opaque and illiquid and carries high fees — they say they have little choice.

“Private equity isn’t my favorite asset class,” Theresa Taylor, the chair of the CalPERS board’s investment committee, said at a recent meeting. “It helps us achieve our 7 percent solution,” she said. “I know we have to be there. I wish we were 100 percent funded. Then, maybe we wouldn’t.”

CalPERS, like many other pension funds, began putting money into private equity funds decades ago. But its reliance on such funds has increased in recent years, as low interest rates have made bonds less attractive and stocks have proven too volatile. Adding to the urgency are an aging population, expansive pension benefits that can’t be reduced and a major funding shortfall.

Mr. Meng’s abrupt departure in August, and CalPERS’s slow-moving search for a replacement, are delaying its plans to increase its private equity investments. Mr. Meng resigned after compliance staff noticed that he had personal stakes in some of the investment firms that he was committing CalPERS’s money to, most notably Blackstone. California state officials in that situation are supposed to recuse themselves, but Mr. Meng did not.

Some of the fund’s stakeholders, including cities, school districts and other public employers, worry that in the meantime, CalPERS’s trustees could react by putting new restrictions on investment chiefs, discouraging top candidates from applying for the job or otherwise making it harder for CalPERS to achieve its target rate of return. If investment returns fall short, local officials know they’ll have to make up the difference, dipping into their budgets to free up more money to send to the fund.

“It gets harder and harder each year,” said Brett McFadden, the superintendent of a large school district northeast of Sacramento. He has cut art, music and guidance counselors to get more money for the state pension systems every year. “These policies are being made in Sacramento, and I’m the one left holding the bag,” he said.

Marcie Frost, the chief executive of CalPERS, said that Mr. Meng’s departure would not prompt the board to change CalPERS’s investment strategy. She said a study by CalPERS and its outside consultants showed that private equity and distressed debt were the only asset classes powerful enough to boost the fund’s overall average gains up to 7 percent a year, over time.

“So we have to have a meaningful allocation to those,” she said. “There are no guarantees that we’re going to be able to get 7 percent in the short term or, frankly, in the long term.”

Data shows that CalPERS’s private equity returns are consistently lower than industry benchmarks, but private equity has still performed better than other assets and “has generated billions of dollars in additional returns as a result of our investments,” said Greg Ruiz, CalPERS’s managing investment director for private equity.

Mr. Meng was a big proponent of private equity, telling trustees that “only one asset class” would deliver the returns they sought and that the fund would need to direct more money into it. But while CalPERS sought, under him, to increase its private equity allocation to 8 percent of total assets, the holdings fell to 6.3 percent, in part because the private equity managers were returning money from previous investments and CalPERS did not jump to reinvest it. Over all, the fund had about $80 billion — or 21 percent of its assets — in private equity, real estate and other illiquid assets as of June 30, the end of its last fiscal year.

CalPERS has sometimes moved slowly on private equity partly because of its trustees’ qualms.

At one recent meeting, Ms. Taylor, the investment committee chair and formerly a senior union official, recalled that some of CalPERS’s private equity partners had bought Toys “R” Us in 2005. The transaction loaded it up with $5 billion in debt just as the retailer’s bricks-and-mortar sales strategy was becoming antiquated, and the company went into a long, slow collapse that ended in liquidation and cost more than 30,000 jobs.

“I’m hoping that we can get to a better strategy of mitigating some of these problems,” she said.

Other trustees questioned the validity of the internal benchmark that CalPERS uses to evaluate its private equity investments, saying they didn’t believe the returns were all that good after fees were deducted.

“We’re going to be sold a bill of goods, and we’re going to believe what they say, because we want to believe it and we want to make higher returns,” said Margaret Brown, a trustee and retired capital investments director for a school district southeast of Los Angeles.

Still, the marching orders for CalPERS’s next investment chief are apparent: Find ways to increase the pension giant’s investments in private equity funds.

Independent analysts have long urged public pension trustees to stop chasing higher returns and instead take a deep, hard look at how they got to be so underfunded in the first place. A growing school of thought blames the way they calculate their total obligations to retirees for understating the true number — specifically, how they translate the value of pensions due in the future into today’s dollars.

To do that, CalPERS uses the routine practice of discounting, which all financial institutions use and is based on the principle that money is worth more today than in the future. It requires the selection of an appropriate discount rate. CalPERS uses its target return on investment of 7 percent as its discount rate — a practice flatly rejected by financial economists, because 7 percent is associated with a high degree of risk, and CalPERS’s pensions are risk free. Economists say that CalPERS, and other public pension systems, should be using the rate associated with risk-free bonds like U.S. Treasury bonds. Doing it that way shows the tremendous intrinsic value of risk-free retirement income.

But by assuming a high so-called discount rate that matches its assumed rate of return, CalPERS makes its shortfall look much smaller on paper — which allows the fund to bill the State of California and its cities for smaller annual contributions than it would otherwise have to. That helps everybody balance their budgets more easily, but it has left the pension system chronically underfunded.

Public pension systems in California, including CalPERS, reported a combined shortfall of $352.5 billion as of 2018, using their high investment assumptions as discount rates, according to a compilation by the Stanford Institute for Economic Policy Research. But by replacing just that one assumption with what economists consider a valid discount rate, the institute showed that the funds were really $1 trillion short that year. If CalPERS suddenly started billing local governments accordingly, it would cause a crisis.

CalPERS stepped into this trap in 1999, at the end of a powerful bull market. On paper, it appeared to have far more money than it needed, and state lawmakers decided to increase public pensions after hearing from CalPERS officials that it would not cost anything so long as the fund’s investments could produce 8.25 percent average annual gains.

Then the dot-com bubble burst, and the investment gains on paper that CalPERS had amassed melted away, leaving a shortfall. But the big pension increase was locked in because California law bars any reduction in public pensions. Similar things happened in many other states. Before long, the race was on for higher investment returns.

“Over the past 20 years, U.S. pension funds have set aggressive targets and failed to meet them,” said Kurt Winkelmann, a senior fellow for pension policy design at the University of Minnesota’s Heller-Hurwicz Economics Institute.

He recently compiled the investment returns of the 50 states’ pension systems from 2000 to 2018 and compared them with the states’ average targets during that period. It turned out that the actual returns were 1.7 percentage points per year less.

CalPERS’s investment results were even more off the mark, Mr. Winkelmann found. Its target averaged 7.7 percent over the 18 years. But actual average returns were only 5.5 percent over that period, Mr. Winkelmann said.

“There were periods when public fund investments exceeded their targets,” Mr. Winkelmann said. “However, these periods were more than offset by periods with dramatic losses.”

Any way you slice it, CalPERS is in big trouble and Ben Meng's "abrupt" departure only adds to the plan's problems.

Now, I am hearing the board of trustees squabble over whether or not to continue with what Ben Meng started and allocate more to private equity.

My thoughts? Absolutely allocate more to private equity but if you think this is going to save CalPERS, you're delusional. 

There are a couple of things about private equity I do want to point out:

  • First, returns are coming down and in an ultra low rate environment, they may be better than other asset classes, but they're still coming down.
  • Second, the approach matters a lot. If you're mostly doing fund investing, you won't achieve required scale and allocation and fees will eat up a huge chunk of your returns over the long run which is why Canada's large pensions have approached private equity by doing fund investments and co-investing alongside their partners to reduce fee drag

If you look at CPP Investments, Canada's largest pension fund, it invests 25% in private equity, a lot more than its large Canadian peers which average 12% and far more than CalPERS which has a 6.6% allocated to private equity (see details here).

It has a benchmark for base CPP which is 85% global equities and base CPP is partially funded so it can take more equity risk across public and private markets (enhanced CPP is fully funded, so less equity risk).

The key thing, however, is CPP Investments invests in top private equity funds and co-invests alongside them on bigger transactions to reduce fee drag.  

Co-investments are a form of direct investing (no fees) and they make up roughly half of CPP Investments' private equity portfolio (if not a bit more).

To co-invest properly, however, CPP Investments has a professional team of private equity experts headed by Shane Feeney.

These professionals are able to quickly analyze complex co-investments and revert back to their private equity partners quickly to gain access to these co-investments.

Importantly, 50% or more in co-investments allows CPP Investments to maintain its high allocation to private equity (for base CPP) and it's critically important because in private equity, you have distributions every year and need to manage the program carefully to maintain scale.

CPP Investments also has a very well thought out secondaries program in private equity to maintian liquidity. 

The key thing I want to get across, CalPERS isn't CPP Investments, not even close, when it comes to its approach to private equity.

That's not to take anything away from Greg Ruiz, CalPERS’s managing investment director for private equity, and his team. I'm sure they are highly qualified but they don't have the resources to do what CPP Investments and other large Canadian pensions are doing in private equity.

But let me be clear on something, the reason why Canada's large pensions are fully funded (in case of pension plans) or exceeding their funding requirements (in case of pension funds) is because of plan design, not private equity or private markets.

You can have the best investment teams across public and private markets but if you don't get the plan design right, your plan is in deep trouble.

If you don't believe me, read the study Ingo Walter and Clive Lipshitz recently completed, Public Pension Reform and the 49th Parallel: Lessons from Canada for the U.S., which is available here.

I'll go a step further because I know CalPERS' board of trustees and Marcie Frost read my comment.

Given that CalPERS is only 69% funded (if not worse now), you absolutely need to introduce conditional inflation protection at CalPERS, focus on risk a lot more and implementing a better total fund management approach.

On that last point, Mihail Garchev, BCI's former Head of Total Fund Management, recently started posting his insights on my blog on total fund management. You can read Part 1 here.

Every Thursday, we will bring you a new installment (Part 2 is coming ot in two days).

I highly recommend you bring Mihail Garchev into CalPERS to give you his honest and thorough assessment on where you can improve total fund management.

That's far, far more important than allocating more into private equity, and I'm pretty sure Mihail can do this remotely (he's currently based in Victoria, British Colombia).

Lastly, CalPERS has to step it up and hire a CIO to replace Ben Meng. There are excellent candidates internally and in Sacramento but there are others too and I'm surprised it's taking so long to find a suitable replacement.

A pension plan the size of CalPERS needs a dedicated CIO and the sooner they get someone in there to fill Ben's shoes (no easy feat), the better off everyone will be.

Stop making it impossible to attract talented individuals. I know a few people I'd recommend for this position but they're all hesitant about joining CalPERS and suffering the same fate as Ben Meng.

The organization goes through CIOs like some people go through shoes. Ben Meng was the sixth CIO at CalPERS in how many years? It's ridiculous and it needs to stop.

Pick a highly qualified CIO and stick with him or her over the long run.

Alright, enough rambling for a Monday. 

Below, the latest CalPERS Board meeting webcast which took place on Friday and is available here. Fast forward to one hour and 43 minutes to get past the close camera session.

CalPERS CEO, Marcie Frost, discussed finding a suitable CIO candidate at two hours and 31 minutes. They hired Korn Ferry to undertake the search and while I'm sure they're good, they should really contact me before hiring any CIO. 

Also, CalPERS CEO Marcie Frost joined "Squawk Box" a few weeks ago to discuss the fund's target over the long-term and how it is approaching the markets in the current environment.

Lastly, Elizabeth Burton, CIO of Hawaii's pension fund, recently joined "Squawk on the Street" to discuss the markets and the pension fund's investment approach in the lead up to the 2020 presidential election.

Smart lady, wonder if she made the short list to replace Ben Meng.  

Update: A very wise former Canadian pension fund manager shared some observations and insights after reading this comment: 

How do we know co-investing is enhancing the return of a private equity portfolio?  Is there any instance where for example the direct/co investment 5 and 10 year track record is compared with the fund only track record?  I am unaware of any institution ever disclosing this. Lots of unsupported claims and assertions, but mostly on the theory that reducing effective fund fees in blending the outcomes of co-investment somehow creates better overall returns. 

Reducing effective fees through direct investment comes at the cost of the substantial risk of adverse selection, and undoing some of the diversification decisions that the funds themselves think through very carefully.  I have no doubt there are co-investment wins, but there are losses too. Rarely do we hear about the losses, although the anecdotes suggest to me some pretty outsized losses are piling up, and there is way more unrealized rather than realized track record at this point in pretty much any institution that has scaled up this activity in recent years.

Many institutions have not been co-investing for that long, but for those that have for all we know they would have been better off with the funds on their own. Absent disclosure, comments that this approach is in fact working are simply anecdotal. 

Sometimes you do get what you pay for, that is the task and goal of managing fees, not reducing them in isolation. Further there are illiquidity implications. There has been good and creative development of the secondary markets over many years such that the fund interests can achieve some enhanced liquidity when the need arises.  The ability to sell down co-investments, especially where the company performance is questionable, trips up various co-invest agreement terms and makes for a much more bespoke secondary market, if any exists at all for a specific asset.

I support the idea of co-investment but the accountability for this should be completely transparent, at least in the fullness of time.  Otherwise there are misleading signals to the pension market about what strategies to employ.  In an era of up risking due to low bond returns, these signals are resulting in increased private equity allocations which seem to now include co-investment as a necessary component.  The cost and governance implications of building in-house capability is considerable. As usual, the idea is fine but I fully expect that the execution can bring, or more likely already has brought unintended consequence.  Which may actually be reduced returns, and at the least even greater illiquidity on increasingly levered balance sheets.  
That prompted this response from me:
I agree with you that they need to disclose more on co-investment portfolios. On that, BCI has explicitly stated their co-investment portfolio is outperforming their fund investments one and others have told me the same. Is it because they’re not paying fees on co-investments? 

One thing Ben Meng told me before he left, CalPERS can’t expand its private equity portfolio through funds alone, it would force the to allocate to third and fourth quartile funds and defeats the purpose.
 And he replied:
Yes, I have heard the statements about performance butt when you dig, it is usually "since we changed out strategy in 2015" or "under the watch of the present leader/team", or "including the secondaries deals which we view as direct investments", or "before non-core activities" and so on. 

It is possible that there has been good performance in recent years, all with mark to market, but the current state is lagging in showing that it is typically risky deals that get syndicated. It would actually be a very simple thing to disclose, but the implications that the direct activities detracted from value would be really hard to explain. I am ok with the lack of transparency to the point of protecting long term capability. But the other side of the coin is insufficient data to actually rationally advocate for a strategy, which is what you would expect for any other asset class.

Doing third and fourth quartile funds is probably better than doing third and fourth quartile co-investments. But we don't know about the quartile breaks for any co-investment programs, so it is all just talk and wishful thinking.

I personally think that pensions taking on more illiquity through privates and more leverage at the total fund level will be the downfall of the pension system, and that will manifest quicker than people expect. Bit by bit, the old prudent man/woman fiduciary rules of play are being discarded in the quest for returns so that employers and members can avoid the full cost of excessive pension arrangements.  I love risk, but rightsizing portfolios is the way to control it, and privates or all types should be way less than the current advocates suggest.  Liquidity is way undervalued.
I thank this person for sharing these wise insights and he emphasized that he's not against co-investments but we need better data to understand the merits of the approach.
He's right, public pensions need to manage their liquidity risk more carefully and they need to be more upfront on their co-investments. But one thing I am absolutely certain of, more fund investments for a pension fund the size of CalPERS will only dilute overall performance and raise fees astronomically. 
In fact, prior to Réal Desrochers, CalPERS used to invest in almost all PE funds, to the point where their PE portfolio was one big fund benchmark that significantly underperformed its large peers.That approach has proven to be an abysmal failure which is why I prefer fund investments and co-investments, as long as you have the right team to co-invest properly. 
Lastly, Mark Wiseman tweeted this FT article recently stating this: "PE managers are turning to specialist borrowing facilities to ensure their highly leveraged strategies can survive the pandemic, but there are growing concerns that the use of these complex financing deals poses new threats to investors."

If anyone knows a lot about private equity, it's Mark Wiseman, listen to his warnings.