Will CalPERS's Turn to Private Equity Work?

Alicia McElhaney of Institutional Investor reports that CalPERS is turning to private equity and leverage to boost returns and reduce risk but will it work?:

With interest rates low enough to sometimes render bond investing all but futile, and questions as to whether the public equity markets can keep increasing at the same torrid pace seen in recent years, allocators are plagued with worry about meeting their investment targets.   

At its mid-November meetings, the California Public Employees’ Retirement System revealed its plan to manage these changing market dynamics. The fund intends to change its strategic asset class allocation, funneling more money into private equity and adding a small amount of leverage to the portfolio.   

But industry experts are mixed on whether or not these decisions will bolster the $495 billion fund’s portfolio.  

“To me, this highlights the biggest challenge that institutional investors have, which is achieving a rate of return that will meet their investment goals,” said Michael Rosen, chief investment officer at Angeles Investment Advisors, a California-based investment manager. “I applaud CalPERS for moving in this direction.” 

As a part of the larger strategic asset allocation plan approved in mid-November, CalPERS will be increasing its private equity portfolio from 8 percent to 13 percent of its total assets, or roughly $25 billion. CalPERS is selling some Treasuries and stocks to push further into privates.   

One former member of CalPERS’s senior investment team, Ron Lagnado, is raising concerns about the plan. “That’s an enormous amount of money to be shoveling into private equity,” Lagnado said. “Everybody is trying to crowd into the space. If this is all the largest pension fund in the United States is going to come up with, I don’t think they’re thinking carefully about what they’re doing.”  

CalPERS, however, said that the move will be measured and incremental. “It’s not that July 1 rolls around and we’re suddenly at 13 percent,” said Megan White, a spokesperson for the pension fund, via e-mail. She added that private equity has been the fund’s best-performing asset class over the most recent ten- and 20-year periods.  

Lagnado left CalPERS in March 2020 to become a director at Universa Investments, the investment firm that was managing part of the tail-risk hedging strategy for CalPERS. Just before the markets cratered in March 2020, the pension fund ended the strategy, missing out on roughly $1 billion in gains. That event became a lightning rod for CalPERS and what it was doing to mitigate risks in its portfolio in the months that followed.  

“I have no axe to grind,” Lagnado said in response to a question about his criticism of the CalPERS plan. “I voluntarily left.” But Lagnado is passionate about how public pensions will make good on their promises to investors and the limitations of traditional approaches to diversification, including the diminishing protection that comes from bonds during a drawdown. He previously argued in an II opinion piece that state pension funds are underfunded and that will only get worse when markets inevitably turn down “A considerable body of evidence shows these funding problems are connected with how most pension portfolios have been constructed for more than a decade. Without changing the approach, it seems unlikely that funded status can be improved in the coming decade through investment performance alone.” 

Lagnado pointed to historically high valuations in the private market as a big cause for concern. Many investors share those worries, given how much the industry has raised in recent years and the increase in competition for deals.

Rosen pointed out that most asset classes are overheated these days. “Questions always come about high valuations in equities,” he said, “[but] I never get a question about high valuations in fixed income. And yet, by any measure, valuations are far more extreme in fixed income than in equities.” Rosen quipped, “bond prices are the highest they’ve been in 5,000 years.”

CalPERS isn’t alone in boosting its private-equity allocation — the move is one that most pension funds in the U.S. have made in recent years. However, adding leverage to the portfolio is not as common. That’s particularly true given that risk-parity strategies, which are an alternative diversification scheme that relies on leverage, have fallen out of favor among investors.  

The pension fund plans to add up to 5 percent of leverage, borrowed money, to its portfolio. CalPERS argued in the recent presentation that leverage would improve diversification and reduce risk. 

“By and large, with the use of leverage we can reduce the equity exposure just a smidge and increase the fixed-income exposure,” said James Sterling Gunn, CalPERS’s head of its trust level portfolio management program, during the mid-November meeting. “And the overall effect is [that] with a modest level of leverage, we have a modest decrease in the drawdown risk of the portfolios. So that really is the key takeaway message for the strategic allocation of the leverage.” 

According to Rosen, the decision to add leverage has the potential to boost returns. “It’s important that you’re confident that you’ve got a program in place and a discipline and process associated with leverage,” he said.  

Ludovic Phalippou, a French financial economist and researcher whose work has been highly critical of private equity, cautions about the use of leverage in a portfolio. “Most people think that adding leverage increases returns, and that is a mistake,” he said via e-mail. “Put as simply as possible: If you invest in AAA bonds, let’s say you receive 2 percent for sure. If you lever up an equity portfolio, [you may, let’s say,] have a 50 percent chance of receiving 20 percent and a 50 percent chance of losing 10 percent. The expected return is higher in this example, but you don’t receive the expected return, [and] this is where the mistake is: You either win a lot more or lose a lot more. If you are a pension fund and increase leverage, you are doing the latter — i.e. basically betting the house. You are taking the risk of losing a lot of money because you want to have a chance to become solvent.” 

While headline-grabbing, however, CalPERS's addition of leverage to the portfolio may not be as large as it seems. “There's a ton of implicit leverage everywhere,” Rosen said. “Obviously, private investments are typically levered. It’s embedded in that space.”  

This is something that the CalPERS board and investment team touched on during the November 15 meeting. According to interim CIO Dan Bienvenue, there is already about four percent active leverage in the portfolio. Even Ron Lagnado says that that figure isn’t a concern. “They’re adopting leverage, [and] the interpretation is that they’re leading the way and it’s a direction all funds must follow,” he said. “[But it’s] a minuscule amount of leverage.” 

What CalPERS is doing is changing its asset-allocation strategy as it adds leverage to its portfolio. The pension fund is reducing its allocation to Treasuries and public equities while adding to private equity and investment-grade credit, among other asset classes. In effect, Lagnado said, this is a bet on the outperformance of private assets, and of credit relative to Treasuries. Risk mitigation via diversification relies on perfectly timed rebalancing to add value over a drawdown cycle – something CalPERS failed to do in 2008 and in 2020, he added. 

In response to a follow-up question, Megan White clarified via e-mail that adding 5 percent leverage to the portfolio applies uniformly. “It is not tactical,” she said. “It’s part of the strategic asset allocation.”

CalPERS declined to make board or investment staff members available for interviews.  

Alright, I first covered how CalPERS is adding a modest amount of leverage here a few weeks ago. 

I got flack from some guy called Brad Case ("PhD, CFA, CAIA") on Linkedin, saying I don't know what I'm talking about and that "a strategic allocation to cash is better than a strategic allocation to leverage."

So I asked David Long, partner at Alignvest and former CIO of HOOPP to respond to him because I didn't feel like engaging and David was kind enough to share his thoughts on Linkedin:

For a given level of risk, one can own a portfolio of higher risk assets or one of leveraged lower risk assets. While the latter can frequently look more attractive than the former, one has to also consider that one’s risk estimates could prove too low for “low risk” assets. It could be that either strategy is the right one depending on circumstances.

Beyond the assets, the type of liabilities taken on also need careful consideration. How long is the guaranteed term of the liabilities? Are the assets reliably easy to re-finance? Is the liability limited to the value of an asset or theoretically unlimited? The answers indicate the liability related risks of using leverage.

Along the same lines, having access to additional cash to pursue an immediate investment opportunity will depend upon a leveraged investor’s ability to increase leverage and/or sell other assets quickly. Leveraged portfolios containing large amounts of government bonds or large cap equities are better suited for this than other such portfolios.

Leverage offers the potential of higher risk adjusted returns, but requires a holistic approach to managing risk.

David Long is one of Canada's foremost derivatives experts and he knows what he's talking about.

The leverage CalPERS is talking about here is indeed "minuscule" to use Ron Lagnado's words.

They are reducing their fixed income exposure (Treasuries) and leveraging it up to increase their private equity exposure.

Hmmm, where have I heard this before? Ever heard of Bridwater's All Weather portfolio? Risk-parity strategies? 

There is indeed a way to add modest leverage to very liquid fixed income instruments (like Treasuries) to increase the risk-adjusted return of your total portfolio (see here).

Risk parity is designed to help investors maintain a portfolio with significant risk diversification benefits while still meeting their return expectations. This result is achieved through the prudent use of leverage. Specifically, leverage is employed within the Risk-Diversified portfolio to move it further up the capital market line to the point where it becomes risk equivalent to the 60/40 portfolio. The resulting levered Risk-Diversified portfolio has a higher expected return than the 60/40 portfolio with an equivalent amount of risk. Some have argued that if all asset classes can be adjusted to contribute the same total level of risk and therefore similar expected returns, then choosing between asset classes is no longer important. This is not the case. If all asset classes had the same expected risk, then the selection of which asset classes to include in the portfolio should be driven solely by the asset class’s diversification benefit. Put another way, if the question of expected return is removed from the portfolio construction process, then the focus is shifted to managing risk through portfolio diversification.

A less discussed, yet important, advantage of a risk parity approach is its potential to realize significant incremental returns through rebalancing. The amount of excess return generated through rebalancing is a function of asset class volatility and diversification. All else equal, the more volatile and diversified the assets within a portfolio, the more value that can be created through rebalancing. In the risk parity portfolio, assets are selected based on their diversification benefits and levered up or down to achieve target volatility. This construction process creates an ideal environment for systematically harvesting gains in the portfolio through rebalancing

This is how I read CalPERS's use of modest leverage when James Sterling Gunn, head of its trust level portfolio management program states: “By and large, with the use of leverage we can reduce the equity exposure just a smidge and increase the fixed-income exposure.”

Anyway, all this to say way, WAY, too much of a big stink is being made of CalPERS's use of modest leverage and that's not where I see a problem at all.

A bigger issue for me is how will CalPERS move from 8% in Private Equity to 13%?

Here is what I posted on Linkedin earlier today:

[...] the biggest issue CalPERS will face going from 8% to 13% in private equity is how to do this in a cost effective manner which takes into account the size of their total portfolio. For example, CPP Investments which is Canada’s biggest pension fund, has roughly the same assets as CalPERS (a bit less in USD but growing fast) but invests 25% of its assets in PE through partnerships with top global funds and more importantly through co-investments with top funds on large transactions to reduce fee drag and remain well allocated in private equity. This allows them to get the most bang for their PE buck but to do co-investments properly, you need a dedicated PE team that knows how to analyze them and direct investments. You need to compensate these people properly to attract and retain qualified staff.

Importantly, forget leverage, the focus needs to be on the approach CalPERS will use to invest in private equity.

If CalPERS doesn't beef up its co-investment capabilities, it will never be able to increase its allocation to private equity in a cost effective way and achieve its long-term return target.

Only investing in funds won't cut it, the fees are a big drag on returns over time.

Also, there aren't one thousand Thoma Bravos out there, there's only one and they are in a league of their own!

Led by Bravo and a tight-knit group of managing partners, the firm has done nothing but buy software companies for nearly 20 years. The focus contrasts with listed rivals such as Blackstone and KKR which have built sprawling businesses that make them look more like asset managers than a private equity firm.

Software valuations have been soaring, but Bravo said he was unfazed. Since the beginning of 2020, his firm has exited over 20 software investments through sales or initial public offerings, generating $29bn in gains on $7bn of invested capital, according to people informed on the matter.

A $2.2bn equity investment in mortgage software company Ellie Mae in 2019 yielded an $11bn windfall when the business was sold to Intercontinental Exchange a year later, which pushed the internal rate of return on its 2018 fund up to more than 50 per cent, according to disclosures from multiple state pension funds.

These returns colour Bravo’s optimism. “It’s amazing to me that people get out there and say the market is overvalued. It is irresponsible, almost,” he said. “Good luck in sitting on cash and waiting for the market to get cheap.”

Again, there are some excellent buyout funds out there but when you're the size of CalPERS, you want to co-invest with them on larger transactions to reduce fee drag. 

Greg Ruiz leads the Private Equity program at CalPERS, he knows all this. 

Ben Meng, CalPERS's former CIO, knows all this and we spoke about it at length in our discussions.

Going from 8% to 13% in Private Equity isn't easy, you really need to get the approach right, investing in top funds al over the world and co-investing alongside them on larger transactions to reduce fee drag. 

That should be the only concern at CalPERS, their Board and members, namely, does CalPERS have the capabilities to emulate Canada's large pensions when it comes to co-investing in private equity?

If not, they need to increase compensation and get the governance right to attract and retain qualified staff.

Lastly, there is something in the article above that irks me when Ron Lagnado states this:

“A considerable body of evidence shows these funding problems are connected with how most pension portfolios have been constructed for more than a decade. Without changing the approach, it seems unlikely that funded status can be improved in the coming decade through investment performance alone.” 

Well, Ron, there are plenty of reasons as to why so many US public pensions are underfunded, not just one:

  • Yes, rosy return expectations
  • States shirking their responsibility to top up pensions (huge cause of the problem)
  • Poor governance, poor compensation schemes
  • Lack of a shared risk model where active and retired members share the risk of the plan (no conditional inflation, etc)

It seems Ron is talking up his tail-risk hedge fund (Universa Investments) which bleeds money in fees most of the time and has a good payout when it hits the fan (CalPERS was right to pull out of this fund).

Alright, let me wrap it up there.

Below, I embedded the latest CalPERS board meeting (three clips covering three days). You can fast forward through some parts but it is definitely worth listening to others.