CalPERS appears to be reading the handwriting on the wall.
The giant public pension fund, which regularly serves as a de facto standard setter for its peers, is looking into cutting out ludicrously overpaid private equity middlemen and making private equity investments directly.
Admittedly, it would take a while for CalPERS to flesh out a plan and to get a narrow carve-out from the state rules that prohibit employees from profiting from state expenditures or investments. Participating in the upside of successful private equity investments is a widespread industry standard and it would be difficult to attract experienced people.
But it’s puzzling that CalPERS has not considered this step before, in light of the fact that seven public pension funds in Canada have been making direct investments in private equity for years. Admittedly, they started out by investing along-side private equity firms, but these in-house teams have built up their skill levels over time.
With private equity total fees and costs an estimated 7% a year, why haven’t more limited partners gone this route sooner? It is fair that developing a new set of capabilities takes time, and managements are often leery about undertaking long-term, ambitious initiatives. But one also has to wonder about the role of McKinsey in deterring CalPERS and other limited parters from going this route.
In 1999, CalPERS engaged McKinsey to advise them as to whether they should bring some of their private equity activities in house. My understanding was that some board members thought this issue was worth considering; staff was not so keen (perhaps because they doubted they had the skills to do this work themselves and were put off by the idea of being upstaged by outside, better paid recruits).
In hearing this tale told many years later, I was perplexed and a bit disturbed to learn that the former managing partner of McKinsey, Ron Daniel, presented the recommendations to CalPERS of not to go this route. Only a very few directors (as in the tenured class of partner) continue at McKinsey beyond normal retirement age; one was the head of the important American Express relationship at the insistence of Amex. Daniel served as an ambassador for the firm as well as working on his former clients. Why was he dispatched to work on a one-off assignment that was clearly not important to McKinsey from a relationship standpoint, particularly in light of a large conflict of interest: that he was also the head of the Harvard Corporation, which was also a serious investor in private equity?
Although the lack of staff enthusiasm was probably a deal killer in and of itself, the McKinsey “no go” recommendation hinged on two arguments: the state regulatory obstacles (which in fact was not insurmountable; CalPERS could almost certainly get a waiver if it sought one), and the culture gap of putting a private equity unit in a public pension fund. Even though the lack of precedents at the time no doubt made this seem like a serious concern, in fact, McKinsey clients like Citibank and JP Morgan by then had figured out how to have units with very divergent business cultures (investment banking versus commercial banking) live successfully under the same roof. And even at CalPERS now, there is a large gap between the pay levels, autonomy, and status of the investment professionals versus the rank and file that handles mundane but nevertheless important tasks like keeping on top of payments from the many government entities that are part of the CalPERS system, maintaining records for and making payments to CalPERS beneficiaries, and running the back office for the investment activities that CalPERS runs internally.
Why do I wonder whether McKinsey had additional motives for sending someone as prominent as Daniel to argue forcefully (as he apparently did) that CalPERS reject the idea of doing private equity in house? Clearly, if CalPERS went down that path, then as now, the objective would be to reduce the cost of investing in private equity. And it would take funds out of the hand of private equity general partners.
The problem with that is that McKinsey had a large and apparently not disclosed conflict: private equity funds were becoming large sources of fees to the firm. By 2002, private equity firms represented more than half of total McKinsey revenues. CalPERS going into private equity would reduce the general partners’ fees, and over time, McKinsey’s.
In keeping, as we pointed out in 2014, McKinsey acknowledged that the prospects for private equity continuing to deliver outsized returns were dimming. That would seem to make for a strong argument to get private equity firms to lower their fees, and the best leverage would be to bring at least some private equity investing in house, both to reduce costs directly and to provide for more leverage in fee discussions. Yet McKinsey hand-waved unconvincingly about ways that limited partners could contend with the more difficult investment environment, and was discouraging about going direct despite the fact that the Canadian pension funds had done so successfully. From its report:
Some limited partners have begun to “insource,” effectively to doing private-equity investments on their own. Recent academic research has found this approach preferable for institutional investors in certain circumstances; direct private investment saves fees and can generate better results than an external manager. The research considered a small sample of seven Canadian pension funds that have enjoyed higher returns from their own deals than from their investments in private-equity funds or even from their coinvestments in the funds’ deals.
While the returns may be enticing, this kind of forward integration is not for everyone. Many institutions may face daunting structural obstacles, notably in their ability to hire, govern, and retain top talent. And the effort put forth by the Canadian investors was substantial: first, they had to establish professionalism in their management and governance, including the board. To build and sustain internal teams of investment professionals with the right skills, the funds had to be able and willing to provide an attractive level of compensation that was frequently much higher than that of professionals in other asset classes. The funds had to learn to trust these professionals with investment decisions. And they needed to build strong research teams to understand the cyclical and structural trends of private markets to determine the optimal time to invest.
So it’s refreshing to see CalPERS recognize that the difficult investment environment means it needs to take more aggressive steps to improve its returns. It has treated private equity as a savior, but as we’ve stressed, top players in the industry have warned that returns over the next few years are likely to be lackluster. Although it will take time, it would be very beneficial for CalPERS and other major private equity investors to improve their returns by saving on fees, which has been a big priority for every asset class save private equity.
From Pensions & Investments:
CalPERS Chief Investment Officer Theodore Eliopoulos asked the retirement system’s senior private equity staff Monday to explore options to the change the $299.5 billion pension fund’s private equity program, including cutting out general partners and making private equity investments directly.
Mr. Eliopoulos said he was concerned about the small number of top-performing private equity managers, who because of their performance have been able to maintain high fees and are oversubscribed. He said the California Public Employees’ Retirement System, Sacramento, might have to come up with alternatives to the general partner/limited partner fund structure.
“It’s not a game of chicken,” Mr. Eliopoulos said in his remarks at the pension fund’s investment committee meeting in Sacramento, saying CalPERS is not attacking general partners, but rather putting its focus on making its private equity program as cost-effective as possible.
Other options that will be explored include increasing the number of co-investments and increasing the number of separate accounts with general partners, Mr. Eliopoulos said.
As we indicated, this is a big step forward and has the potential to be as important a development as CalPERS’ decision to exit hedge funds at the end of 2014, which more and more investors have emulated. And if CalPERS pursues this initiative, it would be an important step in combatting the private equity industry’s failure to make fee concessions as performance has fallen over time and has been less than the level needed to compensate for its risks for pretty much the entirely of the last decade. Applause is in order.