CalPERS Considers Cutting Out Private Equity Firms, Making Direct Investments in Companies

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.

Print Friendly, PDF & Email


  1. flora

    Applause, applause. CalPERS seems to be moving in the right direction.

    re: Your story about McKinsey’s partner emeritus Ron Daniel being dispatched to CalPERS to advise them against doing inhouse PE and CalPERS following his advice. Later CalPERS and others discovered McKinsey itself had a large financial interest in PE.
    It’s dangerous to assume an expert is, *by default*, a neutral and personally financially disinterested presenter of information. The cloak of expertise can disguise financial or other special interests of the expert. I hope CalPERS is now shrewd enough not to make “expert = financially impartial” their default assumption. As former California governor Reagan said, “Trust but verify.”

    Thanks for your continued reporting.

    1. Yves Smith Post author

      I don’t know that CalPERS ever found out McKinsey had a conflict of interest, particularly one that large. I learned that from my contacts at McKinsey. It’s more that so much time has passed that CalPERS no longer considers the old McKinsey study important, and may not have any institutional memory of it.

  2. flora

    Applause. CalPERS is moving in a better direction. Your reporting has no doubt added to their decision making. The NC readers who called newpapers and legislators, putting the local spotlight on CalPERS helped. Thanks so much for your continued reporting on PE and pensions.

    re: the McKinsey expert advice to not bring PE inhouse. This is a good example of incorrectly assuming *by default* that “expertise=personally financially impartial”.

        1. steelhead23

          I believe Normal was referencing CalPers there – that potentially, through association with the CA government, CalPers may have access to non-public information and then trade on it. PE contracts could then be seen to provide a buffer. I too think this is a non-issue because insider trading is a no-no and there would be no incentive to individuals to break the rules.

          1. Yves Smith Post author

            CalPERS runs an enormous S&P index fund in house. They don’t actively manage. So your scenario isn’t applicable. And PE has nothing to do with public companies, so even if CalPERS did do stock-picking, I don’t see how your theory would hold.

  3. Sluggeaux

    This is potentially a game-changer, but I’m concerned that even if CalPERS is able to hire quality managers that their Board is so full of political hacks that they won’t be able to engage in the level of oversight necessary to make sure that direct investment doesn’t become a swamp of graft.

  4. tegnost

    Thanks for the private equity series, at the beginning I really had to push myself to do so but having been a long time reader who had seen many times that yves insights could inform me in spite of my ignorance of finance, I made myself read every PE post looking for education and this topic was kind of clunky and difficult to grasp the ramifications of and now it becomes more clear obviously not only to me but to many others. I have no doubt that when yves showed up at a meeting of the board it caused some consternation among them. A concrete example of how TINA is just a propaganda tool to entrench the status quo. Thanks to yves for this, and a well deserved, maybe not victory, but certainly another reluctant step in a direction that breaks the status quo death grip on the wealth of the nation. Three Cheers.
    An additional thought occurred to me in reading, that a bit of activist local investing where, in the event that CalPers completes this transition, local investing can impact the pensioners positively by not only helping the fund but also the localities in which they live.

  5. Jim Haygood

    On a more macro basis, Calpers should think about where we are in the business cycle: that is, 7.5 years into an unusually long-lived expansion. Debt-to-Ebitda ratios for public equities have reached their highest levels of the 21st century (for private equity, they’re even higher). Chart:

    High debt-to-Ebitda means enhanced bankruptcy risk in the next recession, which I have penciled in for 2018.

    Timing-wise, entering the DIY private equity market in the depths of recession to vulture-feed on some busted wreckage would be ideal.

    But given that Calpers is going to be booking some ugly numbers from their existing PE partnerships in the next recession, the political will to go defiantly contrarian and buy with blood in the streets just won’t be there.

    It’s a slow march to oblivion — HUT two three four. Seven percent hasta la muerte!

    1. Yves Smith Post author

      No, CalPERS hires fancy consultants and sticks with asset allocation models with not much variation among asset classes. So they’ll buy both at peaks and when blood is in the street.

  6. Enquiring Mind

    California politics, like those elsewhere only bigger, worse and fortunately somewhat gridlocked at times (see our glorious referendum process for examples), demonstrate routinely the principles of What is in it for me. This being the Golden State, we take that What is in it for me in new directions more obviously like:

    What do you have that I can take, or better yet,
    What can I get you to pay for that I want for myself and a small circle of friends.
    What can I pretend is for the greater good by stuffing in numerous platitudes while obfuscating or eliminating the greater bad.

    Our voter pamphlets, real tree killers for this last go-round (bigger than those venerable weekly news magazines of yesteryear), touch on fiscal impacts and offer pro, con, rebuttal, etc. In the interest of greater transparency I’d like to see more detail about who funds what, who benefits from what and who is excluded or marginalized.

  7. Dave

    How about some real progressiveness? Imagine if California created a state bank like North Dakota. Think how much money that CALPERS cash could earn if it paid less than what we pay the bond hustlers for large projects?

    The voters narrowly rejected a measure that would have required statewide voter approval for any bond issuance over $2 billion.

    Guess who voted against it? Same areas that voted for Mzzzz. Wall Street.

    All these wailing “progressives” that used to laugh at Texans and Cascadians who wanted to secede as right wing lunatics, but who now accosting me in shopping centers, begging me to sign their petitions to withdraw California from the Union, might do better to promote the idea of a state bank.

    1. Arizona Slim

      One of my friends just won her election to the Arizona House of Representatives. Public banking was a major plank in her platform.

    2. RUKidding

      Great idea. Would love to see it happen. And yes, a public bank makes heaps more sense that secession.

    3. Yves Smith Post author

      Hate to tell you, but pretty much every state had a state bank once upon a time. Pretty much all failed because they became cesspools of corruption.

      1. makedoanmend

        Yes, but there is a difference between a State Bank (run for the benefit of politicians and their cronies during most of the 19th century) that acted as state Central Banks and a state bank (e.g. North Dakota) that acts as a business with a specific state wide remit and is regulated accordingly.

        I wonder if any parallels between 19th century State ‘Central’ banks and the Wall Street (and beyond) behemoths we now enjoy could be drawn today?

  8. susan the other

    confused here – does this new investment angle mean that CALPERS is going to buy into the PE funds and become their own general partners and/or does it mean that CALPERS is going to become an investment house on its own and just play the market like say a good index fund? Either way it beats being a limited partner to a bunch of scam artists. Good for CALPERS.

  9. RUKidding

    Thanks for the good news. I hope this happens and happens soon.

    Keep up the good work, Yves. It’s bearing some real results.

  10. Andy T

    The thing is the best and brightest will always spin out and start their own firm.
    The money they can make an equity holder in an independent GP is so much greater then what they will make as an employee. That’s the benefits of GPs, they are normally the best.

  11. steelhead23

    As regards the need to pay for talent and how to do it, I hope there is some research on the marginal benefit of investment manager pay and performance. I believe that it is not compensation alone that attracts good talent and that excessive pay-for-performance can harm moral. And like every lay investor, I simply don’t imagine it is that hard to be a successful PE GM.

  12. Steve

    Tell me why we have a CALPERS in the first place while the rest of us need to depend on Social Security?

    1. Sluggeaux

      Because public employees forego present compensation in favor of making pension contributions of approximately 12 percent of gross compensation — the sort of saving that others never seem to get around to. These contributions are invested on behalf of the employee and employer over the course of a career — 32 years in my case. Contributions and interest are then drawn as an annuity. The money is locked-away, however, until retirement.

      Private sector employers (and many public sector employers) have a long and dirty tradition of “raiding” their pension funds, and then complaining that they have to pay promised benefits out of current revenues instead of investment savings and returns. Sort of like bank robbers coming back the next week and complaining about the lack of deposits…

Comments are closed.