CalPERS is acting exactly the way traders on Wall Street do when they are sitting on serious losses, or in CalPERS case, underfunding so deep that they can’t earn their way out of it. They put on desperate, high risk positions in the hope they can climb back out of their hole. Pros will tell you that this is just about always a fast path to ruin. CalPERS’ version of swinging for the fences is to increase its commitments to its riskiest strategy, private equity, embark on investing in a new risky category, private debt, and leverage the entire fund.
The fundamental outlook is so poor that even Warren Buffet, known among other things for astute contrarian plays, can find nothing to buy. Yet CalPERS thinks that now is the time to load up on risk. It not only plans to add to private equity but also to load up on another speculative investment, private debt, while also leveraging the entire portfolio. Did CalPERS miss out on the finance lesson that leverage increases losses as well as profits?
This scheme smacks of CalPERS yet again going for fads after their sell-by date. Remember how the giant fund was gung-ho to get into late-stage venture capital, as in unicorns, right before their valuations started to plunge? The only reason CalPERS didn’t go ahead was press and beneficiary criticism, particularly since the plan was so badly thought out.
CalPERS appears to have learned all the wrong lessons from that episode. Instead of recognizing that they are a favorite target for gimmicks, and they tend to be very late to the party on investment trends, they instead have opted for ideas that are simpler to implement than their newfangled “new private equity business model”.
There’s an additional cause for pause in the Financial Times summary of CalPERS’ plans: CalPERS yet again is abusing transparency laws by holding discussions of these plans in secret. The fund is required to discuss this matter in public under the Bagley-Keene Open Meeting Act; it doesn’t fall under any of the few exemptions. Yet none of this information can be found in agenda or documents for the Investment Committee meeting later today.1 The fact that CalPERS planted this story (it has extensive quotes from Chief Investment Officer Ben Meng) says there was nothing that needed to be kept confidential.
Key points from the Financial Times account:
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.
“In a presentation to the Calpers board”? No such presentation has been or is on deck to be made in open session. That is an admission that CalPERS provided closed session materials to the Financial Times. Notice the double standard: CalPERS executives routinely leak what they’ve designated as confidential material (whether it is legitimately confidential or not) while anyone else suspected of doing so, even a board member, is strung up.
But let’s focus on the substance: the idea of upping CalPERS private equity and private debt wagers, and turbocharging risk with fund-level borrowing.
We don’t need to break a sweat to show what a bad idea it is to increase private equity and private debt investments now. Financial Times stories in the past ten days give ample evidence.
Even before the coronacrisis, private equity for more than a decade has not been generating enough in the way of return to compensate for its extra risks. That means that it cannot be regarded as a prudent investment. And the wreckage of a deflationary shock that is taking out or severely damaging entire sectors of the economy, from business travel to restaurants to gyms to live entertainment to restaurants, is pulling down other areas, like commercial and residential real estate and state and municipal governments. The few pockets of opportunity won’t begin to offset the wreckage.
As we described in our related post today, the Financial Times featured a new, important paper by Oxford professor Ludovic Phalippou that shows, in considerable detail, how since at least 2006, private equity has merely produced returns similar to public equities. That means there is no justification for investing in private equity, since it needs to generate a higher return to compensate for its greater risks (greater leverage and lack of liquidity). It is a loser on a risk/return basis.
Private debt is even more loopy. Consistent with CalPERS adopting trends only when they are after their sell-by date, private debt was once an attractive investment. Private equity insiders would point out that it offered only slightly lower returns than private equity, with markedly lower risk.
By contrast, as a Financial Times story pointed out, corporations have already binged on debt between buybacks and now loan-based rescue schemes. If they don’t get more equity, they will go bankrupt on a widespread basis. From the Financial Times in Fidelity chief warns of global corporate solvency crisis:
Fidelity International boss Anne Richards has warned that the asset management industry will struggle to provide enough capital to fix the solvency problems public businesses face as economies emerge from lockdown.
The fund management executive, whose investment company oversees £305bn in client assets, said many businesses would need an injection of capital to offset the high levels of debt they had accumulated during the crisis, which has left whole industries unable to operate….
The scale of cash needed to repay the public funding businesses have received from governments or central banks is likely to be so large that it is “either going to be written off or sit on balance sheets, where it will have a depressing effect”.
As for the idea of leveraging the entire fund, we had argued that German investors, who eschew private equity, instead borrow against their entire portfolio to achieve a similar level of risk. Upping the level of private equity and debt investments and adding fund level leverage is going all in at just about the worst time to do so. Has CalPERS forgotten that it took over 20 years for US stocks to get back to their 1929 levels? The Atlanta Fed’s GDPNow’s second quarter forecast is -48.5%. What about “probable depression” don’t you understand?
Not surprisingly, the Financial Times shows CalPERS to be deluded on other fronts:
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.
Huh? CalPERS is not special in being a long-term investor. So to are other public and private pension funds, life insurers, along with many sovereign wealth funds.
And the “access to top managers” is misguided. If Meng means “top managers in terms of performance” he ought to know it’s impossible to find them ex ante, since top tier performance no longer persists. You might as well throw darts. And the fact is that CalPERS is so large it will tend to have private equity index-like returns no matter what it does.
If Meng means CalPERS size gives it some sort of advantage with respect to the biggest funds, he’s high on his own supply. Private equity fund managers do give fee breaks on larger size investments, but anyone who makes that big a commitment gets that deal. And as the Phalippou paper makes clear (and as we’ve reported based on other studies), the biggest funds, which do classic leveraged buyouts, have delivered the weakest returns of all private equity sub-strategies.
And if anything, CalPERS is disadvantaged in its access to private equity. The former head of private equity, Real Desrochers, was seen in the markets as difficult to deal with. CalPERS’ failure to replace him and its consideration and then abandonment of its confused and shape-shifting “private equity new business model” revealed CalPERS to be in internal disarray. Private equity firms don’t make investors in political turmoil their first call. It’s too hard to close the sale.
Not surprisingly, the comments at the Financial Times ranged from politely skeptical (several “What could go wrong?”) to brutal. A sampling:
Leveraging up a pension fund or endowment is a terrible idea at any time, but this has to be the worst possible time to do so — virtually all asset classes are expensive and the macroeconomic environment is awful. Low rates are not a good reason to borrow. The people running Calpers should be immediately fired.
Hawaii’s pension system used leverage and was hit very hard in 2018. Who the hell is running Calpers? LOL! Sad day in America. Oh yea, Hawaii isn’t front page news… Just take Hawaii’s situation and 100x it… You get California in 2025 when the S&P 500 is down 50%…
From the basement
The top is in.
Neil at home
Can you short pension funds?
“Bold move” is not what you want from your pension administrator
Sounds like an absolute disaster in the making.
I am quite shocked reading this. A return target was (is?) the curse of European asset managers in the run up to 2007. The Japanese pension funds had similar targets in the 1990s which spawned the growth of PRDCs (power reverse dual-currency notes). With rates close to zero, a target of 7% and a willingness to take illiquid assets I fear the worst for the CALPERS beneficiaries.
Needless to say, there is seldom so much unanimity of opinion in the Financial Times’ comment section, which has market savvy readers. But CalPERS is firmly ensconced in its bubble. Normally, more bad results might shake the board out of its stupor, but this board is so captured by staff that nothing is likely to change until the board is turfed out or Gavin Newsom wakes up to the risk of CalPERS getting in even more trouble than it ought to on his watch.
1 This has to be a closed session matter. All the items are routine and/or recurring except for #4:
This isn’t about legacy assets, plus the Financial Times makes clear Ben Meng is behind these plans, so it looks as if CalPERS is hiding the discussion of these major policy changes under the opaque and innocuous label, “Toward a 7% Solution”. That’s confirmed by the subhead of the Financial Times piece: “Calpers hopes bold move will boost efforts to achieve its 7% return target.”