When CalPERS does something as obviously nonsensical as planning to dump $6 billion of its private equity holdings, nearly 13% of its $47.7 billon portfolio, when it just committed to increasing its private equity book from 8% to 13%, it’s a hard call: Incompetent? Corrupt? Addled by the latest fads (a subset of incompetent)?
And rest assured, the harder you look, the more it becomes apparent that this scheme is as hare-brained as it appears at the 30,000 foot level. But unlike another recent hare-brained private equity scheme, its “private equity new business model,” beneficiaries won’t have the good luck of having it collapse under its own contradictions. CalPERS has loudly announced that Jeffries & Co. will be handling these dispositions, so they will get done….at least in part. But the fact that CalPERS’ staff has gone ahead and merely informed the board, as opposed to getting its approval, is yet another proof of how the board has abdicated its oversight and control by granting unconscionably permissive “delegated authority” to staff.
The one bit of possible upside would not just be unintended, but the result of CalPERS acting in contradiction to its expressed objectives: that its allocation to private equity would undershoot its targets by an even bigger margin than otherwise.
Background: CalPERS’ Value-Destroying Love Affair with Private Equity
Recall that CalPERS has long acted like a battered spouse, unwilling to leave a man who is abusing her and a defending the relationship. As this site, relying on the work of prominent academics and top financial analysts, has documented for many years, private equity does not provide enough return to justify its high level of risk, namely, illiquidity and leverage. Even CalPERS’ special guest expert in 2015, Harvard Business School professor Josh Lerner, said there was no justification for investing in private equity unless CalPERS invested in top funds….the same sort of “beat the market” fallacy debunked decades ago for other active managers.
More recently, multiple studies have shown the role of alternative investments like private equity in public pension fund underperformance. One by industry leading quantitative expert Richard Ennis, founder of KruppEnnis, not only documented how “alts” dragged down public pensions results, but also identified CalPERS as one of the worst via generating high “negative alpha,” meaning its management efforts hurt beneficiaries. That result is even more appalling given that CalPERS has the biggest and best paid investment office among all public pension funds.
And CalPERS continues to flounder. Its investment performance for its latest fiscal year was at the bottom in various listings of public pension performance, again begging the question of how CalPERS can be so bad at its big job of managing retiree funds well. A program at Stanford Business School ascertained that a simple investment strategy using 5 Vanguard funds would beat 90% of public pension funds. CalPERS would do better to fire virtually all of its investment team and at most create an additional index fund or two in addition to its internal S&P 500 fund if it believed it could manage other core index strategies more cheaply in house.
This unjustifiable fealty to private equity is even more difficult to explain given the damage it has done to the giant fund. CalPERS’ former CEO Fred Buenrostro recently finished a four and one half year sentence in Federal prison for taking bribes and other charges in connection with a private equity pay to play scandal. Former board member Al Villalobos shot himself. Fund manager Apollo and four Apollo connected funds paid over $52 million in pay to play fees, simply staggering sums compared to norms in this seedy business. And Apollo did not need to pony up to get in front of CalPERS; its then head Leon Black could have gotten a meeting any time he wanted. But the “investigation” conducted by law firm fixer Steptoe & Johnson pointedly avoided looking into what exactly these fund manager thought they were getting in return for these huge bribes.1
Yet rather than step back and try to learn from this record of failure, CalPERS has kept meeting Einstein’s definition of insanity by doubling down on its failed private equity strategy, or at least trying to. Investors generally have been throwing more dollars at private equity than the industry can absorb, with too much “dry powder” (funds committed but not invested) one of many signs of too much money chasing too few deals. Departing Chief Investment Officer Ted Eliopoulos tried launching a not-at-all-thought-out “private equity new business model” which was supposedly to allow CalPERS to invest in private equity in size and somehow beat all of the very well established private equity managers and their investors in finding good deals. The hazy plan fell apart when subject to mere basic questions.
Eliopoulos’ successor Ben Meng, shortly after he arrived at CalPERS, said in a widely repeated quote, “We need private equity, we need more of it, and we need it now.”2
CalPERS’ Incomprehensible Private Equity To-ing and Fro-ing
In a move that required formal board approval, CalPERS increased its asset allocation to private equity last November. From Institutional Investor in December 2021:
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…
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.”
Contrast that decision with this story in Chief Investment Officer yesterday:
The California Public Employees’ Retirement System (CalPERS) has engaged financial services company Jefferies about the potential of selling up to $6 billion of its private equity stakes, according Buyouts magazine. This comes just after CalPERS announced it would be increasing the percentage of its portfolio allotted to private equity to 13% from 8% in November.
To recap: CalPERS has been whining for years about having difficulty meeting its private equity asset allocation targets, to the degree that it’s cooked up novel-sounding gimmicks to try to solve that probem which fell apart once they got a teeny bit of scrutiny. So despite not having succeeded in meeting lower targets, CalPERS is now trying to hit a much bigger private equity allocation goal… and planning to cut its existing holdings, making the task even harder?
None of the Plausible Explanations Make Sense…at Least for Beneficiaries and the State of California
As you’ll see, the only way this exercise makes sense is as part of a full employment act for the private equity team.
Let’s look at the rationales and see why they don’t add up.
CalPERS wants to clean out old deadwood investments. If you look at CalPERS’ Private Equity Program Fund Performance Review, and then sort by vintage year, you can see that there are funds dating to 1992.
But if you do a quick eyeball, you can see that the story does not add up. I looked at vintage years though and including 2006. Nearly all the funds had the same number for “Cash Out” and “Cash Out and Remaining Value,” meaning the fund manager (remember the fund manager is responsible for the net asset value calculation) had written the fund down to zero. Yet the funds are still being kept alive, which means CalPERS is still paying its share of the annual fees for accounting and investor reporting. Do these funds still hold a final doggy asset? It’s not clear why they haven’t been wound down,3 but the flip side is CalPERS is presumably paying only nuisance level annual charges.
If you scan the list, there are some funds older than 2006, there are some where “Cash Out and Remaining Value” is greater than “Cash Out,” meaning the fund manager does attribute a positive value to whatever is left. But in most cases, the discrepancy is only a few millions dollars, and only 16 funds does it exceed $10 million. The biggest examples I saw were California Emerging Ventures III, LLC, a 2001 fund allegedly worth a bit under $60 million; vintage year 2005 Bridgepoint Europe III ‘D’ valued at $41 million; California Emerging Ventures IV, LLC, a 2006 fund with a reported net asset value of just under $152 million; Golden State Investment Fund, LLC, a 2006 fund marked at $94 million; KKR 2006 at $78 million; another 2006 fund, MHR Institutional Partners III, at $171 million; 2006 child Permira IV L.P carried at $56 million; 2006 vintage year Sacramento Private Equity Partners for $200 million; and last but far from least, VantagePoint Venture Partners 2006 at $34 million.
The last entry, VantagePoint Venture Partners 2006, is on its face implausible: a $100 million commitment, where the entire $100 million was spent, and in 15 years, CalPERS has gotten only $15 million back. We are supposed to believe this fund miraculously has $34 million worth of unsold investment? Note that even with that charitable assumption, the fund has a negative IRR of 7.9%.
The others in the “over $10 million” cohort on average were under $20 million.
The big point here is that these are orts and scraps of funds, with mainly $0 to the private equity equivalent of couch lint in net asset value. They all have carrying costs to CalPERS. CalPERS would likely have to pay money to get out of them, since they represent a string of liabilities, not assets.
And the reason old funds with a crappy company or two left in them are kept around is they are worth more alive than dead to the manager. The remaining assets presumably cannot be sold for their reported net asset value or that would already have happened. Selling them would lead to a loss recognition and in a worst case scenario could trigger a clawback of the carry fee, a discussion the general partner would not want to engage in if any limited partners were alert enough to clear their throats about it. If the company/companies in the fund are still generating revenue, they can probably support at least some monitoring fees, making them worth keeping to the general partner, if not so for the limited partner.
So in other words:
1. These orts and scraps don’t come anywhere within hailing distance of $6 billion. So where does that figure come from?
2. These deal would also all or nearly all be sold at losses compared to their current net asset values. So CalPERS would recognize a loss.
This further implies that CalPERS would sell some stakes where the market value of the holding is higher than what the private equity manager is valuing it at right now. This is not such a hot idea because:
1. CalPERS selling out of a “looks profitable” investment is a slap to a manager who provides conservative valuations so as not to deliver disappointments. It will also lead them at the margin to be less inclined to invite CalPERS into future funds
2. If other investors think the fund has more upside than current manager valuations show, CalPERS may wind up leaving money on the table, as in the ultimate performance may be better than what they get by cashing out now.
CalPERS’ Strategy Is Not Likely to Work
$6 billion is a lot of private equity. It is highly unlikely that anyone would have the firepower and the appetite to buy it as a portfolio (and as we will discuss, if that was the approach, CalPERS staff would be violating its delegated authority to attempt to do so).
So Jeffries will presumably be marketing the portfolio as individual deals, or at best as lots.
Investor of course will want to buy only the good deals. That means if CalPERS proceeds, it’s likely to be left with a lot of its legacy dogs. It will have paid Jeffries for moving out mainly better deals and not accomplished its supposed objective of really cleaning house.
CalPERS’ Possible Nefarious Plans Are Also Likely to Be Bad Ideas
Why would CalPERS want to create an additional $6 billion of firepower when it already has more dollars it wants to throw at private equity than it can deploy now?
Consider: if CalPERS succeeds in its aims, it will retreat from its 13% private equity allocation goal. Having pre-signaled to the world that it wants to dump a big slug of private equity, CalPERS can’t readily drib and drab the assets it wants to ditch onto the market. CalPERS is also likely to need to set some time parameters, as in if some positions don’t find buyers in a certain period of time, it will need to set a new price target or consider withdrawing the positions.
So say CalPERS succeeds or at least significantly succeeds. That means it will be under even more pressure to put money to work. Will it lower its investment standards? Or does it have a plan up its sleeve? Insiders wonder if CalPERS is thinking about implementing its plan to increase co-investments by making mega co-investments, say on the order of $2 billion.
The problem with that idea is that it’s akin to a drayage company deciding it’s in the transportation business and buying a 747 to fly.
CalPERS is behind many other public pension funds in how much it has done in the way of co-investing. Even though CalPERS still claims it has done better with co-investments than its private equity portfolio overall, that may largely be a function of smaller average deal size. CalPERS unwisely decided to move its portfolio to fewer, bigger fund commitments and reduce the number of fund managers it dealt with. The result was CalPERS was invested in proportionately more mega funds with mega managers. Those funds are overwhelmingly in the buyout sector, which has performed worse than other strategies.
Not only would mega co-investments double down on CalPERS’ bad idea of preferring big funds (because big?), they are also very complex and far more susceptible to adverse selection than other co-investments. CalPERS doesn’t have the seasoning to expect this idea, if this is one of their ideas, to work out well.
The more mundane risk of having private equity burning a hole in CalPERS’ pocket is that its commitments will be lumpy, as in very high in next two or three years. Fund performance is very dependent on vintage year. Trying to spread investments out over time is the best way to minimize that risk. CalPERS will be deviating further from that principle as a result of the need to reinvest its $6 billion deal dump on top of its decision to ramp up further.
Another Indictment of Board Oversight
It beggars belief that CalPERS can launch a plan to sell $6 billion in assets without briefing the board and getting approval in advance. Staff is presenting the board with a fait accompli; recall that CalPERS has already hired Jeffries.
CalPERS’ officers might try to justify this brazen move by saying that it it falls under their delegated authority because even though the total number of deals put on the market might add up to an impermissibly large number, individually they are all fall under the threshold for board approval.
However, staff’s argument fails on a different prong. The plans to offload as much as $6 billion is an asset allocation decision. It will shrink CalPERS’ holdings. The staff is not authorized to reduce the size of the private equity portfolio. And staff has also made clear it is at the vagaries of what general partners bring to them and whether they like it as to how quickly they could fill the hole.
A final issue is that CalPERS has had a desperately hard time in hiring a new Chief Investment Officer, to the degree that it has become an industry laughingstock. Incoming senior executives prefer to the degree possible to have freedom of action. Saddling an incoming CIO with a new mandate that he may not like, or might want to execute very differently, isn’t helpful to the recruitment process.
So at best CalPERS looks to be jumping on yet another industry fad bandwagon, to the benefit of keeping staff looking busy and oh so modern. At worst, one can wonder why CalPERS is so keen to enrich Jeffries.
1 Villalobos got the big haul; Buenrostro’s take was penny ante in comparison.
2 Of course, one could in theory take what Meng said with a fistful of salt, given that he owned stock in Blackstone, Carlyle, and an Ares credit fund at the time and through early May 2021, but the board was just as enthusiastic about private equity as Meng.
3 The fund managers don’t charge management fees on funds this old, and all those juicy hidden fees come out of portfolio companies…and there either are none or they are doing so badly that there’s very little blood to suck from them.