In December, CalPERS announced it was firing most of its external equity managers. Now, a good portion of the more than $30 billion that the California Public Employees’ Retirement System (CalPERS) removed from them may find itself in direct lending private debt strategies.

“I think [direct lending is] something we overlooked in the past, particularly given the changes in regulation after the Global Financial Crisis,” Ben Meng, the system’s chief investment officer, told the CalPERS investment committee at its last meeting on December 16. “Private debt has grown very rapidly.”

“It’s currently not in our portfolio but we think it should be,” he added, specially mentioning the direct lending strategies.

CalPERS has been moving the $30.7 billion in equity investments from outside managers to internally managed index strategies. This followed Meng’s disclosure four months ago that it has terminated 14 of its 17 outside equity managers and three of its four emerging equity fund of fund managers.

Most of the money being moved from fired equity managers is ending up in CalPERS’s internally managed index equity strategies. CalPERS reported as of December 16 that $24.5 billion has been transferred to those strategies.

CalPERS sources say that the bulk of the remainder, more than $5 billion, will likely be part of CalPERS direct lending strategies. The money may first go into the equity index funds and later be transferred to money managers specializing in direct lending strategies, depending on the timing of the hiring of the managers, the sources say.

Meng left the specifics of the potential direct lending investment to a closed session meeting of the investment committee on December 16, shows the transcript.

The CIO of the $380 billion pension plan did say if he was running a smaller $10 billion fund and determined that it was late in the economic cycle, he would want to move money invested in equities to private debt.

Meng didn’t offer an opinion of where the economy was in terms of the economic cycle, and whether the economic expansion that has lasted more than a decade and has delivered a compounded return of nearly 18% a year for the S&P 500 is almost over.

In the past, Meng has said he was concerned about CalPERS’s large bet on equities. CalPERS statistics show that the pension plan had $195.5 billion invested in equities alone as of October 2019.

Pension plans that have invested in direct lending typically don’t have more than 5% of total assets invested in the strategy, meaning if CalPERS was to apply that rule, it would have no more than $20 billion in the asset class.

There are exceptions, however. Arizona’s $41 billion State Retirement System has a more than 13% allocation to direct lending.

Private credit strategies like direct lending have been popular in the last decade among pension plans as an alterative to junk bond strategies that pay only 5% on average and core bond strategies that pay less than half of that.

Direct lending strategies can pay between 8% and 10%, making loans to midsize business caught in the credit squeeze after banks cut back on business loans after the financial crisis. In many cases, banks were forced to tighten their lending practices by banking regulators concerned about the bank’s solvency in the aftermath of the financial crisis.

CalPERS Chief Executive Officer Marcie Frost disclosed that Meng had terminated most of CalPERS external equity managers back in an October 21, 2019, memo to members of the investment committee.

The memo said the equity terminations were necessary because of long-term underperformance. The memo obtained by CIO says that Meng is putting a “renewed focus on performance and our ability to achieve our 7% assumed rate.”

Meng, who took over as CalPERS CIO in January 2019, has repeatedly expressed concerns, not only about CalPERS achieving the 7% assumed rate of return, but of its underfunding. CalPERS is only around 70% funded.

The CalPERS press office has confirmed the reductions and terminations but has not offered an explanation of the moves. The pension had refused to turn over a list of the terminated managers.

After the terminations, CalPERS only had three of its 17 external equity managers still on its roster and one of its four emerging manager of managers.

Each of the manager of managers fielded a lineup for CalPERS of other investment firms. So by firing the manager of managers, CalPERS ended up firing more than several dozen equity firms. Most of those firms were owned by minorities, black and Hispanic, and/or women.

The firms were part of recruitment efforts by CalPERS to hire a more diverse lineup of outside firms than the typical white male-dominated investment firm. However, since the firms were small and were given small allocations, typically under $50 million, CalPERS did not hire them directly.

The firms were paid by CalPERS but their actual boss was the manager of managers. Since CalPERS paid two sets of fees – one to the manager of managers and the second to the individual managers – it made it even harder for the individual firms to beat equity benchmarks, particularly during the up equity cycle of the past decade.

The overall manager of manager program was started by CalPERS more than 25 years ago. Returns began to be questioned by CalPERS investment staff in 2008 and 2009 as underperformance compared to broad market indexes became pronounced.

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