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Newsmakers

CalPERS Planned Private Equity Program Could Grow Quickly

Official says system could easily commit $10 billion in just five years via direct investment organization.

By Randy Diamond

A California Public Employees’ Retirement System (CalPERS) official says the system’s planned private equity direct investment organization could easily commit $10 billion of capital within five years and could also take on several additional investment partners.

The comments of John Cole, a CalPERS senior investment official, offer detail about the efforts by the largest US public pension plan to launch an up to $20 billion investment organization that would take investment stakes in late-stage companies in the venture capital cycle as well as buy-and-hold stakes in established companies, a la Warren Buffett.

The CalPERS Investment Committee has not yet approved the plan, but most of the 13 members are generally supportive of the concept, though questions clearly remain.  

The committee is expected to formally vote on the plan within the next several months.

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Cole said at the committee’s meeting on Dec. 17 that time is of the essence. CalPERS has been negotiating with investment teams to run the new private equity organization but can’t hire anyone until the organization is approved.

 “The kind of talent we need always has options,” Cole said, noting the competitive nature of hiring top investment teams.

He also said the private equity plan has the full support of incoming Chief Investment Officer Ben Meng, who is expected to start next month.

Cole said the organization, once approved, could make its first investments within six to 18 months. He then sees a rapid infusion of cash into the two CalPERS-backed organizations: Innovation, which will invest in late-stage companies like the Ubers of the world, and Horizon, which will take buy-and-hold stakes in established companies.

Asked by investment committee member Margaret Brown how long it would take for the two entities to reach the $10 billion investment level, Cole replied: “In these two entities, we’re projecting easily within five years.”

CalPERS ultimately expects to commit $20 billion to Innovation and Horizon, but that could take up to a decade.

In response to another question from Brown, Cole said initially CalPERS would be the sole investor in Innovation and Horizon, but said additional investors were possible in future years. “What we’ve done is to enter into this with a belief that we must be the sole investor in order to set this up and to make sure that it meets our needs, first and foremost,” he said.

Cole then said CalPERS could be open to one or two additional partners that could add capital and share expenses for the planned private equity organization, dubbed “CalPERS Direct.” He did not lay out a timetable for additional investment partners.

The investment officer also defended the “CalPERS Direct” concept, which has been met by some criticism, including that of former committee member and system portfolio manager, J.J. Jelincic.

The criticism is that “CalPERS Direct” isn’t really direct at all, like the way the Canadian pension plans operate, because the pension plan is proposing a limited partner (CalPERS) and two yet-to-be-announced general partners that would make the investments for Innovation and Horizon. This contrasts with major Canadian pension plans who have in some cases cut out the middleman and do private equity investments directly.

“For us, what it means is that we will have an exclusive relationship,” Cole said. “We will be the only investor and therefore define specifically the entire investment agreement with an outside team of the investment managers acting solely on our behalf.”

CalPERS officials have never fully explained why they have rejected the Canadian model, except to say that the general partner-limited partner arrangement would allow CalPERS to pay the multimillion-dollar salaries that are necessary to attract top investment staff.

Jelincic attended the December 17 committee meeting, arguing that the new private equity investment program would be risky investment-wise. He said that if the investment committee was intent on a new private equity program, it should run the program internally without an external general partner. Jelincic said that would give CalPERS full control managing the program.

Jelincic has also made comments previously that the new private equity organization would not save CalPERS any money on fees. The expense of CalPERS’s existing $28 billion private equity program, which would run alongside the new private equity organization, has been a long-term controversy.

In the existing program, CalPERS pays management fees of up to 2% to the general partners who manage the funds that CalPERS participates in as a limited partner. The general partners take 20% of the profits from managing the investments, even though they put up little or no money.

Acting investment committee member Steve Juarez, representing State Treasurer John Chiang, brought up Jelincic by name, and questioned Cole about the fees that would be paid to the general partners and their investment staff in the new private equity organization.  

Cole responded that CalPERS will be saving management fees as assets increase in the planned organization. He said at first, CalPERS will pay the two management teams for Innovation and Horizon that act as the general partners a 2% management fee and a 20% profit sharing but “as you get closer to $10 [billion], [the management fee] will be closer to half a percent, you don’t have to wait until 10 to get there.” 

Cole also said the 20% profit sharing received by the general investment partners would also decrease over time as investment organizations become larger and increase their asset base. He didn’t offer specifics.

Another area of controversy is the limited disclosure that would be made to the public about investments by the new private equity organizations.

The investment organizations would disclose investment results, but much of their activities would operate in secret. Advisory boards formed to monitor the Innovation and Horizon investment teams would not have public meetings and the overall investment organizations would not be subject to public record requests. Also, the investment staff of new organizations would not be required to fill out state disclosure forms on their investment holdings.

Brown said she and other unnamed investment committee members remain concerned about the lack of transparency.

“This board has a fiduciary responsibility to 1.9 million members and thousands of employers,” she said at the Dec. 17 meeting. “And so, with that in mind, I wanted to let you know that I have a lot of concerns that we are putting this program together, I think in part to avoid transparency.”

CalPERS general counsel Matthew Jacobs responded that “would defeat the entire purpose of the endeavor that the Investment Office is undertaking, [because] these are private investments and they’re private for a reason, which is that the financial information needs to be private and the people running them have these types of preferences.”

Cole also jumped in. “I think Matt put it succinctly, private investing means private,” he said. “And an attempt to take private investing and make it public is, runs the risk of undercutting its very purpose.”

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Home > News > Newsmakers > Three Managers Put Under Review By San Francisco Pension Plan
Newsmakers

Three Managers Put Under Review By San Francisco Pension Plan

AQR, William Blair, and DFA all have seen their international equity strategies reduced by the San Francisco Employees’ Retirement System.

By Randy Diamond

Investment staff of the $24.4 billion San Francisco Employees’ Retirement System (SFERS) has added three money managers running international equity strategies to its managers under review watch list and has been gradually reducing their allocations because of poor performance.

Investment staff documents dated Dec. 12 show that the AQR international strategy, the William Blair international growth strategy, and the DFA international small cap strategy were all added to the managers under review list.

Four other managers’ investment strategies were already on the list: Advent Capital’s balanced convertible strategy, the Fidelity international small cap strategy, Oaktree Capital Management’s high-yield strategy, and the AFL-CIO Housing Investment Trust.

Companies on the watch list receive in-depth monitoring from SFERS investment staff and are subject to termination.

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However, the San Francisco system, the board documents show, has been reducing the managers’ allocations while still keeping their investment contracts in place.

As of Sept. 30, the AQR international strategy was down to $612 million after a $100 million reduction in June 2018. The William Blair international growth strategy was down to $360 million, after a $150 million reduction in March, a $100 million reduction in July, a $50 million reduction in August, and a $50 million reduction in October.

The third investment strategy, the DFA international small cap strategy, was down to $367 million as of Sept. 30, following reductions by SFERS staff of $100 million in March and a second $100 million in June.

The managers all face potential further reductions, according to the staff memo, because the SFERS board in Oct. 2017 approved the reduction in the target allocation to public equities to 31% of the overall $24.4 billion portfolio from 40% (the current weighting is 39%). “Hence, over the next few years, we will be reducing public equity by approximately $2 billion,” the memo said.

It added that the three managers “will be evaluated in the context of the redesigned public equity portfolio.”

The documents show that the AQR international strategy has underperformed its benchmark in the third quarter of 2018 and “over the trailing one- and three-year time periods.”

“Relative to its peer group, AQR’s performance (gross of fees) ranks in the bottom quartile for the one-year time period and in the third quartile for the three- and five-year time periods,” the report said. “Since inception, AQR has outperformed the benchmark by 80 basis points.” The San Francisco pension system hired AQR in August 2006.

In the third quarter of 2018, ending Sept. 30, the AQR strategy had an investment return of 0.1% compared to the MSCI EAFE benchmark of 1.4%. For the one-year period, the AQR strategy had an investment return of -1.5% compared to the MSCI EAFE benchmark of 2.7%. For the three-year period, the AQR strategy had an investment return of 9% compared to the MSCI EAFE benchmark of 9.2%.

“The strategy employs two models seeking to take advantage of three sources of risk: (1) the stock selection model which uses bottom-up analysis to express stock/industry views and (2) the asset allocation model which uses top-down analysis to express country views and currency views,” the San Francisco report stated.

It went on: “a majority of the portfolio’s 3Q underperformance came from the strategy’s global stock selection model, which makes country and currency bets within developed markets, (which)was neutral for the quarter. Over the trailing three years, the negative contribution from the stock selection model and the positive contribution from the asset allocation model have roughly offset each other.”

The report said the William Blair strategy “underperformed its benchmark in the 3Q 2018 and has underperformed over the trailing one- and three- and 10-year time-periods and is in the third quartile for the five-year time periods.”

In the third quarter of 2018 ending Sept. 30, the William Blair strategy had an investment return of -0.1% compared to the SFERS custom international equity benchmark of 1.5%. For the one-year period, the William Blair strategy had an investment return of 2.1% compared to the SFERS custom international equity benchmark of 5.5%. For the three-year period, it had an investment return of 8.9% compared to the SFERS custom international equity benchmark of 9.9%.

“Underperformance relative to the benchmark was primarily driven by negative stock selection,” the report said. “Within the Materials sector, positions in Boliden and Covestro were the biggest detractors. Boliden, a Scandinavian mining company, was hurt by weaker metal prices. Covestro, a chemical spin-off from Bayer, is a global leader in polycarbonate and polyurethane production. The stock dropped despite 2Q results that were ahead of consensus estimates.”

The report went on to say that “M&A Capital Partners, a Japanese company that provides M&A advice to small and medium companies was another significant detractor in the third quarter. The company reported weak 3Q results driven by fewer deals and fewer large transactions.”

One bright spot in the William Blair international portfolio, the report noted, was the money managers holdings in MTU Aero Engines, one of the world’s largest aircraft engine module manufacturers.

“The William Blair team believes that as air traffic increases and capacity improves, the demand for spare parts and maintenance services should also increase,” the report noted.

For DFA, the San Francisco system’s investment staff said the manager had “underperformed its benchmark in the third quarter and over the trailing one- and three-year time periods. Relative to its peer group, DFAs performance (gross of fees) is in the third quartile for the one-year, three-year and five-year time-periods.”

In the third quarter of 2018 ending Sept. 30, the DFA International Small Cap strategy had an investment return of -1.1% compared to its benchmark, MSCI World ex USA Small Cap, of -0.9%. For the one-year period, the DFA International Small Cap strategy had an investment return of 1% compared to its benchmark, MSCI World ex USA Small Cap, of 3.4%. For the three-year period, the DFA international small cap strategy had an investment return of 11.9% compared to its benchmark, MSCI World ex USA Small Cap, of 12.2%.

“DFA applies insights from theoretical and empirical research to identify systematic differences that can be exploited to achieve higher returns,” the report said. “This results in a portfolio that is tilted toward smaller caps versus larger caps, value companies versus growth companies and more profitable companies versus less profitable companies.”

“In the third quarter, DFA’s tilt towards smaller companies hurt absolute performance while their stock selection in the large cap segments hurt relative performance,” the San Francisco report went on.  “Additionally, holdings in the materials sector hurt performance relative to the benchmark.”

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