Looking For The Next Generation In Private Equity

Private equity was a big theme at CalPERS' investment committee meeting on Monday.

The $356.5 billion California Public Employees' Retirement System, Sacramento, adopted a new investment policy statement that includes lowering the benchmark return for its private equity portfolio. The committee also discussed a proposal to change its private equity investment structure that includes creating an outside corporation to make direct investments, and it reviewed the first draft of a new private equity investment policy.

Chief Investment Officer Theodore Eliopoulos kicked off the meeting by stressing the importance of private equity to the system's total portfolio.

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Private equity has had the highest return of any asset class and that is expected to continue, Mr. Eliopoulos said. He said the private equity portfolio has added $11 billion over public equities. Private equity also expands the investible universe and has exhibited the most growth in the capital markets, he said.

"There's no obvious public markets substitute for the private equity portfolio," he said.

This is important because CalPERS is 71% funded and has an expected rate of return of 7%, which is "relatively high" and could be difficult to achieve, especially with a lower interest-rate environment, Mr. Eliopoulos said.

"Private equity is the only asset class projected to provide more than 7% return over the next 10 years," he said.

CalPERS' new investment policy for the entire plan lowers the private equity benchmark to FTSE Global All-Cap index plus 150 basis points, lagged by a quarter, from a custom benchmark of 67% FTSE U.S. Total Market index and 33% FTSE All-World ex-U.S. index plus 300 basis points, also lagged one quarter. The new policy also requires prudent person opinions by an outside firm for private equity co-investments and customized separate accounts.

During the discussion of its new private equity structure, Mr. Eliopoulos noted that CalPERS would have to commit about $10 billion to $13 billion a year to get to and maintain a 10% private equity allocation. Currently, the private equity target allocation is 8% plus or minus 4 percentage points, with a 7.7% actual allocation.

"This strategy reflects our conclusion that CalPERS needs to substantially add to our current business model and to our internal resources to achieve our objective of a substantial and successful private equity portfolio over time," he said.

The structure has four pillars: the partnership model; emerging managers; and two strategies that would be run by a separate corporation, CalPERS Direct — private equity and venture capital. CalPERS' investment staff will now begin researching industry best practices regarding the makeup of both the independent advisory boards for the private equity and venture capital direct investment strategies and the management teams for CalPERS Direct.

CalPERS executives would like to invest more capital in its emerging private equity manager fund-of-funds program and add co-investments with the managers, Mr. Eliopoulos said. CalPERS currently has $350 million in two private equity emerging manager funds-of-funds portfolios.

During the discussion on the new private equity structure, Ashby Monk, executive and research director at Stanford University's Global Projects Center, told the committee it was not the only asset owner considering establishing an "arms-length" entity to invest in private equity.

Investors are stuck with private equity, even if they don't like the alignment of interest or the fees, because it is likely to produce better returns than the public markets, Mr. Monk said.

"So, you need it but the challenge is that everybody else has realized they need it too," resulting in a flood of money into the asset class, Mr. Monk said. "We need to be innovative," he said.

A few committee members noted that time is of the essence and that CalPERS needed to create a new structure soon or it would be left behind.

"The fact that it's not going to get better where we are today ... we have a lot of choices in how we design this, how we construct it," said Bill Slaton, board member. "I don't think we have a lot of choice doing it. I think we'll be compelled by the marketplace to do it."

Mr. Monk agreed. "You're not alone," he said. "You guys are on a journey I can think of probably 20 or 25 plans like you right now are saying, 'how are we going to do this?'"

CalPERS' investment committee also had a first look at a new private equity investment policy proposal that removed direct investments in private equity firms as a transaction type. The current policy includes direct investments "including independently sourced investments." However, during the investment committee meeting, Sarah Corr, interim head of CalPERS' private equity program, explained that "direct investments" referred to investments in private equity general partnerships.

The only direct investments CalPERS has made in private equity are stakes in general partnerships, said Megan White, spokeswoman.

CalPERS invested in private equity firms only a few times on an opportunistic basis and hadn't taken a general partnership stake since 2007, she told the investment committee. In that year, CalPERS took minority stakes in Apollo Global Management and Silver Lake. CalPERS had also taken a minority stake Carlyle Group in 2001.

In an interview, Ms. Corr said the new private equity investment policy, if adopted, would remove the strategy as a simplification measure. The new policy also expresses staff's authority to make investments without board approval in dollar terms from percentage of the total private equity assets.

The policy would also remove the requirement that staff obtain board approval for private equity funds of managers that are not at least second quartile. However, CalPERS staff would need to obtain a prudent person opinion for commitments to funds of managers that are not at least second quartile.

The private equity policy would also lower staff's authority to make commitments to top-quartile investments without investment committee approval, while increasing that authority for second-quartile funds. The managing investment director authority to commit to top-quartile funds without investment committee approval would be reduced to $500 million from 4% of the private equity portfolio, and the CIO's limit would be reduced to $1 billion from 8%. But the managing investment director's authority to invest in second-quartile funds would be increased to $500 million from 0.75% of the portfolio and the CIO's authority would increase to $1 billion from 1.5%.

Impact investing

Separately, CalPERS staff and Pacific Community Ventures, a impact investing consultant, gave the final report for its $2.1 billion California private equity investment initiative, a program it has been winding down since 2013, Mr. Eliopoulos noted. The only portion of the program that will be kept are co-investments, which will be part of CalPERS' new private equity structure, he said. CalPERS is winding down the program to which it committed $1 billion since its 2001 inception in order to move "side programs" into the main private equity investment program.

The program which was established to invest private equity in traditionally underserved markets, primarily but not exclusively in California, and has been successful in investing in underserved markets and in women and minority-owned businesses, he said. CalPERS will support women- and minority-owned businesses as an ancillary benefit of its emerging manager program. Staff is studying whether investing in emerging managers also has an impact on investing in underserved areas, Mr. Eliopoulos said.

Board diversity

Also, the investment committee plans to enhance its definition of what it means to have a successful board diversity program so that staff can file shareholder proposals and vote against directors at U.S. companies that lack diversity. The so-called "key performance indicators" would change to require all public companies in which CalPERS invests have a level of board diversity that reflects each company's business, workforce, customer base and society in general. Currently, the key performance indicator showing success is that the companies in which CalPERS invests has "a dimension of board diversity."

"I think many of us on the board and staff are concerned about how long it's taking to improve board diversity, particularly in the U.S., when we see it could benefit performance," said Beth Richtman, managing investment director of the sustainable investment program.

At the July 16 off-site meeting, staff plans to provide a session on innovations in board diversity, including technology and new practices. In response to committee member questions, Simiso Nzima, investment director, global equity and head of corporate governance, told the committee that staff is talking to a number of institutional investors about mandatory diversity data disclosure, but that building coalitions of investors takes a long time.

"Our approach really is multipronged and we don't want to wait to build the coalition," Mr. Nzima told the committee. "We want to be able to start moving in that direction."

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