As CalPERS culls its buyout ranks, the big will get richer
The largest U.S. pension fund leads the way in reducing its external managers. Firms and other funds watch closely to see where the axe falls.
by Armie Lee and Ronald Orol
When the largest U.S. public pension system, the California Public Employees' Retirement System, or CalPERS, recently revealed plans to significantly pare back its investment in private equity firms, the largest U.S. buyout shops could be forgiven if they broke out the champagne.
That's because not only are the largest PE firms likely to be among those surviving the purge-their allocations are likely to rise significantly.
CalPERS has said it plans to cut the number of its external managers -- private equity, real estate and global equity -- to about 100 from 212 by 2020 as part of an effort to reduce costs and complexity. The number of private equity firms managing for the pension fund will go down to around 30 from the 98 that do so currently.
Roughly 9.4% of CalPERS $306 billion in assets is allocated to private equity. The 98 buyout shop external managers CalPERS allocates its funds to represents one of the largest external allocations among public pension funds.
Other big pension funds not only allocate a great deal to PE managers but also are considering reductions. For example, the State of Wisconsin Investment Board, which began investing with private equity in 1985, has allocated capital to 80 private equity managers as part of its Core Private Equity Portfolio. However, a spokesman said the $99 billion public fund has sold a number of "non-core" private equity funds over the last three years and "will look to opportunistically sell more non-core relationships in the future."
How CalPERS goes about the winnowing process is what will have other pension funds -- and the private investment industry -- on tenterhooks to see what the biggest of them is likely to do. In a presentation set to be discussed at a June 15 investment committee meeting, CalPERs said it aims to have "fewer and larger relationships with those external managers who are most aligned with CalPERS' investment strategy."
When asked whether that alignment might mean that funds with negative internal rates of return (net of fees) might be the first ones cut, a spokesman declined to comment on returns. But, he noted, "[w]e want to encourage robust competition among the managers." He did point out that the changes contemplated by the review will phase in over the next five years.
Peter E. Michelsen, partner at CamberView Partners LLC, said that based on his understanding, CalPERS still sees value in private equity but that staffers and the board believe the fund was much too fragmented. He said that CalPERS expects that by consolidating investments to a few private equity managers "that have generated sustained returns" and culling the rest they will be able to improve returns and reduce fees materially.
David Druley, who leads the global pension practice at Cambridge Associates, said that although it makes sense to concentrate with its highest conviction managers, especially if the pension fund can capture lower fees, "it would seem that they would want to maintain a good diversified roster of managers," adding: "What you don't want to do in this case is to increase the risk."
However, the CalPERS spokesman acknowledged that, with $30 billion in its current PE allotment going toward fewer firms, only a portion of the remaining outside managers will get increased allocations.
Of those survivors, observers say, expect the larger funds, especially the listed behemoths like KKR & Co. LP (KKR), Blackstone Group LP (BX) and Carlyle Group LP (CG), to come out the winners.
"Do you have the ability to handle the large money?" a source familiar with CalPERS said. Some firms will "just not be able to play in that field," this person said.
That, according to one former CalPERs staffer, could be a decision the pension fund may live to regret. "I get the mechanics are that you are forced into bigger funds," this person said. "But look at the history of big money managers. A lot of outperformance comes from smaller younger funds."
Amid the move to trim the manager roster, CalPERS will be taking a look at its benchmark for private equity investments. The figure is two-thirds of the FTSE U.S. Total Market Index plus a third of the FTSE All World ex-U.S. Total Market Index plus 300 basis points.
Over a 10-year period through June 2014, CalPERS' private equity program had net returns of 13.3%, trailing the benchmark by 2.1%. In a committee meeting document in December, CalPERS said the benchmark should be reviewed in 2015, adding that the benchmark "creates unintended active risk for the program, as well as for the Total Fund."
The manager reduction plan and CalPERS' announcement last fall that it will pull the plug on its hedge fund program come after years of increasing its allocations with an ever-growing number of external managers.
The ex-CalPERS staffer, who held a high-level position at the public pension fund in the early to mid-2000s, described the fund's board and investment team as "deal junkies" in that they were encouraged over the years to allocate assets to hedge funds and PE firms. He said the board rewarded CalPERS' private equity team for bringing in deals over the years.
The CalPERS spokesman acknowledged that in that time period, CalPERS was more "expansionary" when it came to PE and hedge fund investments. He added that during that period CalPERS had an influx of capital from employees and employers which required it to disperse cash and have it invested.
The latest move comes as CalPERS seeks to reduce risk with investment income and the contribution from employees and employers falling below the amount that is distributed to beneficiaries each month. "That is framing this move," the spokesman said. "We really are reducing risk and reducing complexity and costs in the portfolio."
One person familiar with the situation noted that the mega-fund has recognized that its large portfolio of external managers was so expansive that it was almost like "indexing," which was negating what the firm was trying to do. "Having fewer managers will allow CalPERS to better manage its relationships and interactions so it has a better sense of who does what well."
Gordon Caplan, chairman of the private equity practice at Willkie Farr & Gallagher LLP, said those firms that don't make the cut at CalPERS may not have a problem replacing the lost funding.
However, "many, if not most, alternative money managers--particularly in the PE space--would like to have CalPERS as a large investor," he said. "It's an indication that one of the most important investors in this space believes in you."
The CalPERS spokesman said that it would be "presumptive" to conclude that the bigger the firm, the more likely it will be to see allocations. "We haven't made any decisions on who will get increased allocations," he said. "We haven't decided any of this yet."
