By Ed Mendel.
Private equity has been the highest-yielding investment for CalPERS. But it’s also resulted in prison for a former chief executive, criticism because sky-high fees were not tracked, and frustration from being unable to target specific investments and shunned by some big firms.
Once regarded as an alternative to stocks and bonds, private equity is moving into the mainstream as the number of U.S. companies with publicly traded stock declines, dropping by half in the last two decades from roughly 7,200 to 3,600.
Pension funds and other large investors, told by experts to expect lower returns in the future, are lining up to put money into private equity firms, despite high prices. An estimated $1 trillion of “dry powder” has been committed to private equity but not yet tapped.
Continuing to get high returns from private equity may be difficult. Much of the “low-hanging fruit” is said to have been plucked for the most lucrative form of private equity, the leveraged buyout.
In a typical buyout a private equity firm gets loans to buy a company, often using the company’s assets as collateral, and then returns the company to the market years later after making it more efficient through cost cutting, product improvement and other means.
Done properly, some studies found buyouts are good for the overall economy. But critics say too often a buyout is a “rip, strip, and flip” where jobs are ruthlessly cut, product quality lowered, lucrative units sold off, and the company left crippled or bankrupted by debt.
Buyouts are a growing part of the CalPERS private equity portfolio, 64 percent or $17.4 billion of the $27.2 billion net asset value as of last June. Other parts are listed as growth/expansion 16%, credit related 10%, opportunistic 7%, and venture capital 3%.
When CalPERS adjusted its entire portfolio two years ago, private equity was the only asset class expected to exceed the earnings target of 7 percent. The investment fund, $344 billion last week, has only 71 percent of the projected assets needed to pay future pensions.
Private equity has been an investment bright spot for CalPERS, according to an annual report given to the board this month. As of last June 30, the net return was 16.1% for one year, 11.9% for five years, and 10.5% for the last 20 years.
Two years ago CalPERS began working on a long-range private equity plan. During a nine-month “listening tour” the staff sought the advice of 50 experts from private equity, Wall Street, business, and academia.
The plan announced last May continues the current stream of investments in private equity firms, the “general partner” that in a buyout selects, purchases, manages and sells the company while CalPERS and dozens of other big investors remain passive “limited partners.”
A much smaller emerging manager program, which may grow to about $500 million, also will continue. It’s aimed at promoting diversity, new thinking, the development of investment talent, and a transition into larger revenue sources.
CalPERS Direct is the new part, expected to launch in the first half of next year. A new independent board will govern two new funds, each expected to grow to about $10 billion in a decade, that are intended to give CalPERS two things difficult to get now.
An “innovation” fund will focus on “late-stage investments in technology, life sciences, and health care.” A “horizon” fund will focus on “long-term investments in established companies” perhaps lasting generations.
The former CalPERS chief investment officer, Ted Eliopoulos, who is relocating to the East Coast to be closer to family, told the board this month that the new funds will operate on the general partner model with only one limited partner at the outset, CalPERS.
Eliopoulos said alternatives such as creating or buying companies and bringing them in-house were considered. Staff settled on the general partner model, familiar from the private equity, real estate, and infrastructure portolios.
In the world of top private equity firms, the customer has not been king. Most of the big profits are made by a relatively small number of private equity firms that can choose their own limited partners.
Private equity firms have produced dozens of billionaires, thanks to a tax break and a payment structure that allowed many to collect a 2 percent annual fee for managing investments and 20 percent of the profit over a minimum “hurdle” such as 6 to 8 percent.
“The fastest path in America today to becoming a billionaire is not starting a tech company. It’s starting an asset management firm by a factor of two,” Ashby Monk of Stanford University, a pension fund advisor and researcher, told the CalPERS board last June.
An example of how private equity firms seemed to turn the tables and become the buyer, while big investors became the sellers of their own merits, occurred in 2006 when CalPERS rejected a Public Records Act request from the Los Angeles Times.
The Times reporters asked for letters, emails, or memos from former state Sen. Richard Polanco and Alfred Villalobos, a former CalPERS board member who had become a “placement agent” collecting fees for helping private equity firms get CalPERS investments.
A letter from a CalPERS attorney to the Times said “the release of the (sic) some of the requested information may harm CalPERS’ ability to continue to invest with top-tier private equity funds.”
Some private equity firms warned that “CalPERS’ current status as an ‘investor of choice’ will be damaged” and other private equity firms “recently expressly refused to allow CalPERS to invest with them” because of concerns about disclosure, said the letter.
In January 2015 Villalobos, who collected about $50 million from firms seeking CalPERS investments, apparently committed suicide shortly before his trial on bribery charges was scheduled to begin.
His inside man, Fred Buenrostro, a former CalPERS chief executive officer who also had served on the board, was sentenced in May 2016 to 4 1/2 years in federal prison after pleading guilty to bribery charges.
After the pay-to-play scandal erupted in 2009, CalPERS re-negotiated lower fees with some private equity firms. Beyond the public relations black eye, the scandal may have had some financial impact.
“A number of successful GPs (general partners) have told us that we have become too unpredictable to do business with, and many larger GPs are cutting back the amount they are willing to allocate to us within their new funds,” John Cole, CalPERS investment director, told the board in July last year.
CalPERS, once criticized for not knowing private equity fee amounts, has become one of the leaders in revealing private equity costs. The board is scheduled to receive a report next month on the completion of the Private Equity Accounting and Reporting Solution (PEARS).
Among concerns about the new CalPERS Direct private equity funds raised by two retiree groups at the board meeting this month: Will the funds yield enough to cover the expensive cost, and will the “two private companies” who appoint their own boards have adequate public scrutiny?
Stanford’s Monk was generally supportive of CalPERS Direct at the board meeting last June. But he said the plan lacked consideration of how technology such as alternative data and artificial intelligence will disrupt the current understanding of private equity value.
“I promise you how we invest today is not how we will invest 15 years from now,” Monk said.
Originally posted at Cal Pensions.