PE gets tongue lashing in CalPERS’ PE ‘workshop’

The California Public Employees’ Retirement System conducted a comprehensive review of its private equity allocation on November 16, providing board members and the public a glimpse into how staff weighs PE’s high returns against elevated costs and murky terms.

Controversy dogged the $293.4 billion pension system through much of the year after it came to light that CalPERS did not keep track of the amount of carried interest its investment managers took as a share of profits. Board members also expressed frustration over staff’s explanations of management fee offsets and distributions. The workshop was meant to address these questions, as well as provide clarity on how CalPERS plans to approach the asset class moving forward.

CalPERS will remain an active limited partner over the next five years, even as it culls its roster of existing GP relationships from around 100 down to around 30, said CalPERS staffers. Private equity netted CalPERS a higher return than any other asset class over the last 20 years, notching 12.2 percent, according to pension documents.

Even though private equity continues to be a top performer for CalPERS, “the fees are too high and these structures are too complex and not transparent enough to the investors,” Chief Investment Officer Ted Eliopoulos said during introductory remarks.

Eliopoulos’ comments set the tone for the rest of the four-and-a-half-hour workshop, which included presentations from Harvard Business School Professor Josh Lerner, California State Teachers’ Retirement System CIO Chris Ailman, Public Employee Retirement System of Idaho CIO Bob Maynard, and several CalPERS staffers and consultants.

Speakers said private equity provides public pensions superior and more stable returns than public equities, but the asset class is plagued by a host of expensive and complicated problems.

“Rampant greed, actually, is the challenge of the asset class,” said Maynard of Idaho. “The problem is like — it’s almost like the reasons the SEC [is investigating firms] — it’s nickel grabbing. We either play the game with the rules as established, or we don’t. And because of the advantages of the asset type … we have preferred to play the game.”

Ailman said CalSTRS’ board also engaged in serious discussions about the pros and cons of private equity in recent months.

“GPs are, by nature, greedy and self-interested,” Ailman said. “We know that and we understood that. It’s not like LPs are being surprised.”

Ailman added: “Most of the buyout funds you have exposure to, and we do to, the returns are showing up as very similar. So the skill in picking managers is going to be tougher, not easier.”

Manager selection has grown increasingly difficult as larger institutions and sovereign wealth funds have entered the market over the last half-decade, fueling competition for access to top-performing funds. The size and breadth of the new entrants caused CalPERS to lose some of the negotiating leverage it had prior to the financial crisis, when its commitments accounted for approximately 2.8 percent of the industry’s total fundraising. The pension’s market share has since fallen to 1 percent.

“CalPERS, being 1 percent of the market, cannot dictate terms,” said CalPERS private equity chief Réal Desrochers. He also noted staff rejects commitments when it finds terms are too GP-friendly. “We are insistent on working with ILPA, getting transparency … getting the information that we need on fees, carried interest, on all of that,” he said.

To that end, even though CalPERS cannot dictate terms, the pension still managed to bring down the average management fee and carried interest charged by its fund managers over the last three years, according to pension documents.

Furthermore, as ILPA rallies the limited partnership universe around a new standardized reporting template for fees, and the SEC cracks down on private equity firms, LPs have become more sophisticated in their approach to the asset class, said the presenters.

“Literally from the time [private equity] started, which was in the late ‘70s, the general partner had the dominant role in the negotiations,”  said Pension Consulting Alliance’s Allen Emkin. “And limited partners had a choice: They could sign the documents or they could walk away.”

“The world has changed,” Emkin said. “It’s still far, far, far from perfect. And all the recent controversy, all the recent disclosures, is evidence that there’s a need for far more change in the industry.”

Action Item: Watch the webcast of CalPERS’ PE workshop here: http://bit.ly/1PEv2ZW

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