Here are my opinions about yesterday’s broad strokes of the CalPERS announcement and how they relate to the risk deployed in asset management.
CalPERS, the largest pension fund in the country with over $349 billion in assets under management (still a tiny fish in a big global pond consisting of trillion-dollar funds in countries like Norway and Japan), announced yesterday it is considering establishing a direct investment vehicle for private equity in 2019 with the Board requesting input from the public on the idea.
The devil, of course, is in the detail of how CalPERS intends to execute this program. Having had previous conversations with CalPERS board members, I will report back when I hear more. But I want to give my first-glance opinions about the broad strokes announced yesterday and how they relate to the risk deployed in asset management.
Let me walk through the press release (in cursive) and dissect what appears to be divulged:
SACRAMENTO, Calif. – CalPERS today unveiled two new strategic business models for its private equity program, after more than a year of discussion and examination among the Board and investment office.
The forward-looking models, which are part of a larger review of the private equity program, would create a new and separate entity known as CalPERS Direct to make direct private equity investments.
CalPERS appears to believe it can be a better judge of private equity investments than privately managed funds, seemingly in conflict with the asset class producing decent average 10% returns over the last twenty years. Without specifying the theory at the foundation of that forward-looking discovery in the press release, it will be hard to gauge the integrity and validity of CalPERS’ foresight.
The release does not divulge the real impetus for change at CalPERS; the press suggests it would be related to the expense of doing business with external private equity funds. In my view, an expense is only relevant when the upside of the asset-class performance is not achieved. So, to me, the incarnation of this program suggests volatility is too high and the predictability of consistency too low.
CalPERS Direct would be governed by a separate, independent board to advise on allocation and longer-term capital market perspectives. It would consist of two separate funds. One would focus on late-stage investments in technology, life sciences, and healthcare, and the other on long-term investments in established companies. These would operate alongside CalPERS’ existing private equity structure that typically invests in co-mingled private equity funds.
The problem with asset management, in general, is that its risk model is (historically), first and foremost, tied to the kind of distribution rather than the type of risk (regardless of distribution). The very reason why asset management is now filled to the brim with self-induced, endlessly diversified, bottom-heavy risk (in some cases with a critical path up to ten levels deep) from which only an alert musical chair game of risk escapism can provide moderate or subpar relief. Not entirely commensurate with the ability to produce returns from a well-defined and responsible pursuit of risk from an understanding of the underlying asset.
A great example of this confounding is how venture capital and private equity are lumped together in one asset class, while the risk of venture capital could be no more diametrically opposite to the risk of private equity. In simple terms, venture capital constitutes an investment in foresight, and private equity is an investment in hindsight, fundamentally different risk profiles that should not be lumped in the same asset class.
Back to the press release, identifying the industry sectors reveals a continued confounding of risk about each. An investible entity in technology is bound to require a venture capital allocation producing 7x returns in 7 years, while other entities in the same sentence supposedly managed by the same fund are known to produce no such returns within that timeframe. The way the press release is written reveals an even more intertwined complexity and collusion of distributions of asset management, not less. And the more complex the distribution of risk, the more unlikely the propensity for returns.
Plans call for CalPERS Direct to launch in the first half of 2019, following final review and approval by the Board. CalPERS anticipates that up to $13 billion a year will need to be invested in private equity to achieve a ten percent allocation of the portfolio.
Putting the program’s impact in perspective, it appears CalPERS Direct is not a grandiose bet on a new private equity investment model for CalPERS. It instead seems a trial of sorts, allocating a mere 10% of total private equity exposure, heavily padded with its existing private equity programs.
“We’re excited to move forward with this new approach for CalPERS,” said Ted Eliopoulos, CalPERS chief investment officer. “Our investment team has spent months exploring options in order to design an approach to private equity that takes advantage of our size and brand. We believe it will drive stronger private equity returns and help achieve economies of scale over time.”
Frankly, I find it a little odd that the outgoing Chief Investment Officer is launching this program without him being around to manage it to successful implementation. It behooves the Board to have this program validated by Ted’s replacement before its definition and implementation are decided upon.
CalPERS’ private equity program was launched in the early 1990s, and over the past 20 years has been the fund’s highest returning asset class, with a 10.6 percent annual return. The CalPERS Direct model continues the fund’s efforts to find new approaches to increasing investment returns, while it works to increase the System’s funded ratio and help its employer partners manage pension contributions.
The proper risk assessment preceding the allocation is the impetus for producing tremendous and consistent returns. And late-stage and established companies, listed as the focus of the funds, are not in short supply of money. Plenty of firms with dry powder and better operating experience than CalPERS are competing to become the new father of established success.
“We need to think differently about how we invest so that we can generate the returns that we need,” said Marcie Frost, CalPERS CEO. “Our members and employers need us to be focused on strong risk-adjusted returns and growing our funded status, and this approach does just that.”
This plan allows CalPERS to deploy investments at the scale CalPERS requires, and builds a base of talent and relationships that will strengthen over time.
Indeed, Marcie, asset management must organize around a better assessment of the innate risk of the investable asset rather than be built around the type of distribution. A suboptimization of the existing asset management strategy is not a solution but, at best, a band-aid to an incurable disease, except that the self-induced disease (of asset management) is curable. In the context of how the press release is formulated, this program must be reduced to a mere band-aid, not a fundamental asset management rethink.
“CalPERS Direct is a long-term investment strategy specifically designed to align with the long-term liabilities we have as a pension system,” said Henry Jones, chair of Investment Committee. “That long horizon also gives the CalPERS Board an opportunity to influence the culture of CalPERS Direct to ensure their actions are in sync with our Investment Beliefs. The Board will continue to review each step in the development of CalPERS Direct before we give final approval to launch it.”
Before CalPERS launches this, I recommend that the pension fund perform an x-ray of its risk management across the Board, a bottom-up analysis of risk correlated to a top-down analysis of risk. Bound to expose exactly how the traditional asset management constructs must be restructured to meet, greet, and adequately categorize the risk of the underlying assets and align distribution to the risk of the asset, not the other way around.
CalPERS’ Investment Office will now begin talking with industry professionals about the makeup of both the independent advisory boards and the management teams.
Count me in.
I cannot repeat Einstein enough in investment arbitrage: the theory determines what can be discovered. The quality of the thesis of investment allocations by CalPERS determines what output can be derived from it and, more importantly, what input provides a more vibrant society on which a pension fund’s members can continue to depend. A 360-degree risk analysis is what CalPERS must deploy to figure out the best way to serve its constituents for years to come.
