The challenges for new California Public Employees’ Retirement System CIO Ben Meng were laid bare at the $340 billion pension fund’s February board meeting.
CalPERS is only 70 per cent funded and increasingly mature; it faced its first negative equity market in a decade in 2018 yet, with a 7 per cent return hurdle, is committed to keeping a large allocation to risk assets in what Meng called a “no pain, no gain” strategy.
Meng, who left his role as deputy CIO at China’s $3.2 trillion State Administration of Foreign Exchange to take over from Ted Eliopoulos in January, has just lost chief operating officer Elisabeth Bourqui following her resignation after just seven months. CalPERS also needs to fill long-standing vacancies in roles heading up the private equity and fixed income teams. Meng is also working with three new members on CalPERS’ 13-strong board: Mona Pasquil Rogers, Fiona Ma and, most notably Jason Perez, the police sergeant from Corona, California, who ousted board president Priya Mathur in an election upset last October.
Equity risk
The biggest challenges for the CalPERS portfolio reside in the public and private equity allocations. A key task is navigating risk in a $178 billion listed equity portfolio and the vulnerability to a drawdown that brings. Even though CalPERS’ allocation to growth assets (public and private equity) is 58 per cent of the portfolio, it represents 83 per cent of risk, Andrew Junkin, president of CalPERS consultant Wilshire Associates told the board at the meeting.
“If there is a significant sell-off, your portfolio is not insulated because it is still 83 per cent of risk in your portfolio,” Junkin warned.
Yet Meng’s options are limited because CalPERS’ funded status and need for a high return force it to take a degree of risk. His solution is to be “smart” about what, when and how much risk to take.
Smart strategies include “sticking to our course, even during times of inevitable market volatility”. He pointed out that to the board that last year’s equity drawdown was relatively small and noted efforts to mitigate the impact of a large equity market drawdown via diversification and defensive strategies. He also said there were only “modest” amounts of leverage in the portfolio and, most important of all, adequate liquidity coverage, which he believes is the best hedge against a fall in equity.
Indeed, Meng intends to focus more on ways to develop CalPERS’ liquidity profile during his first 180 days, developing what he calls a comprehensive, proactive liquidity management tool.
“This will be the front and centre of my focus area,” he told the board.
He is hunting for a liquidity sweet spot that ensures enough on hand to allow the fund to take advantage of market drawdowns, but not so much that it loses out on returns.
“Too much liquidity is costly but too little liquidity is deadly,” he said.
Not long-term anymore
Some CalPERS board members would like to see much more focus on downside risk.
“I just need to remind everyone that I don’t believe we should have a false sense of security that we are a long-term investor anymore,” board member Dana Hollinger warned. “We are at 68 per cent funded, we have asymmetrical risk – we have more of our population maturing than coming into the system. We have to get through these next five to 10 years by focusing on our downside risk and there is a point at which you can’t recapture.”
CalPERS has a ratio of one active employee for every retiree, compared with a 4 to 1 ratio at the fund’s inception.
Hollinger wasn’t alone. Mindful of last year’s spike in volatility, board member Betty Yee wanted to know how successful measures to reduce volatility had been and asked the investment team for closer analysis, going forward, of how much lower the returns would have been without defensive measures in place.
Private equity
Resolving the inherent challenges in CalPERS’ $28 billion private equity portfolio remains another “dilemma”, Meng said. Accessing top-quartile private equity funds so the pension scheme can make the annual $8 billion-$10 billion deployment necessary to ensure its target 8 per cent allocation to its best-performing asset class has become critical.
About two-thirds of CalPERS’ private equity allocation sits in traditional co-mingled fund-of-funds investment, in so-called Pillar II of the portfolio. Here, investments are tilted to large and mega-buyout funds run by managers like Blackstone, Carlyle, CVC Capital Partners and TPG. However, the number of top-quartile managers is limited, and these managers come to the market only every three or four years. The best general partners also seek a diversified limited partner base, and for this reason don’t want to take money only from CalPERS.
“One place your scale has meaningful disadvantages is that it is hard to get money deployed,” Junkin said.
Internal constraints also thwart CalPERS’ ability to deploy capital in Pillar II, including a commitment to invest more in secondary and co-investment opportunities.
“The private equity staff has not been budgeted to the $8 to $10 billion a year, they’ve been budgeted a lower number,” said Steven Hartt, principal at private equity consultant Meketa Investment Group, who referenced the “interaction between the private equity team and the broader CalPERS staff” and the need to “think about what’s budget they’re going to be able to deploy”.
The investment team also told the board how CalPERS staff were working to “re-energise” the manager program, “refresh” and “add” to the pool of managers to choose from, and “re-engage” with opportunistic transactions around co-investments and secondaries “that have not been done in the last several years”. For the second half of 2018, staff completed eight commitments totalling $3.1 billion, part of 18 commitments totalling $6 billion for the full year.
Meng stressed the urgent need to push ahead with CalPERS’ new, direct-style Innovation and Horizon pillars in the private equity program. These pillars focus on late-stage investment in technology, life sciences and healthcare companies, and on long-term investments in established companies, respectively.
Both will allow CalPERS to exploit its advantages in scale, brand and an improved liquidity profile, to access opportunities when they arise, Meng said.
Under these pillars, which are still awaiting board sign off after a year of discussion, CalPERS will fund Innovation and Horizon investments as the sole limited partner in a traditional LP/GP relationship. Meng kicked any idea of CalPERS building its own in-house private equity allocation into the long grass.
“Our current governance structure, and the fact that we’re not located in a global financial centre, seriously hinders our ability to attract the expertise in-house,” he said.
