CalPERS battles ‘denominator effect’

The $234.2bn pension is mulling a possible change to its private equity allocation, as the twin forces of sinking assets under management and shrinking distributions have combined for an overweighted alternatives exposure.

The California Public Employees’ Retirement System is considering a change to its private equity target allocation as the $234.2 billion (€156.9 billion) pension fund tries to temper an overweighted alternatives portfolio.

The fund, the largest public pension in the US, currently maintains a 10 percent target allocation to private equity with a range of 7 percent to 13 percent. But CalPERS' actual allocation could reach 12 percent by the end of 2008, according to a memo compiled by the retirement system’s investment committee staff.  

The memo says the pension will review its asset mix in the fourth quarter of 2008 and “potentially recommend any changes to the range for AIM [alternative investments] if warranted.” It added that in recent months public equity markets had continued to decline “thus increasing the likelihood of AIM overweights.”

The memo details CalPERS’ recent struggles with the so-called “denominator effect”, an increasingly common phenomenon afflicting institutional investors’ asset mixes.

As CalPERS’ public equity portfolio has plummeted in value since the beginning of the year, its total assets under management have suffered accordingly – dropping from an all-time high of $253 billion in December 2007 to $234.2 billion earlier this month.

As the pension’s total assets under management shrinks, its exposure to private equity as a percentage of total assets naturally rises, causing the overweighted allocation. Adding to the problem, as a result of the credit crunch, buyout fund distributions have slowed considerably while commitments to those funds have continued, causing even more dollars to flow towards and remain in CalPERS’ alternatives bucket.

“This has created a circumstance, not unexpectedly, that the allocation to AIM has exceeded its target, and it appears highly likely that it may exceed the maximum end of the range in the foreseeable future if the public markets do not recover and if distributions do not return to more normal levels,” the memo said.
It remains to be seen whether CalPERS will adjust its asset allocation mix, and whether it would in fact lower its exposure or even raise its target allocation to one of its top-performing asset classes. Last December, the pension raised its private equity allocation to 10 percent from 6 percent. In the fiscal year 2007 to 2008, private equity returned 19.6 percent for the retirement system, leading all other asset classes save one.

Asked if CalPERS would likely lower its target allocation, a spokesman for the pension told PEO: “It’s premature to speculate about what might happen. Risk is always part of the equation. If the board tweaks the allocations, as it does every three years anyway, it will only be a few percentage points up or down. AIM has been a pretty consistent long-term performer with good diversification for our portfolio.”

The spokesman stressed that the investment committee staff had not yet made a recommendation to the board on any allocation changes.

CalPERS faced a similar dilemma in the early 2000s following the bursting of the tech bubble which sent its public portfolio reeling. However the pension adjusted its target allocation to private equity by only one percent.

CalPERS, often considered a bellwether of limited partner sentiment, is not the only institutional investor struggling with the denominator effect.

As the memo points out, several other pensions with significant exposure to the public markets are confronting similar issues.

Massive pensions such as CalPERS have traditionally been thought more immune from the denominator effect because of their size and highly-touted focus on long-term investment strategies.