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Friday Letter: CalPERS' cull

As large LPs continue to consolidate, smaller managers will have to source their capital form elsewhere, but that needn't be a terrifying scenario

 

CalPERS’ decision this week to dramatically scale back the number of external managers it works with was certainly eye-catching, but hardly a huge surprise.

First the bare facts: the $303.6 billion Californian state pension fund will tell its investment board on 15 June that it plans a cull of its external managers, from 212 to 100. Within that number, private equity GPs will be cut back from 98 to 30, meaning that the remaining firms will over the five year timeframe of the plan receive a far greater slice of CalPERS' $30 billion private equity pie.

While the move will have dramatic consequences for those GPs who will eventually find out that CalPERS will not be making commitments to their future offerings, it makes eminent sense for CalPERS, and would do for many other large investors too.

Cost savings and efficiency gains are the expected benefits. In 2014, the Californian giant paid $1.6 billion in fees to external managers, a figure it will likely be able to reduce by placing larger amounts of capital into fewer funds on better terms. Moreover, being able to point its limited resources at a radically consolidated portfolio of managers will be a relief for its stretched investment team.

As America's biggest pension, CalPERS is a bellwether for its peers. Others will surely follow its example and rationalise their portfolios too, and many, including the Washington State Investment Board recently, have already started.

It doesn't mean that they're turning their backs on private equity. By and large, despite their innate fee aversion, US pension funds will remain enthusiastic sponsors of what has been their best-performing asset class. And in today's persisting low-yield environment they may well need to: if anything, in many cases, allocations are only likely to get fatter.

Nevertheless, the landscape will change as the trend towards fewer GPs in the portfolio continues. The winners are easily identified: for secondaries specialists, the funds that are falling off the CalPERS list will provide an exciting buying opportunity, and the world's largest private equity firms can look forward to filling their boots with even more Sacramento cash than previously. They're the ones with the capacity to take the billion-dollar commitments the big pension plans want to be making.

Mid-market funds and other small providers on the other hand, who cannot accommodate such huge amounts, will need to go elsewhere for funding. To those with a differentiated offering and the skill set to deliver performance, this need not all spell bad news: there are still plenty of smaller LPs out there for whom it makes good economic sense to invest in smaller funds, and with the likes of CalPERS now getting out of the way, they should be able to take advantage of these strategies more easily, with less competition for access.

There is no doubt that CalPERS’ actions will have wide-ranging consequences. However, this is not the beginning of the end for private equity, but merely another intriguing stage in its evolution.