The benchmark LP

Some people might have thought twice about taking the job.

When Joseph Dear walked in to the California Public Employees’ Retirement System (CalPERS) as its new chief investment officer in March 2009, the US’ largest public pension was in the process of chalking up the steepest single-year loss in its history. Between July 2008 and June 2009, CalPERS’ investment portfolio lost roughly $57 billion – nearly 24 percent of its value. Its allocation targets were wildly off kilter, prompting the pension to increase target ranges temporarily for some asset classes. And tongues were set wagging in the private equity industry when it emerged that the pension giant – one of the largest and most experienced limited partners in the world – had encouraged some fund managers to delay capital calls as it worked to manage the impact of the financial crisis.

The world, post-Lehman Brothers, was an uncertain place for investors. And California, in particular, was becoming a scary one. The Golden State’s $1.7 trillion economy was in a mess: by summer, the state was slashing public services, issuing IOUs to creditors and imposing mandatory leaves of absence for state employees, including CalPERS. The threat of more municipal bankruptcies linked to cities’ inabilities to pay pension benefits (like that of Vallejo, a city just north of San Francisco) was also spurring some explosive debate around pension plan reform.

So it was a particularly fraught time for Dear to take on the CIO role at CalPERS, following his seven-year stint as CIO of the Washington State Investment Board. Even in the best of times, CalPERS has been a highly politicised institution – and although Dear didn’t know it then, things were about to get much more complicated. In the months following his appointment, a massive pay-to-play scandal involving ex-pension officials and placement agents erupted, plunging CalPERS into controversy and ultimately resulting in senior resignations, an internal review and a policy overhaul.

“You know,” Dear says with a laugh, “I came to CalPERS looking for a new professional challenge and succeeded beyond my wildest expectations.”

CRISIS MANAGEMENT

Market conditions coupled with the scandal and internal review made life difficult for CalPERS, which was frequently described at the time as “embattled”. Headlines about CalPERS’ CIO earning a salary larger than the state’s governor, or about the reported $11 million legal bill for its placement agent review, didn’t help matters, either.

“Oh, the reputational damage to CalPERS was considerable and the morale impact on employees and their association with the enterprise was significant,” says Dear. “Those are very hard things to deal with, because people who are here didn’t participate in [the pay-to-play practices that were under investigation] and there’s still uncertainty about what the law enforcement outcomes will be. So that was very hard. But it did force us to look at policies, rules, and legislation. And we took very strong corrective action.”

Joseph Dear

Dear, who is softly-spoken but firm and straightforward, is clearly proud of the measures he’s able to tick off. CalPERS restructured the way it manages private equity relationships, launching an automated system for submitting PPMs. It created a risk management office, established a whistleblower hotline, instituted rigorous travel policies and gift bans and launched its own website, CalpersResponds, to respond to negative press as well as speak out on various policy issues. It prohibited firms that serve as investment consultants for the pension from also managing its capital. It also backed state legislation requiring placement agents to register as lobbyists and forgo performance-based fees, as well as subject themselves to periodic registration and quarterly reporting.

“We followed up with other legislation that restricts post-employment of CalPERS board members and staff so they can’t trade on their CalPERS relationship back with CalPERS,” says Dear. “I think we worked extremely hard to make a repetition of that episode impossible. Furthermore, we recouped more than the total amount paid out to all placement agents from four of our private equity partners. So we can say unequivocally that the fund return was not damaged by any of the payments made to the placement agent.”

In part as a result of its review, the pension collected $215 million in fee concessions from a number of external managers that agreed not to use placement agents when seeking future commitments. Among them was Apollo Global Management, which promised to reduce its fees by $125 million over five years.

PERFORMANCE MATTERS

So how did Dear deal with CalPERS’ internal morale issue? He says matter-of-factly that getting “back in the game”, taking proactive steps and delivering solid results were the best courses of action.

“The best thing … is to have people solve problems that are meaningful and achieve performance that’s recognised – and the portfolio has stood up quite well,” he says. “The team before I got here made significant allocations to distressed debt plays; in the middle of ‘09 they didn’t look very promising, [but] they generally have turned out to be very good investments. So the team has achieved really good results; that’s the best thing.”

According to CalPERS’ preliminary results for fiscal 2011, its Alternative Investment Management (AIM) programme helped to drive the best overall returns at the pension system in 14 years: AIM was expected to produce a 25.3 percent return for the year. That followed a 30.9 percent return for fiscal 2010.

The pension system also made some significant changes to its asset allocation strategy, reorganising its investments into five groups according to how they perform in high- or low-growth markets and the prevailing inflation environment. Private equity was grouped into the ‘growth’ asset class, along with public equity. CalPERS also later approved target allocations for sub-asset classes within alternative investments: buyout (60 percent), credit-related (15 percent), venture capital (1 percent), growth/expansion capital (15 percent) and opportunistic funds (10 percent).

LEVERAGING RELATIONSHIPS

Dear is a firm believer that private equity will play a crucial role in the pension meeting its overall 7.75 percent long-term return objective. And he believes the appointment in May 2011 of Réal Désrochers to lead the private equity group was a key step in achieving that ambition.

Désrochers had most recently worked as CIO at the Saudi Arabian Investment Company, having in 2009 retired from fellow public pension the California State Teachers’ Retirement System (CalSTRS), where he’d led the private equity programme since 1998. Prior to CalSTRS, Désrochers spent 11 years running the international private equity programme for the Canadian pension La Caisse de dépôt et placement du Québec.

“He’s provided a very strong sense of direction and coaching for the younger members of the team,” says Dear. “I think they really feel they’ve got a terrific direction to move.”

That direction includes CalPERS reducing its number of manager relationships, actively managing its portfolio on the secondaries market, increasing co-investments and exploring potential strategic partnerships. 

“Strategic relationships” have been attracting buzz lately thanks to a couple of recently announced high-profile partnerships, including the New Jersey state pension system’s $1.8 billion venture with The Blackstone Group, which includes $1.5 billion in separate accounts to be invested across strategies including real assets and credit. The Teacher Retirement System of Texas also struck a similar multibillion deal with Kohlberg Kravis Roberts and Apollo, proceeds from which can be recycled for further investment. Specific terms on the deals weren’t disclosed, but the conventional wisdom is that such mandates come with more investor-friendly terms and conditions.

“I think it would be better if fees came down generally for all investors and that the carry was adjusted more appropriately,” says Dear. “But if that’s not going to happen, then investors with strategic positions and the capacity to make large commitments should go forward and make more sensible arrangements with the managers. We’ve now seen proof in the marketplace that that’s possible to do.”

Dear refuses to be drawn on any specific plans CalPERS has for such deals, but says it is “paying close attention” to such developments and acknowledges it is a “logical direction” to move.

As he explains: “If you’re going to have fewer relationships and maintain the size of your programme, then the size of your commitment is going to go up. It only makes sense from a business standpoint to leverage those large commitments against better alignment of terms and conditions.”

He points out that the dominant operating costs for CalPERS, by far, are the fees it pays to private equity, real estate and hedge fund managers. At PEI’s recent CFOs & COOs Forum in New York, Janine Guillo, CalPERS’ chief operating investment officer, noted that while private equity makes up 14 percent of the portfolio, it accounts for 60 percent of the costs associated with running the investment programme. The pension wouldn’t be upholding its fiduciary duty, Dear argues, if it were not trying to capitalise on investors’ greater negotiating power in today’s marketplace and lower its cost of doing business.

“The structures that developed around private equity are long-standing, but there is no natural law that says that two-and-twenty fee structures [are] required for success in private equity,” Dear says. “I think it’s extremely important to have good alignment between the limited partner and the general partner. So that means greater clarity about what fees are for, and a better, clearer structure for sharing the profits. The skill required to be successful in private equity is considerable, and will always have a substantial economic reward for success. Nobody is challenging that part, but we’re not doing our jobs as fiduciaries if we are not constantly striving to achieve this better alignment, to get more efficiency and more effectiveness in how we deploy our capital and what we pay for that success.”

One of the issues less clear-cut to the pension is: if its objective is to invest in top-quartile funds, what is the maximum feasible exposure to private equity to obtain that goal?

“That’s the question we’re wrestling with now,” Dear admits. “So it is conceivable that the CalPERS’ private equity programme could shrink over time, but not a huge amount. I’m very doubtful we’ll move to a larger allocation, but there are other issues about portfolio structure, which are dependent not on the market, but on the size of our staff [and] which types of vehicles we invest in.”

Asked what sort of performance he expects from top-tier managers, Dear says the pension’s targets may seem modest compared to other investors, 50 percent of whom, according to a recent survey by Coller Capital, expect annual returns of 11 to 15 percent. CalPERS expects its private equity GPs to consistently deliver 300 basis points above public markets returns. “An asset management programme that produces a 3 percent return above what the public markets get, consistently, is a considerable achievement.”

Might return expectations – and indeed the importance given to one asset class over another, say public versus private equity – vary in light of the challenging market conditions expected this year? Not really, Dear says, who’s unyielding in his long-term view of the asset class’ positive impact on the portfolio.

“Short term developments are important – you have to pay attention to them – but you shouldn’t get too emotional about them,” he says. “Our belief is the equity markets are highly efficient and for publicly traded securities we’re happy with a slightly better than market return. Where we want to earn the premium is with private equity. That’s a deeply held and long held belief,” he says, adding that private equity was “enormously important to the success of the programme in meeting its long-term target [return] objective“.

THE LONG VIEW

Dear has hardly had an easy ride at CalPERS. So it may surprise some that he remains so bullish about the private equity industry’s prospects in coming years.

For instance, he dismisses suggestions that only niche or emerging markets strategies can be truly successful in the current climate.

“This is short-term commentary, which is based on what’s happening in the recent past and expected to occur in the near future. And private equity is a long horizon investment if there is one. Is there an ability demonstrated by private equity managers to produce a higher return reasonably consistently over time? Yes. Has anything fundamentally happened in the capital markets to say that that’s gone away for good? No. Are conditions more difficult, less difficult over time? Sure.

“One of the things we know is that when it’s very hard to deploy capital those are often the periods when the returns subsequently are among the best. In fact, when it’s really easy to invest, when the credit terms are great, that’s when investments come to grief. So I’m not sure it’s a bad thing: there are people who’re predicting it’s more difficult to make money, but it all comes back to who are you choosing to partner with and what’s their level of skill.”

Dear also recognises that Mitt Romney’s presidential bid is bound to result in greater scrutiny of the industry by the popular press. He’s dubious that the industry can do much to alter the focus of an election campaign. But he believes that an organisation like CalPERS, which “has benefited from private equity investment, and sees it as an important strategy going forward to achieve our objective”, ought to speak out publicly in private equity’s defence.

“Capitalism has fabulous advantages and some downsides – and there are legitimate public policy issues about how to mitigate those downsides,” Dear says. LPs and GPs should participate in such public discourse, he says. “But we shouldn’t expect to dominate the debate or to have the debate end.”

This might sound perfectly logical, but it’s not a view that appears to be widely held across the industry – many investors and fund managers are instead going the “no comment” route. So Dear’s inclination to help inform and advance the public debate swirling around private equity’s merits and flaws is welcome. Long a pace-setter among institutional investors, CalPERS’ engagement and support will hopefully influence investment staff at other institutions to champion the industry publicly, too. The need has never been greater. 

Christopher Witkowsky contributed reporting to this article