US pension funds: Going direct

California Public Employees' Retirement System (CalPERS) paid out $689 million in management and performance fees in the 2017 financial year to the firms that look after its private equity investments. The management fees alone accounted for nearly half of what went to managers across all asset classes, although the pension system had only 8% of its assets in PE.

At the same time, private equity is CalPERS' best-performing asset class on a five-year and a 10-year basis and it wants to maintain some exposure. Figuring out how to maximize the upside from private equity while bringing down the costs is a priority for many institutional investors. Various solutions have been suggested, from removing the management fee for larger GPs and increasing the carried interest share to reducing average costs by pursuing zero-fee co-investment.

However, when asked if US pension funds can replicate the direct investment-centric approach of their Canadian counterparts, most industry participants are skeptical. Their mandates are too restrictive, and they can't pay market rate for top talent. Unless co-investment is somehow outsourced, it remains a talking point rather than an action point.

In this context, CalPERS' announcement last week that it would form a direct investment unit marks a significant development. There had been speculation that the pension fund would outsource the business, but as it turns out, the preferred solution is in house. A new entity called CalPERS Direct will deploy up to $13 billion a year through two funds: one focused on late-stage investments in technology, life sciences, and healthcare, and the other on traditional buyouts. CalPERS Direct will operate alongside the pension fund's existing PE program that makes fund commitments.

It will be interesting to see how this strategy develops. On a very broad level, the strategy appears comparable to that pursued by an assortment of sovereign wealth funds and Canadian pension plans. But there is a big difference between theory and practice. CalPERS has yet to receive board approval for the direct investment unit, let alone begin the process of defining governance and oversight protocols or think about staffing. 

Shortly after the CalPERS news broke, Canada Pension Plan Investment Board (CPPIB) released its annual results – so insights into the direct investment ambitions of one LP were followed by a snapshot of a counterpart that is further along the evolutionary curve. Private equity accounted for C$72.4 billion ($56 billion) out of CPPIB's C$356.3 billion portfolio as of March 2018. Over the preceding 12 months, it committed C$7.9 billion to funds, C$3.2 billion to 19 co-investments, and more than C$4 billion to 16 secondary deals. A further C$4.1 billion went into direct PE transactions.

CPPIB paid just over C$1 billion in management fees and C$709 million in carried interest to third parties, primarily private equity firms and hedge funds. Emerging markets and foreign private equity were two of three top-performing segments on a one-year basis, returning 19.5% and 16%. CPPIB's overall return was 11.6%. 

Importantly, the pension plan is willing to invest in the people it needs to deliver outsize returns, with nearly 1,500 full-time employees, of which about 300 are based in seven satellite offices outside of Canada. Total personnel expenses totaled C$712 million for the 12 months ended March 2018, up C$87 million year-on-year. The increase reflected additional hires required to work on a growing portfolio and compensation tied to fund performance.

CPPIB will not get it right all the time, but a key part of establishing a successful private equity program – especially when making less frequent but larger ticket co-investments – is having the conviction that a suitably resourced team will beat the market most of the time. Scattergun approaches are unlikely to pay off in the long term.

Last year, AVCJ sat down with an investment manager from a US pension fund who was part of a small team responsible for private equity. He had been in the job 18 months, was spending much of his time traveling the world looking at co-investments and appeared to be riding a prolonged wave of adrenaline. The deal flow was interesting enough, but there were nagging doubts as to how long it – or he – would last.

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• Topics
• LPs
• North America
• California Public Employees' Retirement System (CalPERS)
• Co-investment
• Direct investment