Managing allocations

The California Public Employees’ Retirement System (CalPERS) is widely considered to be one of the alternative asset industry’s premier investors, having amassed a $31.2 billion portfolio across 741 investment funds through the end of the third quarter.

CalPERS’ private equity portfolio includes $4.5 billion in credit-related strategies (as of 30 September), which accounts for roughly 14 percent of the retirement system’s allocation to the asset class. That portfolio includes investments in distressed securities, mezzanine, debt, turnaround strategies and other similar debt strategies.

Through September, those investments had netted a 27.44 percent one-year return; a 21.45 percent three-year return; a 14.33 percent fiveyear return and a 15.24 percent total return.

Along with its $19 billion portfolio in buyout strategies, credit-related strategies drive longterm private equity performance for the retirement system, according to documents released by CalPERS last year.

Maintaining that portfolio is no easy matter, however. Earlier this month, CalPERS released data indicating that improved equity markets have led many of the private market managers they back to exit a large number of their investments, which in turn has caused an unexpected dip in the retirement system’s actual allocation to private equity.

“Capital market conditions produced outsized returns in the public equity market and other asset classes during 2013. Total fund assets grew from $248.8 billion at January 1, 2013 to $283.6 billion at December 31, 2013, an increase of 14 percent,” according to a Pension Consulting Alliance (PCA) memo presented at CalPERS April meeting. “In 2013 and continuing into 2014, these conditions have encouraged many private market managers (private equity and private real estate) to be net sellers, not buyers.”

The end result was a whopping $7 billion in net cash flows, compared to an original estimate of $3.1 billion, which ultimately resulted in a lower allocation to private equity, according to documents released by the retirement system.

In order to maintain a 12 percent target allocation for private equity CalPERS would have to commit approximately $10.5 billion annually over the next three years, a $4.5 billion increase over than what the retirement system had anticipated when it approved the new target allocation earlier this year.

Although private equity and debt-related strategies have generated strong returns for CalPERS over the years, that performance is very much a function of its investment staff’s ability to invest with top quartile managers.

Tacking an additional (estimated) $4.5 billion per year in commitments could dilute the strength of the overall portfolio. It would also represent something of a setback for the retirement system’s stated goal of minimizing its number of relationships, having recently culled its roster from 762 funds with 398 managers to 741 funds with 389 managers. To circumvent the issue, its investment staff has proposed another reduction in the retirement system’s allocation to private equity, establishing an interim target of 10 percent.

At least one of the retirement system’s advisors agrees with the proposition: “The projected resumption of a 12 percent allocation over two years could, in PCA’s opinion, potentially result in commitments that will produce a reduced level of future outperformance. This could be mitigated by policy revisions that staff is considering for future presentation to the Investment Committee.”

Others differ. Although reducing the private equity allocation to 10 percent would eliminate the possibility of softening returns, doing so would also drop the target below what is considered ‘best practice’ by asset allocation experts.

“The target for private equity violates this best practice by dropping to 10 percent, outside of the old-new range of 12 percent [to] 14 percent. We believe that CalPERS would be more in compliance with common practice by shifting the PE target to the long term target of 12 percent,” according to Wilshire.

CalPERS had yet to decide on its new interim allocation to private equity at press time. Even so, the retirement system’s conundrum presents an interesting case study as to how LPs manage their portfolios, and how fluctuations in equity markets can influence the pace of commitments to other, less liquid strategies.