CalPERS board reflects on liquidity and leverage; higher delegation limits

At the height of the GFC, CalPERS was forced to sell assets it didn’t want to sell at the worst possible time. “What was actually liquid, was the high-quality stuff,” recalled Dan Bienvenue, deputy CIO at CalPERS who joined the fund back in 2004, speaking in a recent board meeting.

The Californian pension fund found itself overweight assets it no longer wanted to hold but finding a bidder was like staring into an abyss. In short, the GFC exposed a profound liquidity crisis, revealing that the giant fund had lost control of its own funding levels with a large securities lending book lent out for cash, liquidity spread throughout asset classes, and poor visibility on what capital calls lay around the corner.

Lessons learnt during those traumatic months rewrote CalPERS approach to liquidity, fed into the decision to add a 5 per cent strategic allocation to leverage and instilled a determination to be able to lean into opportunities in a down market.

Years in the making, these changes are now crystallised in the fund’s latest strategic asset allocation, in execution since July this year. “I can think of few things that are more important than we are prepared to be a buyer as opposed to having to be a seller when the market turns,” said board member Lisa Middleton.

Strategy in Action

Today, the $429 billion pension fund has dry powder on hand to invest, recently witnessed in an ability to buy into opportunities during the pandemic-induced sell off. Unfunded commitments sit ready in dry powder for partners. Dry powder also sits in separately managed accounts, at the ready to deploy alongside handpicked strategic partners in co-investment vehicles. Unlike in the past, all capital calls are in line with assumptions and models, and come at the right pace.

CalPERS sources of liquidity are deliberately diverse. Alongside dry powder stores or the ability to tap pension contributions as a source of liquidity, the fund can seize the opportunity to invest in distressed assets by selling equities, using that cash to purchase the asset while using an equity future to maintain the equity exposure. It amounts to liquidity on demand from the fund’s huge pool of liquid public market assets that are both saleable and desirable. A centralised approach also allows the fund to choose which funding sources best optimises the cost and composition for the portfolio at the time.

Today CalPERS has shrunk its securities lending book, and collateral calls are based on equity for equity the means collateral levels don’t change but move at the same pace as the market, Bienvenue said.

CalPERS regularly reports on its liquidity and leverage position – liquidity levels have been lower in recent months and could fall further on another leg down in markets. But a central pillar to the strategy and mark of its success lies in the fact the investment team doesn’t need to continually focus on liquidity because the pacing and framework is set in place. “We can focus on investment,” CalPERS’ investment director Michael Krimm, told the board.

Today, liquidity provisioning takes into account capital calls and margin for derivatives all with an eye on market movements and volatility based on internal forecasting models. Managing liquidity involves participation from across the fund, forecasting rebalancing needs, planning for capital calls and identifying market trends in a robust process.

The board heard how deep dive analysis over the years involved an exploration of the liquidity inherent in CalPERS assets, exploring the ease with which an asset can be traded and the income it generates. Findings revealed cash, government bonds and equities have the highest level of liquidity and are easily sold to meet funding needs. In contrast private equity and private debt have higher returns, but less opportunity to generate cash on demand.

Private markets

Alongside a new strategic allocation to leverage, CalPERS latest asset allocation promises a boosted allocation to private markets spanning private equity, real assets and private debt. November’s board meeting saw the investment team petition again for fresh tools and flexibility in managing the allocation – namely an increase to staff delegation limits.

“We need more tools and a refresh of policies put in place when the fund had a lower allocation to private assets,” urged CIO Nicole Musicco,  determined to build an agile investment philosophy that goes beyond simply setting a SAA and pressing the button. Set every four years using capital market assumptions stretching 20 years into the future, assumptions must also be reviewed along the way, working with partners and checking the governance, she said.

Although hard to accurately account the opportunity cost for not allocating more to private assets because of staff delegation limits (knowing CalPERS would be unlikely to invest, GPs don’t tend to come forward with opportunities) the investment team warned the cost had been high. For example, every $1 billion invested in co-investment earns around $335 million more over ten years than the same $1 billion invested in fund investments.

Higher delegation limits mean the team can accept the larger deal sizes needed to ramp up private equity exposure as CalPERS targest an annual commitment pacing of over $15 billion to achieve a target allocation of 13 per cent. The private equity team will have to look at as many as 50 deals per year to get close to annual coinvest commitment targets, making the ability to accept larger co-investment deals critical while reducing the monitoring burden of smaller deals.

As for private equity fund investment, CalPERS expects that 70 per cent of commitments will exceed the investment team’s current delegated authority limits. The team expects to commit to around 20 funds this year leading to over 70 core managers over time.

The team made 116 fund commitments in the last 5 years about half of which have exceeded the delegated authority. Two recent investments exceeded the CIOs authority and were scaled down. “It’s difficult to achieve scale with lower delegated authority limits and detracts from our ability to reach our SAA,” said Musicco.

It’s the same problem in infrastructure where investment needs to more than double in size over the next three years to meet SAA targets.  The team needs to commit $5 billion per year to infrastructure with an average commitment size of $1.25 billion per deal. The infrastructure team have made around 19 commitments in the last five years and 32 per cent were above the delegated authority and were approved by the CIO. Two deals exceeded the CIOs authority, and were scaled down to meet the CIO’s delegation limit.

Decision making culture

In the last investment committee meeting of 2022, Musicco explained that a crucial element to building CalPERS private market expertise includes revamping the Investment Underwriting Committee. The committee, one of three CIO-chaired committees and tasked with reviewing all private market allocations above a certain size, is now structured to draw on expertise from all corners of the investment team in a collaborative process.

“I chair it, but the real secret sauce is the asset class heads and other experts providing a diverse lens,” said Musicco. “You have better decisions when you have the right eyeballs round the table,” she said, concluding that a collaborative approach allows the team to  “learn a ton from each other.”