Eighteen months ago, the £16 billion ($20 billion) London-based Local Pensions Partnership, the new asset manager for three pooled local authority schemes in the UK, sent a member of its investment team on secondment to Australia’s Future Fund.

Still working for the LPP but based in Melbourne, the employee travelled back to the UK through the course of their stay to report what they’d learnt. LPP chief executive Susan Martin says the initiative reflects the organisation’s desire to challenge itself and learn from others.

“We are new and young, and we don’t have all the answers,” Martin says.

It is one of many endeavours over the last two years that have helped define LPP’s emerging culture, which will bind together its values, mission and aspirational vision for the future as one of the UK’s eight pools to emerge from 89 local authority schemes. Martin’s challenge has been to build a culture from scratch, rather than add to the existing ones she inherited from LPP’s two founding client funds, the London Pensions Fund Authority (LPFA) and the Lancashire County Pension Fund. The idea was to avoid one pre-existing culture becoming dominant, which would’ve endangered a central part of LPP’s ethos – that all clients must be treated the same. The Berkshire Pension Fund joined the pool at the end of last year.

LPP has a keen desire to partner, leading it to glean information from Canadian and Dutch pension funds, but other characteristics have emerged as its cultural building blocks as well. LPP combines public- and private-sector values; it is a public-sector owner and understands public-sector values such as not-for-profit status, yet it is wrapped in a keenly commercial, private-sector business. The public-private dynamic creates a constant juggling that Martin believes can make excellent organisations.

“We treat all clients as partners, treat their assets like they are ours, and act like we are a pension fund ourselves,” she says. “We come from a pension fund background and we understand this better than some other fund managers.”

Delegation and trust

Delegation and trust is another central theme. Just as client funds have delegated strategy implementation and the selection and monitoring of external managers and stock selection to LPP, so LPP delegates to its own internal teams.

“Investment implementation decisions are made by the executive investment committee, rather than by LPP’s board; investment decisions are made by the people who have the experience and knowledge to make those decisions,” Martin explains.

Within those teams, robust discussion and consultation are the norm, as the structured process for sounding out new investment implementation ideas illustrates. When an employee brings a new idea to the investment committee, someone else is tasked with playing devil’s advocate and challenging every point, she says. It’s an openness to ideas and challenges that will also nurture the LPP’s keen focus on risk, which runs throughout the business.

“Whether it’s liability risk, employer risk or just fostering a risk awareness, colleagues have the confidence to speak up about risk and you don’t see this amongst many consolidators,” she says.

LPP’s emerging culture already is reflected in the 120 people it has recruited since it set up two years ago, 29 of whom sit in the investment and risk team. Employees are a mix of gender, ethnic and cognitive diversity that will allow the fund to innovate and think differently, aligned by shared values. Martin has also sought to embed an open and meritocratic culture where new ideas are valued and staff are given the time to research them.

“It is about empowering colleagues who know they are valued, listening and encouraging them to come up with new things,” she explains.

Not counting on size for opportunities

LPP has also set itself apart from the other seven entities to emerge from the UK pooling process in another important way: it believes big isn’t necessarily better.

That said, assets under management have grown. LPPI, the wholly owned investment arm of the pool is now running the alternative investment fund behind £1.2 billion ($1.5 billion) GLIL Infrastructure, an investment platform with a UK and European bias backed by five local authority schemes.

The number of clients has also grown, with the arrival of the Berkshire Pension Fund, but at only £16 billion, LPP is still noticeably smaller than other pools; for example, Border to Coast comprises 12 partner funds with £50 billion ($68 billion) in assets under management.

Even so, rather than size, Martin says her priority is to add value to her current client base; she won’t chase growth and scale for the sake of it and has turned down opportunities for LPP to expand its asset base.

“We are not here to grow the business, investment team or the assets under management for growth’s sake. All we want to do is add value for our clients and this is how we look at every project.”

With that same goal in mind, she isn’t prioritising bringing management in house and has no plans to build a big internal team. For now, internal management is confined to a £2.2 billion global equity allocation and about half of LPP’s infrastructure allocation, which LPPI invests directly, via the GLIL Infrastructure platform. Martin’s strategy is to run assets in-house where the LPP can add value but defer to fund managers with whom she has long-term partnerships for other allocations. LPP wasn’t set up only to save on fees, she notes. It’s also tasked with creating diverse portfolios, accessing new markets, hitting return targets, reducing risk and improving funded levels.

This means she downplays the importance of size in accessing investment opportunities. Of course, LPP is now able to look at different opportunities and has attracted more interest from co-investors, but Martin believes opportunities arise between like-minded partners no matter what the size. Infrastructure investment is a prime example of where opportunities to invest, either alongside the LLP or through GLIL, are open to other local authority schemes and investors, whatever their assets under management.

“It’s not about putting in big ticket, it is about a collaboration of like-minded people putting the work in to get that big ticket,” she says.

Building a new culture is challenging; culture is intangible and difficult to define and measure. But there is one way to tell if you are getting it right or wrong.

“Our clients are happy,” Martin concludes.

The One Planet Sovereign Wealth Fund Working Group has published its framework for integrating climate-change risks and investing in the smooth transition to a low-emission economy. Now the group is encouraging other large institutional investors to adopt the plan.

The framework is one of the commitments of the SWF working group established at the One Planet Summit held in December last year. It aims to accelerate the integration of climate-change analysis into the management of large, long-term asset pools.

The goal is to help investors identify the exposure of investee companies to climate-related risks, and determine which companies are best prepared to manage or exploit opportunities.

The idea is that SWFs are in a unique position to promote long-term value creation and sustainable market outcomes due to their size and investment horizons, and that the framework will help create consistency and common methods in disclosure, analysis and decision-making around climate-related issues.

The six founding members of the working group, which collectively manage more than $3 trillion, are: Abu Dhabi Investment Authority, Kuwait Investment Authority, the New Zealand Superannuation Fund, Norges Bank Investment Management, the Public Investment Fund of the Kingdom of Saudi Arabia, and the Qatar Investment Authority.

The plan was developed by the founding partners in consultation with other institutional investors. While voluntary, the hope is that SWFs and other large institutional investors adopt it.

The framework sets out guidelines under three principles:

  • Principle one: alignment. Build climate-change considerations into decision-making.
  • Principle two: ownership. Encourage companies to address material climate-change issues in their governance, business strategy and planning, risk management and public reporting, to promote value creation.
  • Principle three: integration. Build the consideration of climate change-related risks and opportunities into investment management to improve the resilience of long-term investment portfolios.

The working group states that the methods it identifies in the framework should help improve the quality of climate-related financial information and support the assessment of climate risks, which will ultimately help investors allocate long-term capital more efficiently.

“By using the framework, SWFs can reinforce their long-term value creation, improve their risk-return profile, and increase long-term portfolio resilience by factoring and integrating climate issues into their decision-making,” the group states. “The One Planet SWF Group hopes that other long-term institutional investors will be able to make use of this framework in the execution of their mandates and investment objectives.”

A number of the founding signatories, including Norges Bank and NZ Super, have been world- leaders in climate-change investment integration (see NZ Super cleans out its carbon, and Norges’ 1-stop shop for risk data).

The One Planet SWF initiative is championed by French President Emmanuel Macron. Earlier this month, he and Norwegian Prime Minister Erna Solberg convened a roundtable discussion with the working groupat the Elysée Palace to mark the publication of the framework.

 

The framework can be accessed here: One Planet SWF

 

A group of institutional investors are collaborating to address the G7 priorities of climate change, gender inequality and the infrastructure gap. They have agreed to commit resources, expertise and networks to these key areas.

Canada’s Caisse de dépôt et placement du Québec and Ontario Teachers’ Pension Plan (OTTP) lead the group, which also includes Alberta Investment Management Corporation, California Public Employees’ Retirement Scheme, Ontario Municipal Employees Retirement System, OPTrust and PGGM. They have all agreed to: prioritise speeding up the implementation of uniform climate-related disclosures; open opportunities for women in finance and investment; and enhance expertise in infrastructure financing and development in emerging and frontier economies.

Commenting on the collaboration, Barbara Zvan, chief risk and strategy officer at OTPP and one of the key organisers of the global initiative, said the investors were “excited” and have developed practical programs to further these G7 priorities, including through capital commitments.

With regard to climate-related disclosures, the priority is to promote a common approach to adopting FSB Task force on Climate-related Financial Disclosures (TCFD)guidelines, to make disclosures easily comparable across institutions and companies.

Partner institutions will set up an advisory committee made up of their representatives, which will assess existing efforts to adopt the TCFD recommendations, leverage these into a unified approach, and publish guidance. They will also promote the adoption of the recommendations at portfolio companies.

With regard to gender diversity, Zvan says global investors’ size and reach make them well-positioned to exert a powerful influence over the industry.

To increase the number of women in investment management, the partner institutions have agreed to develop and implement diversity policies inspired by global best practice, including the 2016 International Finance Corporation report SheWorks: Putting Gender-Smart Commitments into Practice. Alongside the Canada Pension Plan Investment Board, partner institutions will also collaborate with the CFA Institute to set up an internship program for women studying in developing markets to gain experience in the investment industry.

“As investors, we all work with a lot of fund managers, and we will be asking them to set these policies, too,” Zvan says.

OTPP will insist managers have a diversity policy and measure them on adoption of it.

Describing the infrastructure gap, the group cites the fact that the world needs to invest $3.3 trillion in infrastructure annually through 2030 to keep pace with projected growth.

To tackle this problem, partner institutions will launch a fellowship program for senior public-sector infrastructure managers in emerging and frontier markets.

The fellowship will include a three-month intensive business school program and an internship on the infrastructure teams of some of the world’s leading investors.

Initially, the fellowship will be in partnership with York University’s Schulich School of Business, in Toronto. Other business schools in Canada and around the world will eventually participate.

The fellows will also receive advanced training on the Sustainable Infrastructure Foundation’s (SIF) platform for infrastructure project development. The number of fellows is expected to grow to more than 30.

“It’s really hard to buy emerging markets infrastructure, and it depends a lot on the relationships you have,” Zvan says. “We thought of the internship idea, with SIF, to help create better documentation for these projects. There are plenty of studies saying we need to invest trillions, so we wanted to look at how we could help get these projects created and funded.”

The internship will be aimed at engineers. It will help give them the ability to understand finance and create a network, then the pension funds can learn from them.

“It won’t solve the problem around infrastructure but will make a dent,” Zvan says.

These global initiatives were launched in June to coincide with Canada hosting the G7.

 

Like many super funds the Australian fund, Local Government Super (LGS) had a rough time in the global financial crisis. It performed poorly and its board became risk averse. As a result, by June 2011, the portfolio was restructured around a passive core. About a third of it was in passive investments, and in some core asset classes such as Australian equities and international equities, 50 per cent was managed passively. Australian bonds were entirely passively managed.

This plan was centred on reducing management fees at a time when performance was off, and as chief investment officer Craig Turnbull says, it was about controlling risk relative to the benchmark.

Fast forward to June 2018 and the $11 billion fund has no passive investments.

Over the last seven years, it has gradually allocated more and more of its portfolios into active strategies, culminating with the final chunk that was still passively managed – 10 per cent of international equities – moving to active last year.

Within equities, the change was focused on finding managers that were risk controlled. It’s true that some of LGS’s assets are managed in enhanced passive. In fact, four low-risk quantitative managers – State Street Global Advisors (SSgA), Hermes, BlackRock and AQR Capital Management – now account for 40 per cent of all equities, but “enhanced passive is still active”, Turnbull says.

The preference for active management came as Turnbull and the board gained confidence in finding active managers.

“We wanted managers that had a good track record and were willing to back themselves,” he says.

As part of the deal, new fees were put in place – a base rate that is the equivalent of a passive fee, and a performance fee where the manager keeps 10 per cent to 15 per cent of the outperformance over the benchmark.

These enhanced passive managers are complemented by a handful of highly concentrated active managers, with some mandates, such as ECP Asset Management and Ubique in Australian equities, holding only 20 to 30 stocks.

“Moving to active has worked well for us and our members,” Turnbull says.
For the period ending March 31, 2018, performance numbers from the fund’s custodian, JP Morgan, show that for all of the LGS diversified funds, over one-, three- and five-year periods, active management has added value after fees and costs.

“Every one of the 13 asset classes is outperforming; this is not what you’d expect and it is largely due to active managers,” Turnbull says. We have been in alternatives for eight to nine years, and they have very high fees, but even there we are getting positive returns after fees.”

In Australian equities, the portfolio has a slight tilt to small caps, with an allocation of 14 per cent, versus the 11 per cent benchmark, and while Turnbull acknowledges that “this has helped a bit”, he says the performance is still largely due to manager outperformance.

Similarly, in international equities, there is an emerging-markets tilt, with a 14 per cent allocation versus the MSCI benchmark of 10 per cent. But again, Turnbull says most of the outperformance has come from managers, rather than style or geographical tilts.

The fund’s performance attribution examines a number of elements, including asset allocation performance, manager performance, style bets and currency.

Turnbull says 80 per cent to 90 per cent of the fund’s outperformance has been due to managers.

“We don’t often take tactical asset allocation bets, it is hard to add value consistently. We don’t take extreme positions in style bets and currency positions can be volatile,” Turnbull says.

Spreading the word

It’s a story LGS is keen to tell.

The team feels passionate about the impact active management has had on the fund’s performance, and ultimately
the benefit to members.

It thinks the widespread focus on costs is potentially to the detriment of members’ outcomes, and the fund has been actively engaging with ASIC about the complication of assessing MySuper products on fees alone.

“The RG 97 disclosures don’t make sense,” Turnbull says. “Our outperformance is because of the good performance from our active managers. We think the current disclosure regime is biased against active management. But active does add value for members. In this context, does RG 97 really make consumers make the right decision?”

Analysis by LGS over the last three years shows that a low-cost alternative would have produced 69 basis points a year less than the current LGS balanced fund, which includes alternatives and active management.

Chair of the investment committee, Craig Peate, acknowledges that it was a bold move to shift away from the fund’s traditional passive investment philosophy, especially after the GFC.

“It took foresight and a concerted effort over the last seven years to convince the board and investment committee on the merits of active management and in particular manager performance,” he says. “We watch closely the benefit the members and the fund obtains from higher manager fees.”

More risk

Despite the shift to active, the tracking error of the portfolio has not increased.

“We have a 2 per cent limit on tracking error in the major sectors and the portfolio is now sitting well below that,” Turnbull says.

In Australian equities, for example, he tracking error of the portfolio is sitting below 1 per cent, and Turnbull is, in fact, looking at ways to take on more risk. This might mean a re-weighting to more concentrated managers or allowing managers more freedom to move within mandates.

“This doesn’t mean more market risk, but it could occur in manager weightings or liquidity levels, there are ways to take on more risk,” Turnbull says.

The fund has a limit of 25 per cent it can invest in illiquid assets across Australian direct property, defensive alternatives, opportunistic alternatives and private equity.

“I think that is a bit low,” Turnbull says. “In practice, we have to run it at around 20 to 21 per cent, so we don’t have to sell at the wrong time. Maybe we consider a larger illiquidity allocation.”

Manager selection

LGS has been well recognised for its commitment to sustainability. And Turnbull believes the integration with the sustainability team, led by Bill Hartnett, has given it an edge in manager selection.

“Being a long-term investor, we want managers that are focused on the long term,” Turnbull says. The fund has a relatively low turnover of managers – about one to two a year.

“Some managers have been with us a very long time; for example, PIMCO has been managing money for us for 16 years and BT for 12 years,” he says. “But even though we are a long-term investor, we like to be able to terminate managers at short notice. We need flexibility.”

Turnbull points to some good manager appointments in the last year. These include Resolution, a local global real-estate investment trust manager, and BlackRock for a low-risk Australian equities mandate that Turnbull says is “off to a fantastic start”.

He also says the fund’s sustainability bent has led it to some good niche managers at the margin, such as Attunga, which is “a little hedge fund with incredible performance” that invests in the Australian electricity market. It’s returned 15 per cent for the last seven years, annualised.

The main consultant is JANA, and the investment committee typically takes on its recommendations, which are supported by the consultant and Turnbull’s team.

“We have good support from the investment committee, about 90 per cent of the things we take to them with the consultant they support. But if it’s a new field or they need more time, then they take the time,” he says.

Within alternatives, he gives credit to the advisers the fund has used. For the last three years, this has included Cambridge Associates, but for a long time the principal adviser was Quentin Ayers. These advisers did much work to get the fund access to managers that
have performed well, and Turnbull acknowledges the importance of this access.

“Managers like Bain have been amazing, and Quadrant has been good. You can’t get access to new funds unless you have relationships,” he says.

While traditionally reliant on consultants, Turnbull acknowledges that the internal team of 10 has improved, in particular in areas such as manager selection, and has now built up a good long-term record.

The vast majority of LG Super’s assets are managed externally but the fund does manage a 5 per cent property allocation in-house. It’s been a star performer, returning 21 per cent a year over the last three years.

The portfolio is Sydney-based direct property across retail and industrial, and has a very high green rating.

“The portfolio has 5 green stars, which is very high for a portfolio of older buildings. This hasn’t hurt our valuations and our tenants are happy. Our team has performed very well,” Turnbull says.

In the last six months, the fund has had a governance review and a strategic asset allocation review, which resulted in a swing towards international equities and away from Australian equities.

“A year ago, we had more Australian equities than international equities, [unlike] other funds, now we are winding that back,” Turnbull says.

The governance and decision-making has also been honed slightly. Where previously the board had final sign off on investments, this has been delegated to the investment committee, giving Turnbull and the team one less hurdle to jump through. Turnbull works closely with the investment committee and tracks and measures decisions closely.

For example, it measures the positive value add from the fund’s focus on sustainability and reviews a monthly table on the performance of its sustainability-focused managers.

“They have always made a positive contribution. Not every manager is adding value over every period but as a total they are,” he says.

He says sustainability is largely about having the right managers and whether they care about sustainability risk.

“We have developed a framework that rates managers on sustainability. Every manager gets a rating, we like to invest with leaders.”

The investment committee also tracks every decision it makes and rates them all as good or bad.

“The biggest lost opportunities for the fund have been the managers we looked at but didn’t hire. But you can’t invest in everything,” Turnbull says.

The State of Alaska is rightly known for its frontier spirit and fierce independence. So it may be surprising to some that we at the Alaska Permanent Fund Corporation attribute strong recent performance in part to the vigour with which we have pursued a strategy of teaming up with outside partners across our $65 billion portfolio. This strategy leverages our institutional strengths (clear mandate, patient capital) and mitigates our weaknesses (small staff, remote location). Partnership is among the most overused (and, too often, abused) terms in asset management. For Alaska, the term has central importance and refers to three categories of partners: fund managers, specialised advisers, and institutional peers.

The first category, partnerships with talented fund managers, relies on a critically important task: identifying capable external managers with differentiated skills and sustainable competitive advantages. We seek to team up with these managers to design and implement initiatives that meet their institutional objectives and ours. The MEASA Stock Fund (focusing on publicly traded equities in the Middle East, Africa and South Asia) we recently formed with McKinley Capital management is a good example.

The APFC has been investing in emerging markets for many years. We believe exposure to the fastest-growing economies in the world is increasingly important. And we recognise that there are risks and challenges investors need to address to maximise the probability and extent of their success. In this context, APFC developed the concept of a public equity fund targeting about 30 of 80 eligible markets in the Middle East, Africa, and South Asia that appear to offer the best risk-reward trade-offs. These targeted countries are home to 44 per cent of the world’s population yet account for only 12 per cent of GDP, 6 per cent of equity market capitalisation, and 2 per cent of equity index capitalisation.

APFC considered a range of potential fund managers to lead the launch of the MEASA Stock Fund and ultimately selected McKinley Capital, a quantitative growth investor that has managed APFC assets for many years. Together with McKinley, we designed features to address several concerns. For example, the MEASA fund is intended to offer a listed, closed-end share class in addition to an institutional share class, in order to minimise ‘hot money’ price distortions in these emerging and frontier markets. Also, an arbitrage mechanism is built into the listed share class structure in order to reduce any potential gap between unit price and underlying net asset value. The fund is expected to list on two exchanges eventually – New York (NYSE) and Abu Dhabi (ADGM). As the MEASA fund and the underlying capital markets develop, and the impact of what is expected to be a multibillion-dollar fund becomes apparent, APFC hopes to benefit incrementally from a revenue-sharing provision that further aligns our success with McKinley’s.

Partnerships with advisers

The second category of partnership is with specialised advisers and consultants, to leverage our internal team, improve deal flow, and enhance our due diligence and transactional capabilities. This category includes investment consultants and outside counsel, plus more specialised advisers that offer skills or intellectual capital that complement our internal resources. These advisers can range from credit analysts to molecular biologists, and in all instances, we’ve found that the greatest value for all parties is realised from the most robust, systematic long-term relationships.

Partnerships with peers

The third category of partnership has the potential to be the most powerful and impactful: joining with like-minded institutional investors to pursue important strategic or tactical initiatives. Many institutional investors believe they are competing with their peers for a finite pool of alpha – and this is sometimes the case; however, there are also several areas where common challenges, common goals, and complementary resources create opportunities to join together and create tremendous value for all participants. Private equity co-investments and manager seeding strategies are two prominent examples of areas in which individual limited partners can create powerful affiliations that propel asset growth and extend institutional reach.

Although asset allocators talk frequently about joining with other allocators, the gap between dialogue and formal partnerships has been surprisingly difficult to bridge, with relatively few examples of successes and, until recently, none that combined capital across continents into a shared mandate. This is one reason we have been enthusiastic about the launch earlier this year of Capital Constellation, a joint venture between ourselves, the British Railway Pension System (RPMI Railpen), and the Public Institution for Social Security (PIFSS) of Kuwait, designed to back the next generation of private equity and other alternatives managers.

Constellation’s strategy seeks to back a new generation of managers whom we believe represent some of the most promising investor entrepreneurs in private alternatives. This strategy aligns us with these managers through economic interests in their firms and allows us as asset owners to vertically integrate with investment managers who share our view that collaboration can transform alternatives into a positive-sum game in which limited partners and general partners share a deeper interest in our mutual success and a formal commitment to active partnership. In the months since launch, Constellation has already forged partnerships with Astra Capital and Ara Partners, dynamic teams in the communications and energy sectors.

Not about fee avoidance

Partnership can sometimes be code for disintermediation or fee avoidance. That is neither the form nor purpose of the partnerships we initiate. Our primary objective is not to minimise fees but to maximise net returns, subject to risk parameters our board has established. We believe we can do that most effectively by joining with others and pursuing our mutual self-interests. Very often, this joint pursuit has resulted in reduced portfolio risk and diminished fees. And while fee reduction isn’t the primary objective of our partnering strategy, it has been a substantial benefit.

Our private equity co-investment program is an example. Over five years and 24 separate investments, it has delivered a net IRRof 64 per cent and an investment gain of $1.4 billion (at 31 March 2018). Our primary objectives with this program are to boost returns, improve information flow, and mitigate overall portfolio risk. Based on those objectives, the program has so far exceeded our targets. It has also allowed us to avoid an estimated $282 million in fees and carry.

The spirit of independence is alive and well in Alaska. We believe that the best outcomes follow from an honest assessment of one’s own capabilities and a clear-eyed view of the obstacles ahead. It is our mission to continue to deliver attractive returns for the benefit of all Alaskans and we intend to do that not by chipping away at the fees we pay along the way, but by teaming up with capable partners for the long journey ahead.

Russell Read recently resigned as chief investment officer of Alaska Permanent Fund Corporation. Steve Moseley (pictured) is the head of private equity at APFC and a founding board member of Capital Constellation.

 

The 13 investment committee members for the California Public Employees’ Retirement System were publicly scrutinising unprecedented changes in the $26.9 billion private equity portfolio of America’s biggest pension fund. Their sense of responsibility was tangible.

“I feel the weight of this. I feel the weight it has on the pension plan but also the state and the cities,” said Dr Ashby Monk, executive and research director of the Stanford Global Projects Centre, speaking at CalPERS’ June committee meeting. “This is an incredibly important decision for the health of our state.”

Mixed in with the responsibility was a palpable frisson of excitement, as the $356 billion pension fund prepared to unleash its best-performing asset class. Private equity has averaged 10.6 per cent annually over the last 20 years and is also the only portfolio forecast to beat CalPERS’ 7 per cent return target over the next 10 years.

The new private equity strategy, now just awaiting board approval, will build an arm’s-length entity – CalPERS Direct – with its own investment staff and board, targeting long-term direct investments in private equity and venture capital to better match the fund’s liabilities. CalPERS aims to invest $10 billion to $13 billion a year, building the portfolio from 8 per cent of assets under management to 10 per cent, in an allocation that will also include beefed up emerging manager and partnership programs.

The investment committee didn’t discuss allocations to any of the specific pillars but endorsed the need for change. Members voiced their responsibility to get the structure and governance right. The first step of the process also flagged some of the challenges on the road to the slated launch in early 2019.

Time’s wasting

None is bigger than getting the large, public body to act quickly. Getting this far has already taken three years of intense review and analysis; now market conditions are driving a new urgency, as opportunities in public markets shrink. The number of listed companies is half what it was two years ago, and private equity is the only source of return capable of making a meaningful dent in the fund’s 71 per cent funded status.

“If we are not doing this today, we are going to be passed by,” CalPERS board member Richard Costigan warned.

Moreover, shifting dynamics in the private equity market make reform of the portfolio particularly timely now. The portfolio’s long-rooted and primary focus on selecting external co-mingled fund managers means CalPERS will miss out unless it adapts. Co-investment and secondary opportunities coming out of fund investments, along with opportunities to structure separate account relationships, will increase with disruption in the industry. Founders of many of the original private equity firms are retiring and succession plans will reveal opportunities for structures such as separate accounts or fresh relationships on new terms as talent spins out into start-up firms, CalPERS departing chief investment officer Ted Eliopoulos says.

“The capability to undertake co-investment and a secondary investment program at scale requires a different underwriting capability than selecting [general partners]; the ability to underwrite and invest in an individual portfolio company, or a whole portfolio of portfolio companies, is a different skillset than underwriting capabilities of a GP,” Eliopoulos told the board. “Accessing some new talent in this area is really necessary for us.”

The quicker the portfolio is restructured, the quicker CalPERS can control fees by aligning itself more directly with GPs. Last fiscal year, CaLPERS paid more than $700 million in private equity fees and carried interest giving about 20 per cent of its profits to its GP partners.

“For 10 per cent of what you spent on this asset class last year, you could operate the entirety of this investment operation,” Stanford’s Monk observed.

The board also heard that under the current structure, the ability of the pension fund to negotiate on fees is difficult.

“Our ability to sit across the table from a successful GP and insist fees are lower [is limited] when we have no leverage or basis on which to do this in the primary co-mingled fund area,” John Cole, a senior portfolio manager at the fund, said. “As we become more of a presence in direct vehicles, there is a tremendous potential for economies of scale, as we work away from the management fee towards a budget-based compensation system.”

The new structure will allow CalPERS to lower the risk of its private equity investments but still generate similar outcomes. GPs increase risk in a 2:20 fee structure to capture carry, cover their costs and meet investor returns, introducing leverage and other interesting structures, Monk explained. Because CalPERS Direct will hold assets over decades, it will help eliminate these fees, and holding companies long term will also axe the costs involved in buying and selling companies across the portfolio.

Getting the governance right will be the investment committee’s biggest challenge. Part of the process will involve setting the terms of the process for nomination to the CalPERS Direct board, determining the qualities and expertise it wants, and establishing a detailed definition of the delegations of authority. The arms-length structure needs to give CalPERS Direct the breathing space to innovate and empower success but allowing innovation and creativity to flourish in a public pension plan is difficult.

“Innovation thrives where waste is part of the process,” said Monk, quoting former IBM chief executive and chairman Thomas Watson, who said successful innovation requires high failure rates. “Are you ready to double your failure rate in this organisation? I don’t think so.”

Indeed, some board members are already concerned about the level of control CalPERS will have over the new entity, particularly since ultimate responsibility rests on their shoulders.

“How do we get the alignment of interest when there is no CalPERS board member on the board of the new entity,” elected member representative Margaret Brown asked. “The current governance structure doesn’t have any CalPERS appointees or members on the new entity.”

Other potentially sticky issues include pay. The arm’s-length structure will allow CalPERS Direct to compensate and reward staff differently to what is possible in a public pension fund and is therefore crucial for recruiting the talent required. The appeal of not having to raise funds, and CalPERS’ noble mission, will draw expert candidates, but they won’t come unless the pay is right. CalPERS staff told the committee the new entity would usher in an unprecedented level of expertise and networking capability at the pension fund, yet big salaries could be a source of unease among some committee members, who listened in the same session to persuasive arguments from the public about the role private equity firms played in the collapse of Toys ‘R’ Us. Even so, Monk touted the value in paying for talent.

“Every manager and every company will want to talk to you. You will have networks no one else will have,” he urged. “This could be a breeding ground for a new generation of investor that is thoughtful and is also incredibly commercially successful.”