Beset By Falling IRRs, CalPERS Plays Defense –

SACREMENTO – Shrinking IRRs and a souring capital environment are forcing change upon CalPERS – the California Public Employees’ Retirement System – a colossal investor whose movements in the months to come may cast shadows throughout the private equity universe. For the year ending July 31, 2001, returns on its Alternative Investment Management Program’s (AIM) overall portfolio hit 13.28%, and for the month of July, returns bottomed at 0.57%.

Now Richard Hayes, who stepped in to fill Barry Gonder’s shoes as senior investment officer for the AIM program at the start of the fiscal year, is being forced into a defensive posture. Not only has he drafted an investment program that is refined, focused and opportunistic for the 2001-2002 fiscal year, but he has set into motion a number of administrative reforms to create efficiencies within the portfolio and open the lines of communication between the pension fund and its investment partners.

CalPERS manages about $155 billion for 1.2 million public and state employees and their families. Though a late entrant into the private equity sector, since its 1990 initiation CalPERS’ AIM program has become the world’s largest private equity investor with commitments of nearly $18 billion. Known in its early years as a late-stage and buyout investor in 1996, following the appointment of Gonder as senior investment officer, the program began to diversify across the private equity universe and grow internationally.

At the end of December, the program counted 163 active partnerships, including a $1.7 billion fund-of-funds managed by Grove Street Advisors, stakes in top-tier firms like ARCH Venture Partners and Berkshire Partners, six of its own investment vehicles and 26 direct investments. Corporate restructurings still account for 36% of the portfolio, venture capital is represented by 16%, expansion capital counts for 11% and 4% is held in secondary interests. These investments span the globe and spread across industry sectors to include consumer-related investments, investments in telecom and media, health care and financial services.

Staying in the Game

CalPERS, although faced with plunging IRRs, has not pulled out of the investment market. At its most recent investment committee meeting last month, external advisors Texas Corporate Group, which sources direct investment opportunities for the system, said it had received and reviewed 142 deals this year, including 18 since mid-June. Of those, 117 were rejected and four were in due diligence reviews. Hamilton Lane Advisors, an external advisor that sources LP interests for CalPERS, has received 245 proposals so far this year, and 40 since mid-June. It has rejected 117 of those, while 39 deals are in the preliminary screening phase and another 16 are currently in due diligence reviews.

Still, the retirement system has fine-tuned its preferences within the asset class to position itself defensively, and opportunistically, against a weak capital market. According to the AIM program’s annual plan for fiscal year 2001-2002, the team expects to build and expand new investments in attractive cyclical, contrarian and value-added opportunities.

It also will invest more actively in distressed equities and secondary interests – in deals like the May commitment of $122 million to Sports Capital Partners. CalPERS acquired the position in May from JP Morgan Partners, which had originally paid $100 million in 1998 for its partnership interest, of which about $40 million had already been drawn down when CalPERS stepped in. CalPERS reportedly paid face value for the $60 million worth of undrawn funds, but paid a steeply discounted $13 million for the remainder.

CalPERS also will pursue opportunistic international situations with high-quality partners both in Eastern and Western Europe. Although 81% of the alternative investment portfolio is centralized in the U.S., the system has poured $250 million into European private equity funds since June with investments in U.K.-based Bridgepoint Capital’s second private equity fund and in The Candover Fund.

While the system is still on track to make between $2 billion and $4 billion of new commitments within the private equity sector this year, it has fixed risk-return goals for each investment class. For seed capital investments, the system expects to see a 30% return on invested capital. For early-stage VC and late-stage VC, CalPERS’ goals hover around 25%. It expects a 20% return on buyout and later-stage investment, and set a 15% return target for mezzanine capital.

Faced with recent declines in IRRs, however, Wilshire Associates, an external advisor to CalPERS’ private equity practice, warned recently that it would rather see monies not invested in the AIM program than invested in marginal deals to keep up with expected annual pace. It suggested that selectivity and diversification would be the best defense against a weak capital market, but that the monies should be invested elsewhere, a goal that could be accommodated through the ranges around each asset allocation.

Despite the wary tone of his advisors, Hayes, who developed the 2001-2002 annual plan, said, “I wrote that plan. I’m very confident where the portfolio is today.”

Currently, CalPERS’ allocation for alternative investments is 4.8%. The target is 6%. In CalPERS’ 11-year AIM practice, Hayes said, the group has never reached that asset allocation target. Thus, the group will continue to invest at a steady pace and be opportunistic.

The New Sheriff in Town

“I plan to do a lot of thinking,” Hayes said, upon taking on the senior investment officer role. “It’s a time of transition.”

Hayes joined the group in May 1998 as senior principal investment officer. Credited with spearheading initiatives like CalPERS’ relationship with Thomas Weisel Partners, The Carlyle Group, Texas Pacific Group, and CalPERS’ own Biotechnology, Corporate Partners and California Initiatives.

Following Gonder’s five-year tenure, Hayes was named senior investment officer for the AIM program in July. In his new capacity, Hayes reports directly to the system’s chief investment officer, Daniel Szente.

The system made headlines in August when the private equity industry noticed a list of all CalPERS’ partnerships – along with a total value multiple, IRRs, losses and a performance rating – posted on its Web site. Though there was immediate talk that internal politics forced the system to reveal the information and it was possibly in violation of confidentiality agreements with its GPs, CalPERS has said the decision to post the report online was an administrative one, part of its commitment to open processes. In fact, the report – a quarterly report made to the system’s board on the performance of its private equity portfolio – had been posted on the site since October 2000.

At the same time, Hayes is pushing for administrative change, working to streamline systems and develop Web-based practices in order to create efficiencies and industry-level standards within the private equity universe.

Already the plan sponsor’s benchmark and capital call systems are online. Three years ago it launched an online portfolio accounting system with State Street Private Edge. It also is constructing a stock distribution program with Thomas Weisel Partners that will allow the team to manage the stock portfolio and capture any additional value there rather than sell the stock immediately, Hayes said. The group also is working to develop an online deal log, and use virtual office solutions like desktop videoconferencing to improve communications with investment partners.

As chairman of the Institutional Limited Partners Association, a trade association for private equity investors, Hayes anticipates introducing CalPERS’ initiatives to create industry-wide legal and investment standards and an electronic forum for communication among investors.

With administrative changes on the fast track and an investment strategy set to capitalize on near-term opportunities, CalPERS’ retrenchment may lighten the shadow already cast on the private equity industry by the see-sawing public markets and a potential recession lurking over the horizon. While the system’s mass is enough to move markets, its response to ever-changing investment conditions, its flexibility and maneuverability, may ultimately determine how its weight falls.

“[We’ll] focus our efforts on people who’ve built companies for the long-term, not financial engineering firms,” Hayes said.

Contact Carolina Braunschweig at: