California pensions battle fund restrictions

The nation’s two largest backers of private equity firms are fighting back against a state legislative proposal that threatens to restrict their ability to invest in brand name mega-funds.

The California State Teachers’ Retirement System went on the offensive earlier this month, voicing its opposition to a state bill that would bar state-run pension funds from backing funds managed by buyout firms that are owned or partially owned by sovereign wealth funds affiliated with countries that haven’t signed certain human rights treaties. The California Public Employees’ Retirement System, whose board is scheduled to meet on March 17, is expected to follow suit in its opposition.

The state pension funds, which have staked out reputations as two of the most socially conscious limited partners nationwide, said that they anticipate that the bill would cost them significant revenue from being blocked from investing in high-performing funds.

CalSTRS estimates that the bill’s passage could cost it between $1.5 billion and $5.3 billion in lost investment revenue over five years. CalPERS’s staff was still preparing an analysis of lost opportunity as of press time last week.

At issue is AB 1967, introduced last month by California Rep. Alberto Torrico, a Democrat from Newark, Calif., which is located across the San Francisco Bay from Silicon Valley.

Torrico’s bill addresses the issue of how—as private equity firms have increasingly scoured the globe in search of LPs—a handful of the largest buyout firms have sold pieces of their management companies to sovereign wealth funds.

For example, Apollo Management and The Carlyle Group are two firms that would be subject to the proposed legislation. Last year, Apollo sold a 9% ownership stake in its management company to the Abu Dhabi Investment Authority, while Carlyle Group sold 7.5% of itself to Abu Dhabi-based Mubadala Development Corp.

Meanwhile, the Apollo and Carlyle firms last year contributed to an increase in the value of CalSTRS’s portfolio, which posted a 33% return on its overall private equity investments. Private equity similarly outperformed for CalPERS, which also owns pieces of Carlyle and Apollo and invests in their funds. CalPERS’ private equity portfolio generated a 26% return in 2007.

CalSTRS’ low-end cost estimate of $1.5 billion over five years assumes that the state pension fund must decline to make new investments in Carlyle Group and Apollo Management. The state pension fund estimates that it would shift the money it expects to commit to the two firms into investments in public equities, which generated a 7.5% return.

The high-end $5.3 billion estimate, however, is the “worst-case scenario,” says CalSTRS spokeswoman Sherry Reser. The calculation assumes that CalSTRS won’t be able to follow through on 70% of its anticipated “top-tier” buyout firm commitments as more shops seek to sell pieces of themselves to overseas interests.

However, the estimates exclude The Blackstone Group, which, as a publicly traded company, would not be subject to the proposed legislation. Last year, China’s new state investment agency agreed to take a $3 billion stake in Blackstone Group, giving China a non-voting 10% stake in the U.S. firm.

Beyond potentially losing big bucks, CalSTRS and CalPERS could become far less attractive LPs if the bill passes. That’s because 60 days before making an investment decision, they would be required to evaluate and write detailed reports about the involvement of government funds that aren’t banned by the bill.

“These [top buyout firms] have no trouble raising new funds, and we’re on top of the list of potential investors right now,” Reser says. “If you layer in all this research and reporting and public disclosure, we’ll stop being an investor of choice.”

It could become a major hurdle to overcome for CalSTRS and CalPERS. The 39 largest sovereign wealth funds control combined resources of $3.2 trillion, money that the buyout firms are increasingly seeking to tap, according to the U.S. Congressional Joint Economic Committee.

Passage of AB 1967, which is still winding its way through the state legislature, would not be the first time that CalPERS and CalSTRS have become constrained by perceived social risks. In October, California Gov. Arnold Schwarzenegger signed a bill that gives the state pension funds until January 2010 to divest billions of dollars of stock in energy companies that do business in Iran.

That list includes Brazilian oil company Petrobras, Russian oil producer Gazprom, and multinational Royal Dutch Shell. CalSTRS estimates that this legislation will decrease its revenue by $130 million to $200 million annually over the next five years.