California Public Employees’ Retirement System will take three to four years to execute a bold new leverage strategy to push into private equity and private credit, chief investment officer Ben Meng told the $389 billion pension’s board Monday.
“We are not leveraging the portfolio by 20 percent overnight,” Meng said at the meeting, according to a rush transcript. “We are going to move gradually, prudently, and opportunistically…some of the results will be seen rather quickly, [but] it may take up to 10 years for us to fully benefit from this strategy.”
Last month, Meng rolled out the new strategy with interviews in the Financial Times and Bloomberg. The announcement was met with criticism from some stakeholders as well as board member Margaret Brown, as Buyouts reported. CalPERS policy currently allows up to 20 percent of the total fund value to be levered.
Wilshire Associates, CalPERS’s general investment consultant, gave a separate presentation on asset allocation which also touched on leverage.
Wilshire’s Steve Foresti said the firm had been advocating “the modest use of leverage” to its clients for “many, many years.” Foresti declined a Buyouts request to share which Wilshire clients were doing this.
“Modern portfolio theory” operates by putting together a list of asset classes that add up to 100 percent, Foresti said, but investors can use leverage to invest above that through “direct borrowing or just derivative markets.”
“So, this would be lifting a constraint,” he said. Specifically, Foresti called for “really using leverage as a risk management tool as opposed to a return chase tool.”
When asked if CalPERS planned to use leverage in this manner, a spokesperson said Meng “has said from the start that the use of leverage also allows CalPERS to maintain its diversified portfolio, a classic risk mitigation tool.”
Wilshire also hit on the need to monitor leverage in CalPERS’s portoflio.
“There should be specific guidelines and constraints on the use of leverage within the fund,” said Wilshire’s Thomas Toth. He recommended “coming up with a standardized measure of leverage to monitor and manage and report on in your usual packet on an ongoing basis and ideally you’re going to want to identify why you’re utilizing leverage within these policies.”
This would include the current amount of “explicit leverage,” or borrowed capital, and “embedded leverage” which is “incorporated in strategies across the portfolio.”
Toth stressed that leverage is “fungible.”
“I don’t think you should think about [it] as leverage being utilized to do one thing in particular,” he said. “I think a better way to think about leverage [is] as leverage being utilized, so you have an un-levered target and that has certain percentages and…you’re utilizing the leverage to increase that going forward.”
The use of leverage does come with risks, which CalPERS will need to manage. Wilshire touched on both cash flow uncertainty and the “amplification of upside and downside movements in asset values” as challenges staff will need to manage. Its presentation also mentioned liquidity risk, counterparty risk and market risk as potential issues.
“In no way do we mean to imply this is a magic bullet that can solve all problems,” said Toth.
On Wednesday, CalPERS released its preliminary returns for the 2019-20 fiscal year. The overall fund returned 4.7 percent and private equity -5.1 percent, which Meng connected to the difficult economic climate.
Action Item: read Wilshire’s asset allocation presentation here.
CORRECTION: A previous version of this story said Ben Meng’s comments were given to the CalPERS investment committee. They were given to the full board. The story has been updated.