As chief investment officer, Joe Dear oversees $237 billion in assets for the California Public Employees’ Retirement System, the largest and most influential public pension in the United States. More than 1.6 million state workers and retirees look to Dear to make sure their retirement is secure.
Dear took the investment reins at CalPERS in early 2009, just as the economic crisis was near its frightening bottom. By then, the swooning markets had lopped off nearly $100 billion in investment value from its 2007 peak. But that wasn’t his only challenge. An ugly placement-agent scandal was badly tarnishing CalPERS’s stature, damaging staff morale and leaving the giant pension open to political criticism.
Just as he would with a distressed investment, Dear saw that the core of CalPERS was down but certainly not out. In the three-plus years of his leadership, CalPERS has bounced back, regaining more than $60 billion in market value from its 2009 market low. Confidence is back too, as the pension made some key hires, including private equity chief Réal Desrochers, and moved decisively toward a more transparent structure in the wake of the placement-agent scandal. Dear talked with Gregory Roth, senior editor at Buyouts, about the challenges that still lay ahead.
You started your role in 2009, which was a difficult time for CalPERS on many levels. What do you think is your most important contribution to CalPERS thus far?
I would say it’s refocusing the investment program on performance, restoring integrity to our operations, and building the team that’s going to deliver value for the long term.
CalPERS is the largest and most influential public pension in the United States. Do you feel that the pension’s high profile can be an advantage?
Like a lot of things, the high visibility has its benefits and liabilities, but overall, it’s a benefit to be as visible as CalPERS is because it enables us take leadership positions on investment issues, policy issues and within the pension community.
CalPERS recently joined some of its peers in lowering its assumed rate of return from 7.75 percent to 7.5 percent. You’ve recently said this new rate is achievable, and cited the pension’s 20-year average rate of return. But with interest rates at historic lows, why isn’t CalPERS playing it safe and setting lower return assumptions?
We ought to take a long-term view in what we expect markets to return for us. There’s no question that in the next five years or so, it’s going to be extremely challenging for us to hit a 7.5 percent return. But over the long term, I think we have a lot of confidence in the ability of the market to adapt, to continue its resilience and provide opportunities for investors with discipline and foresight to achieve good returns. But in the near-term, it’s going to be extremely challenging.
So, do you then foresee CalPERS expanding its investments in assets like private equity, which potentially offer higher returns?
Well, we’ve already made a significant and longstanding commitment to private equity. It’s 14 percent of our portfolio. We believe that in private equity, we can generate a return that is 3 percentage points above what the public markets will provide. Are we likely to increase our allocation? At this point, I don’t expect the private equity program to increase, but that’s primarily because it’s already a really big program. The question is: Can you have a stable of top-quartile managers when your program is approaching $50 billion. I think there’s a limit to the number of quality investment relationships you can have. Our 14 percent allocation gives us about $34 billion in invested private equity capital and $12 billion of unfunded commitments. That’s a healthy commitment, and I wouldn’t expect that to increase significantly.
How much money does CalPERS expect to commit to private equity in the next year?
In general, the range is between $4 billion and $6 billion a year. That’s a wide range because we want to be sure that we’re committing to the firms that will produce that 300 basis point boost over the public markets.
What’s been the impact of Réal Desrochers’s arrival to lead your private equity program?
First, he’s energized the private equity team. Second, he has undertaken a restructuring of the portfolio. And third, he’s installed a new discipline to the decision-making process, for the private equity group, and for CalPERS generally. On restructuring the portfolio, CalPERS has too many relationships and too many funds, and that drives the performance toward the median. We want to have a more concentrated, selective portfolio that produces a higher return.
How far along, then, is CalPERS in reducing the number of private equity relationships?
We’re making good progress. We’ve undertaken three secondary sales, including one we just finished where we reduced the number of relationships by 23. We still have 350-plus relationships, but 23 in one go is good progress. As the mega-funds complete their investment periods—and I’m talking about the very large funds from 2005, 2006 and 2007—there will be a lot of opportunity to redeploy capital and adjust the size of relationships and the composition of the portfolio. There will be a lot of opportunity in the next three years to enhance the restructuring that we started.
So, what then will be your strategy for redeploying that private equity capital?
Number one is improving terms and conditions so that there is a better alignment of interests between the limited partner and the general partner. Then, given the nature of our size, we’re always going to be looking for relationships where we can deploy large amounts of capital. These are large buyout funds offered by the brand names in private equity. As we add staff, we’ll increase our capacity to look at the middle market and growth equity, while trying to reduce the number of relationships, and make sure we’re deploying capital with the firms that have the highest probability of achieving top-quartile returns.
The one area I suspect we will deemphasize is venture capital. There are two reasons for that. One is that venture has been the most disappointing asset class over the past 10 years as far as returns. Second, it’s very difficult for a large fund like CalPERS to gain access to the best venture partners in the size that makes a difference to our performance. So, we expect venture capital to move from about 7 percent of our private equity portfolio to 1 percent. That essentially means that we’ll do venture capital on a strictly opportunistic basis.
Do you see strong returns coming from the dislocation in Europe?
Yes. Probably not as great as some people would hope, but we’ve put capital to work with a number of firms there, and there’s a lot of capital waiting on the sideline trying to take advantage of that dislocation. But I think there is a broader dislocation in the market, which is simply that the credit provision by traditional banks is changing, and that opens opportunities for other sources of capital to move in, and that’s another area we’re looking at.
CalPERS has invested directly in a few private equity firms, a couple of which recently went public, Apollo Global Management and The Carlyle Group. Do you think that CalPERS will seek to take on more direct equity stakes in private equity firms?
I’m pausing because I don’t want to say we won’t do it again, but it’s really an opportunistic issue. Our Carlyle investment was very successful, and it proved the concept of investing in the general partner while we’re also investing as a limited partner. Our other investments in private equity general partners, including Apollo and Silver Lake Partners, haven’t been as successful as we had hoped. The real question is: Does investing in the GP and LP create a conflict for an investor like CalPERS? By that I mean, the multiple assigned to the revenue flow from fees from private equity is greater than the multiple assigned to carried interest. That tends to mean that the firms will try and generate higher fee income. Well, who pays the fees? It’s the limited partners. So, I think we’re better off concentrating on relationships from the LP side. Does that mean we won’t ever again entertain the idea of funding a private equity team? We will, but on a very selective basis.
Until your recent separate account deal with Blackstone, some people expected CalPERS to announce a blockbuster separate account deal similar to what the Texas Teachers’ Retirement System did with its $6 billion deal with Apollo and Kohlberg Kravis Roberts &Co. When your $500 million deal with the Blackstone Group was announced, some people were surprised that it wasn’t bigger. What, then, is your main goal with separate accounts?
As far as large (separate account) commitments with flexible allocations, there’s a lot of room for discussion with the major firms. And we are in discussions with them. While I wouldn’t predict a blockbuster announcement, we’re working very hard to come up with some innovative structures to take advantage of our size and our long-term horizon, as well as the depth of the relationships we have with the major private equity firms, so it’s a work in progress. The details of terms and conditions and these structures are really, really important. And that $500 million to Blackstone for the Tactile Opportunities Fund is a major commitment that fits alongside other commitments we have with Blackstone. It’s one of our largest relationships.
In the last few months, we’ve had problems with Libor manipulation, Knight Capital’s trading platform going haywire, the disintegration of MF Global. Do you think these crises can be prevented through better regulation, or were they bound to happen anyway?
Effective regulation is extremely important to preserving investor confidence in the markets. The global financial crisis, and the recent examples of Knight and Libor, illustrate why investor confidence is waning. This is an extremely important issue and it’s why CalPERS devotes some effort to being a participant in the policy-making process. If you’re a long-term investor, you really do care about the quality of regulation. When these accidents happen, we take advantage of them as teaching moments to convince policy makers that the long-term economic growth of the United States and world economy depend on effective regulation, not its absence and not its excess.
Do you feel that CalPERS has been able to put the placement-agent scandal behind it?
Yes. The CalPERS board adopted policies for full disclosure of all placement agent activity. We supported the legislation adopted by the state, which put placement agents under state lobbying regulations. And we have opened up access to our investment process through a Web portal so that investment managers won’t feel the need to use a placement agent to do business with us. I should add that there were a few placement agents that caused a great deal of trouble for us, but the vast majority of placement agents provide a legitimate function in the marketplace.
What are the biggest challenges to creating a high-performance culture at a public institution like CalPERS?
The principal way public pensions can succeed in attracting and retaining a high-capacity team is to assure that each member of the team is committed to the mission of the organization. And our mission is serving 1.6 million state and local government workers and retirees. Compensation, obviously, is really important, but so is achievement and recognition, and we work hard on all three.
What keeps you up at night?
I’m sleep deprived so I don’t have trouble sleeping. The answer that most frequently comes to mind is making sure we hold on to the folks we need in our organization, making sure they have rewarding jobs that will entice them to stay, and that they exercise good judgment at all times.
What do you wish private equity investors better understood about investing with CalPERS?
CalPERS is a serious, sophisticated investor that is vitally interested in the health of the private equity industry. It is committed to the private equity asset class. The health of the private equity industry includes the better alignment of terms and conditions between the GP and LP, as well as an interest in how the industry conducts itself in its investments and its public policy engagement. We share an interest with private equity investors in communicating to the public the value of private equity in producing returns that will enable us to meet our obligations.