CalPERS board reflects on liquidity and leverage; higher delegation limits
At the height of the GFC, CalPERS was forced to sell assets it didn’t want to sell at the worst possible time. “What was actually liquid was high-quality stuff,” Dan Welcome, CalPERS deputy IT director who joined the fund in 2004, recalled at a recent board meeting.
The Californian pension fund found itself overweight assets that it no longer wanted to hold, but finding a buyer was like plunging into an abyss. In short, the GFC revealed a deep liquidity crisis, revealing that the giant fund had lost control of its own funding levels with a large portfolio of securities loaned against cash, liquidity spread across all classes of assets and poor visibility on capital calls. the corner.
Lessons learned during those traumatic months rewrote the CalPERS approach to liquidity, fueled the decision to add a 5% strategic allocation to leverage, and instilled the determination to be able to seize opportunities in a bear market. .
After years of preparation, these changes have now crystallized into the fund’s latest strategic asset allocation, running since July this year. “I can think of few things that are more important that we’re willing to be a buyer than having to be a seller when the market turns,” board member Lisa Middleton said.
Strategy in action
Today, the $429 billion pension fund has dry powder to invest in, as evidenced recently by its ability to buy opportunities during the pandemic-induced selloff. Unfunded commitments remain ready in dry powder for partners. The dry powder is also in separately managed accounts, ready to deploy alongside hand-picked strategic partners in co-investment vehicles. Unlike in the past, all capital calls are consistent with assumptions and models, and are coming at the right pace.
CalPERS sources of liquidity are deliberately diverse. Along with dry powder reserves or the ability to tap into pension contributions as a source of cash, the fund can seize the opportunity to invest in distressed assets by selling stocks, using that money to buy the asset while using an equity futures contract to maintain equity exposure. This is on-demand cash from the fund’s huge pool of liquid public market assets that are both sellable and desirable. A centralized approach also allows the fund to choose the funding sources that best optimize the cost and composition of the portfolio at any given time.
Today, CalPERS has reduced its securities lending portfolio and collateral calls are equity-for-equity based, which means collateral levels don’t change but move in step with the market, a declared Welcome.
CalPERS regularly reports on its liquidity and leverage position – liquidity levels have been lower in recent months and could drop further on another leg down in the markets. But a central pillar of the strategy and the hallmark of its success is that the investment team need not continually focus on liquidity as the pace and framework is set. “We can focus on investing,” CalPERS chief investment officer Michael Krimm told the board.
Today, liquidity provisioning takes into account capital calls and margin for derivatives, while keeping an eye on market movements and volatility based on internal forecasting models. Liquidity management involves the participation of the entire fund, forecasting rebalancing needs, planning capital calls and identifying market trends in a robust process.
The board heard how extensive analysis over the years has involved exploring the inherent liquidity of CalPERS assets, exploring how easily an asset can be traded and the revenue it generates. The results revealed that cash, government bonds and stocks have the highest level of liquidity and are easily sold to meet funding needs. In contrast, private equity and private debt have higher returns, but less opportunity to generate cash on demand.
Along with a new strategic leveraged allocation, CalPERS’ latest asset allocation promises a strengthened allocation to private markets spanning private equity, real assets and private debt. At the November board meeting, the investment team again called for new tools and flexibility in managing the allocation, namely an increase in staff delegation limits.
“We need more tools and an update of the policies put in place when the fund had a lower allocation to private assets,” urged CIO Nicole Musicco, determined to build an agile investment philosophy that goes beyond simply setting an SAA and pressing the button. Established every four years using assumptions about capital markets stretching 20 years into the future, the assumptions also need to be reviewed along the way, working with partners and checking governance, he said. she declared.
While it is difficult to accurately account for the opportunity cost of not allocating more to private assets due to staff delegation limits (knowing that CalPERS would be unlikely to invest, GPs tend not to come up with opportunities), the investment team warned that the cost had been high. For example, every billion dollars invested in co-investments returns about $335 million more over ten years than the same billion dollars invested in fund investments.
Higher delegation limits mean the team can accept the larger deal sizes needed to increase private equity exposure as CalPERS targets an annual commitment pace of more than $15 billion to achieve allocation target of 13%. The private equity team will need to review up to 50 deals per year to approach annual co-investment engagement targets, making the ability to accept larger co-investment deals while reducing the monitoring burden of smaller transactions.
With respect to investments in private equity funds, CalPERS expects 70% of commitments to exceed the investment team’s current delegated authority limits. The team expects to engage in around 20 funds this year, which will lead to over 70 lead managers over time.
The team has made 116 fund commitments over the past 5 years, approximately half of which exceeded delegated authority. Two recent investments exceeded the authority of the CIO and were scaled back. “It is difficult to achieve scale with lower delegated authority limits and impairs our ability to achieve our SAA,” Musicco said.
This is the same problem in infrastructure where investment needs to more than double over the next three years to meet SAA targets. The team is to commit $5 billion per year to infrastructure with an average commitment of $1.25 billion per transaction. The infrastructure team has made approximately 19 commitments over the past five years and 32% exceeded delegated authority and were approved by the IOC. Two transactions exceeded the CIO’s authority and were reduced to meet the CIO’s delegation limit.
At the last Investment Committee meeting of 2022, Musicco explained that a crucial element to building CalPERS’ private market expertise includes revamping the Investment Underwriting Committee. The committee, one of three committees chaired by the IOC and tasked with reviewing all private market allocations above a certain size, is now structured to leverage expertise from all corners of the world. investment team in a collaborative process.
“I chair it, but the real secret sauce is asset class leaders and other experts offering a diverse lens,” Musicco said. “You make better decisions when you have the right eyes around the table,” she said, concluding that a collaborative approach allows the team to “learn a lot from each other.”