STUMP » Articles » Public Pensions, Leverage, and Private Equity: Calpers Goes Bold » 15 June 2020, 21:07

Where Stu & MP spout off about everything.

Public Pensions, Leverage, and Private Equity: Calpers Goes Bold  


15 June 2020, 21:07

The timing on this is interesting.

I will start with the op-ed from the CIO (chief investment officer) of Calpers, the largest pension fund in the U.S.

Calpers Exec: leverage, baby!

WSJ op-ed from Ben Meng, CIO of Calpers: Calpers Prepares for the Long Haul

Market turmoil has thrown a spotlight on the challenges that public pension funds face in delivering retirement security to public employees. The debate about how to meet obligations is important for policy makers, who worry that securing the benefits pensioners depend on will burden state and local governments — and future generations.

As the largest defined-benefit public pension fund in the U.S., the California Public Employees’ Retirement System has been anticipating these questions. We’re now ready to announce our strategy for dealing with them.

Over the past year, we have reviewed our investment approaches. We improved our liquidity position and redeployed $64 billion to reduce active risks in public markets. These decisions, along with asset allocation changes over the past couple of years, helped Calpers reduce by about $11 billion the impacts of the market downturn caused by Covid-19. We also scaled back our use of external asset managers, saving $115 million in fees annually.

Yet even before the pandemic, we knew that our goal of achieving a risk-adjusted return of 7% would require addressing the market’s triple threat of low interest rates, high asset valuation and low economic growth. In late 2019 we mapped out an investment strategy to deliver sustainable results.

The solution is based on “better assets” and “more assets” and will capitalize on Calpers’s advantages: a long-term investment horizon and access to private asset classes.

“Better assets” makes me wary about dipping into alternative asset classes.

“More assets” makes me think of pension obligation bonds… to buy more of these alternative asset classes [like private equity, hedge funds, etc.]

Calpers must diversify and increase exposure to private assets, such as private equity and private credit. We refer to these as “better assets” because they have the potential for higher returns and lower expected volatility when compared with publicly traded assets.

You only truly know the total return on private assets once they “mature” – i.e., once the fund cashes out.

For publicly-traded securities, you can get a market price without needing to sell your asset. That is not true for private assets.

Yes, there are various valuation approaches, but it’s only numbers on spreadsheets until it’s realized in cash. That’s really true of publicly-traded securities as well, given market value can fluctuate… but that’s the point.

Kinda tough for an asset to have volatile values if you measure their value less frequently, and you don’t realize the full loss, say, until you’ve totally cashed out.

“More assets” refers to a plan to use leverage, or borrowing, to increase the base of the assets generating returns in the portfolio. Leverage allows Calpers to take advantage of low interest rates by borrowing and using those funds to acquire assets with potentially higher returns.

Ugh. Look, leverage is not necessarily bad — it really depends on how much leverage you use.

The whole point of leverage is to magnify returns — but that also means your losses are magnified. If leverage is too high, you can take what would normally be just a bad year into catastrophic territory. A little bit of leverage, though, is not necessarily bad. Most of us are leveraged to a certain extent.

So how much leverage?

There is no panacea in the current market. Yet we think this new strategy will increase the probability of achieving a risk-adjusted return of 7% within the next 10 years. This will require sticking to the path regardless of short-term outcomes.

Okay, I don’t necessarily disagree with this. It’s the specific numbers I want to know. It’s not in the op-ed.

Interim: Some twitter reactions

Um, yeah, that Federal Reserve backstopping… yes, I saw what Illinois (and the Fed) did. I’m unhappy about it, but that’s not for this post.

Again, Meng’s strategy may be prudent. It is very dependent on the execution and the specific numbers for the leverage.

But, these people on twitter have a point: if it’s a disaster, they assume California taxpayers will absorb that. (and, failing that, that the U.S. federal taxpayers will bail them out.)

The numbers from Financial Times coverage: Top US pension fund aims to juice returns via $80bn leverage plan

$80 billion in leverage?!

Are you kidding me?!!!?!?

Calpers is to move deeper into private equity and private debt by adopting a bold leverage strategy that the $395bn Californian public sector pension fund believes will help it achieve its ambitious 7 per cent rate of return.

In a presentation to the Calpers board, Ben Meng, chief investment officer, said the giant fund would take on additional leverage via borrowings and financial instruments such as equity futures. Leverage could be as high as 20 per cent of the value of the fund, or nearly $80bn based on current assets. The aim is to juice up returns to help the scheme, the largest public pension in the US, achieve its growth target.

Twenty percent of the total fund value in leverage… is a lot of leverage.


Just… man.

The move comes after a 2019 investment strategy review that found Calpers needed greater focus on the excess returns potentially available from illiquid assets compared with public equity and debt. Under Calpers’ previous asset allocation strategy it was estimated to have a less than 40 per cent probability of achieving its 7 per cent return target over the next decade.

Here’s a thought: why not change the target? Many others are having to do so.

Mr Meng hopes Calpers’ deeper push into illiquid assets over the next three years will help it exploit its structural strengths. Its perpetual nature allows it to make longer-term investments, while its size gives it access to top managers in private equity markets where performance is widely dispersed.

“Given the current low-yield and low-growth environment, there are only a few asset classes with a long-term expected return clearing the 7 per cent hurdle. Private assets clearly stand out,” Mr Meng said. “Leverage will increase the volatility of returns but Calpers’ long-term horizon should enable us to tolerate this.”

I was thinking of trying to say something positive. But I can’t.

The “perpetual nature” of Calpers is very dependent on managing the fund (and benefits) such that it can be sustained perpetually. 20% leverage does not tell me that.

Calpers’ portfolio has also been de-risked by increasing its holdings in longer-dated US Treasuries and switching more assets from capitalisation-related equity indices to factor-weighted equities. These use indices that focus on investment styles such as price momentum or volatility.

According to Mr Meng this strategy protected the fund from losses of $11bn in the pandemic-induced market slide, which far outweighed the $1bn profit forgone on tail risk hedging. He said that unlike in the financial crisis of 2008 Calpers was not forced to sell assets into a depressed market in March. “Too little liquidity can be deadly but too much is costly,” he said.

He is correct about this. I just don’t know their liquidity position or needs. This is just reporting.

Hey, let’s check out what Calpers itself says.

Calpers FAQ on new investment strategy

FAQ: Toward A 7% Solution

Guys? Do you know what the “7% Solution” refers to?


I’ll make it easy for you: the “7% solution” referred to an injection of cocaine that Sherlock Holmes used in some of Conan Doyle’s tales of the detective. Later, someone wrote a book with that title and a movie was made of it.

Somebody was being cheeky here, and it is inappropriate. It’s one thing for a hobby blogger to used animated gifs, say, but if it’s something official from the largest pension fund in the United States, maybe you should be more serious.



Okay, back to the FAQ:

CalPERS’ new investment strategy is a plan to deliver retirement security for its members
The recent economic downturn has thrown a fresh spotlight on the challenges that public pension funds face in delivering retirement security to public employees. The discussion on how to meet obligations represents an important debate for policymakers, who worry about burdening state and local governments — and future generations — to secure the benefits that pensioners have earned.

We’ve developed a strategy to achieve our 7% investment return target necessary for the long-term health of the fund.

Why is 7% important?

7% is the discount rate and what we assume we will earn on our investments. The goal is to achieve a rate of return of 7% in a prudent way on a nearly $400 billion portfolio, over the long-term.

What are the challenges to achieving 7%?

When we surveyed Capital Market Assumptions in 2019, the expected average annualized return of our portfolio over the next 10 years was about 6%, with a less than 40% probability of achieving our assumed rate of return of 7% over that period.


(Yes, I know why)

What is meant by “better assets”?

Given the current low-yield and low-growth environment, there are only a few asset classes with a long-term expected return clearing the 7% hurdle. Private assets stand out with the potential higher returns relative to the more efficient public markets or less-speculative assets such as fixed income. We refer to these as “better assets” because they have the potential for higher returns and lower expected volatility when compared to publicly traded assets.

What is meant by “more assets”?

“More assets” refers to our plan to thoughtfully utilize “leverage,” or borrowing, as a tool to increase the base of the assets generating returns in the portfolio. The use of leverage allows us to take advantage of the low-interest rate environment by borrowing and using those funds to acquire assets with potentially higher returns.

Oh lord. There are so many things I despise here.

I will get to private assets in a moment (which I don’t necessarily have anything against.)

But first, I hate the word “utilize”. Just use “use”, dammit.

Second of all, what’s with the quotes around “leverage”. It’s just leverage. No need for scare quotes.

And now, timeline:

How long will it take to implement this plan?

Given our assessment of market opportunities in better assets (e.g., private debt and private equity) and our ability to build governance around deploying more assets (e.g., incorporating leverage into strategic asset allocation), we can realistically implement a “more and better assets” portfolio over approximately the next three years.

What’s the hurry? I thought you were a long-term investor. Three years ain’t no thing.

Elizabeth Bauer on the Calpers strategy

Elizabeth Bauer: Heads They Win, Tails Taxpayers Lose: Calpers Doubles Down On Risky Investments

As Erik Schatzer at Bloomberg explains,

“To meet its future obligations, Calpers must generate a 7% annual return. Yet an in-house study in 2019 found that its chances of meeting that target over 10 years are just 39%. . . .

“Without any changes, the long-term return on Calpers’s portfolio is estimated at 6%. . . .

“Implementing leverage has the most potential to backfire. While borrowing money can boost profits, it can also magnify losses and exacerbate return swings.

“’We will have to live with the possibility of market drawdowns as the price for increasing the probability of achieving our ambitious target rate of return,’ Meng said. ‘There is no alternative.’”

Of course, that’s not correct; the alternative is fairly straightforward: accept a lower return. The determination that the expected rate of return on assets must not sink below 7% is what is compelling Meng and Calpers to take these risky actions. And the nature of public plan accounting — that they are doubly-dependent on a high return on assets because that expectation determines the valuation interest rate regardless of what actual returns look like from year to year — creates perverse incentives to take even greater levels of risk.

Of course, I agree with Bauer.

There was another choice they could have made: a lower return target.

But if they had chosen that, the employers would have to contribute more. But they don’t want to do that. Hey, even 7% was a decrease from earlier! It was 8.25% in 2001, 7.75% for 2003 – 2010, 7.5% for 2011-2018, and that’s where my link peters out.

I mean, they have been lowering the target, but I would argue it’s not been lowered enough.

But Meng and Calpers [in contrast to private pensions]? They act as if they are wholly isolated from the effects of the risk they’re taking on. If their investments pay off, they’re lauded for their skill; if not, there’s no harm done in the unfunded level worsening or taxpayers paying the bill for funding improvements at some undefined time far in the future — taxpayers to whom Calpers and the entire public pension structure feels no accountability. It’s “heads I win tails you lose.”

This is not unique to Calpers, of course, but the concept behind a lot of the drift to alternative assets for public pensions, even when the managers don’t really have expertise in it.

They know it’s not politically palatable to ask for more contributions now. So they pretend they will be able to fill the contribution holes with outstanding fund returns!

And if that doesn’t happen – c’est la vie!

Yves Smith on the Calpers strategy

Yves Smith at naked capitalism: CalPERS Plans to Blow Its Brains Out: Seeks to Increase Risk by Boosting Private Equity, Private Debt, and Leveraging the Entire Fund

CalPERS is acting exactly the way traders on Wall Street do when they are sitting on serious losses, or in CalPERS case, underfunding so deep that they can’t earn their way out of it. They put on desperate, high risk positions in the hope they can climb back out of their hole. Pros will tell you that this is just about always a fast path to ruin. CalPERS’ version of swinging for the fences is to increase its commitments to its riskiest strategy, private equity, embark on investing in a new risky category, private debt, and leverage the entire fund.

The fundamental outlook is so poor that even Warren Buffet, known among other things for astute contrarian plays, can find nothing to buy. Yet CalPERS thinks that now is the time to load up on risk. It not only plans to add to private equity but also to load up on another speculative investment, private debt, while also leveraging the entire portfolio. Did CalPERS miss out on the finance lesson that leverage increases profits and losses?

Yes, but they only care about the profits side. If they fall on the losses side… the taxpayers eat it. Or bondholders. Or retirees. Somebody not the people managing the funds.

There’s an additional cause for pause in the Financial Times summary of CalPERS’ plans: CalPERS yet again is abusing transparency laws by holding discussions of these plans in secret. The fund is required to discuss this matter in public under the Bagley-Keene Open Meeting Act; it doesn’t fall under any of the few exemptions. Yet none of this information can be found in agenda or documents for the Investment Committee meeting later today.1 The fact that CalPERS planted this story (it has extensive quotes from Chief Investment Officer Ben Meng) says there was nothing that needed to be kept confidential.

Yves is correct. I went looking for the presentation, too. I can’t find it (yet). I can just find the fluff pieces.

“In a presentation to the Calpers board”? No such presentation has been or is on deck to be made in open session. That is an admission that CalPERS provided closed session materials to the Financial Times. Notice the double standard: CalPERS executives routinely leak what they’ve designated as confidential material (whether it is legitimately confidential or not) while anyone else suspected of doing so, even a board member, is strung up.

Yves goes on to beat up on private equity, which does have varied results. The big problem is when dumb money gets involved. I’ve run into private equity groups, and when the fund managers and investors are the same people, I have seen some really good results. But then, they’re working for themselves, not somebody else. The principal-agent problem is tough to get away from in asset management.

As for the idea of leveraging the entire fund, we had argued that German investors, who eschew private equity, instead borrow against their entire portfolio to achieve a similar level of risk. Upping the level of private equity and debt investments and adding fund level leverage is going all in at just about the worst time to do so. Has CalPERS forgotten that it took over 20 years for US stocks to get back to their 1929 levels? The Atlanta Fed’s GDPNow’s second quarter forecast is -48.5%. What about “probable depression” don’t you understand?

Hey, it’s only 20% levered in the plan.

Huh? CalPERS is not special in being a long-term investor. So to are other public and private pension funds, life insurers, along with many sovereign wealth funds.

And the “access to top managers” is misguided. If Meng means “top managers in terms of performance” he ought to know it’s impossible to find them ex ante, since top tier performance no longer persists. You might as well throw darts. And the fact is that CalPERS is so large it will tend to have private equity index-like returns no matter what it does.

If Meng means CalPERS size gives it some sort of advantage with respect to the biggest funds, he’s misguided. Private equity fund managers do give fee breaks on larger size investments, but anyone who makes that big a commitment gets that fee deal. And as the Phalippou paper makes clear (and as we’ve reported based on other studies), the biggest funds, which do classic leveraged buyouts, have delivered the weakest returns of all private equity sub-strategies.

Let me step away from these papers, but point out something about large funds: it is very tough for them to perform better than the markets in general.

I have seen small private equity groups do extremely well — because they just need to find investments fitted to their smaller amount of capital. Finding small growth investments is not necessarily difficult. Finding a low-capital investment that grows 100x — it happens. And you have to hit only one of those in your portfolio to be sitting pretty, if you’re small.

But if you have $400 billion to deploy, it is much tougher to find those super-growing investments. You get large enough, you can’t expand any faster than the economy you’re in.

Prior posts on alternative assets in public pensions

This is not exhaustive. Just a sampling of my posts on alternative assets.

That last linked post is from April 2019, just one year ago. It does touch on alternative asset classes — and it’s chock-full of animated gifs, as is my wont.

Lisa Simpson provides the wisdom on alternative assets:


And I remark:

When a public pension fund takes on additional risk, when it’s deeply underfunded, it might pay off for the taxpayers in reducing future contributions.

However, what has generally occurred is that these Hail Mary passes do not complete, and those trying to be “clever” end up having to go to the taxpayers to ask for even more money than if they had simply done appropriate asset-liability matching.

By trying to hide how expensive these promises actually are, a lucky few manage to get the jackpot, and most find that they’ll need even more money to fill the hole.

It’s one thing when you’re gambling with your own money.

But if it’s other people’s money?

If public market returns and “risk-free” returns don’t get you want you want, you are taking additional risks that impinge on taxpayers, public employees, and bondholders.

Did you ask them if they wanted to take that risk?

People may be feeling pretty full of all sorts of risk right now, and may not feel inclined to bail out public pensions for their investment gambles… especially if they were magnified via leverage.

Parting Thought

Also: leverage can be a lethal tool. Don’t cut yourself. Or others.

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