CalPERS to Cut Investment Fees by 8 Percent Next Year

Calpers

CalPERS calculates that it will cut investment-related fees by 8 percent in fiscal year 2015-16, according to a report by Bloomberg.

The pension fund has been looking to cut costs recently by reducing the number of private equity managers it invests with and moving more investment management in-house.

According to CalPERS’ proposed budget, obtained by Bloomberg, the 8 percent decrease in fees will come from several areas:

Calpers projects it will pay about $100 million less in fees for hedge-fund investments. The pension has said it would take about a year to unwind all its holdings. It paid $135 million in fees in the fiscal year that ended June 30 for hedge-fund investments, which earned 7.1 percent and added 0.4 percent to its total return, according to Calpers figures.

Brad Pacheco, spokesman for the pension fund, wasn’t immediately available for comment.

Base fees for private-equity investments are projected to decline 7.5 percent to $440.6 million as some investments matured, the number of managers was reduced and Calpers won better terms for new deals.

Base fees for company stock managers are projected to increase 25 percent to $51.3 million. Fees for performance are projected to decrease by $32.6 million because of favorable renegotiated contract terms, Calpers said.

[…]

The largest U.S. state pension fund, known as Calpers, projects that it will pay $930.7 million in base and performance fees to investment firms in the fiscal year that begins July 1, down from more than $1 billion this year and $1.3 billion last year, according to the fund’s proposed budget.

CalPERS managed $295.8 billion in assets as of December 31, 2014.

 

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Report: Hedge Fund Assets Will Continue Growing in 2015, But Executives Recognize Underperformance

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A new survey, released Tuesday by Deutsche Bank, reveals that hedge fund executives expect hedge fund assets to grow by 7 percent and exceed $3 trillion in 2015, including $60 billion of net inflows.

But the majority of executives and investors surveyed – 66 percent – also recognized that hedge funds underperformed in 2014.

From the Wall Street Journal:

Investors included in the survey had on average expected returns of 8.1%, but said they only got returns of 5.3%.

[…]

However, some investors are planning to invest more in hedge funds, despite last year’s lackluster returns.

The survey said 39% of investors plan to increase allocations to hedge funds this year, including 22% who expect to increase the size of their allocations by $100 million or more.

Other key findings from the survey, from a Deutsche Bank press release:

Investors are looking for steady and predictable risk-adjusted returns – Investors risk/return expectations for traditional hedge fund products continues to come down in favor of steady and predictable performance: only 14% of respondents still target returns of more than 10% for the hedge fund portfolio, compared to 37% last year.

With this in mind, however, 40% of respondents now co-invest with hedge fund managers as a way to increase exposure to a manager’s best ideas and enhance returns. 72% of these investors plan to increase their allocation in 2015.

Investors see increasing opportunity in Asia – 30% of hedge fund respondents by AUM plan to increase investment in Asian managers over the next 12 months, up from 19% last year. Even more noteworthy is the growing percentage of investors who see opportunity in China, up to 25% from 11% by AUM, year-on-year. India is expected to be a key beneficiary of flows, with 26% of investors by AUM planning to increase exposure to the region, whereas only 4% said the same last year.

 

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Chart: How Institutional Investors Are Changing Their Allocations to Alternatives in 2015

target allocations to alternative assets

Here’s a graphic that shows the percentage of institutional investors that are planning to change their target allocations to various alternative asset classes in 2015.

When it comes to increasing target allocations, 39 percent of institutional investors say they are going to increase their private equity investments in 2015.

Hedge funds may take the biggest hit; 34 percent of investors say they are decreasing their allocations to hedge funds in the coming year.

 

Chart credit: Coller Capital‘s Global Private Equity Barometer Winter 2014-2015

San Francisco Pension Approves 5 Percent Allocation to Hedge Funds

Golden Gate Bridge

After months of discussion and delays, the San Francisco Employees Retirement System on Wednesday voted to invest up to 5 percent of its assets in hedge funds.

The pension fund has not previously invested in hedge funds. Its investment staff had previously recommended a 10 and a 15 percent allocation, but the board voted 6-1 for a 5 percent investment.

More from SF Gate:

The staff, headed by William Coaker, who joined the pension system last February as chief investment officer, evaluated the new proposal and came up with another of its own, which was approved by the board.

It will reduce the target allocation for U.S. and foreign stocks to 40 percent from 47 percent, increase private equity investments to 18 percent from 16 percent, increase real assets including real estate to 17 percent from 12 percent, reduce bonds and other fixed income to 20 percent from 25 percent and increase hedge funds to 5 percent from zero.

It does not call for investing specifically in Bay Area real estate, which the fund already does to some extent.

[…]

Coaker said he wanted a stake in hedge funds to help reduce the portfolio’s volatility and prevent the steep losses suffered during the 2008 stock market crash. Its assets dropped from $17 billion before the crash to a low of $11 billion. To help make up the shortfall, the city and employees increased their contributions to the fund.

In a memo issued Wednesday, Coaker said the staff had “taken into account the concerns” of city workers and retirees, but said it still believes hedge funds “can play an important role to increase the stability of our funded status, improve our performance in down markets, reduce our beta (volatility), and increase or alpha (or excess returns over the broad market).”

The only board member who voted against the proposal was Herb Meiberger, who previously worked as a security analyst with the pension system. “I just don’t think this is the answer,” he said.

The San Francisco Employees’ Retirement System manages $20 billion in assets.

 

Photo by ilirjan rrumbullaku via Flickr CC License

San Francisco Pension Investment Staff Recommends Foray Into Hedge Funds

Golden Gate Bridge

The investment staff of the San Francisco Employees’ Retirement System (SFERS) has recommended to the board that the system allocate up to 10 percent of its assets in hedge funds.

SFERS has been waffling for a year over whether or not to put money into hedge funds, and what the allocation should be.

From Bloomberg, via FinAlternatives:

The San Francisco Employees’ Retirement System staff is recommending its board consider investing 10 percent of assets in hedge funds.

[…]

The staff said it also could support a 5 percent hedge-fund allocation for the $20 billion city pension, according to a memo sent to the board from William Coaker, the chief investment officer. The board is scheduled to consider the recommendation at a Feb. 11 meeting in San Francisco.

“Many of the objections we have heard about hedge funds are at best an incomplete picture,” Coaker’s memo said. “Hedge funds have less than half the volatility of the equity market. Transparency is improving in the hedge-fund industry as a whole.”

The San Francisco pension board in December postponed a decision on adding hedge funds to its investment mix and asked staff for a more detailed analysis ahead of this month’s meeting. The fund isn’t currently invested in hedge funds, which are loosely regulated investment pools that are generally open only to high-net-worth and institutional investors.

The San Francisco Employees’ Retirement System manages $20 billion in assets.

 

Photo by ilirjan rrumbullaku via Flickr CC License

Report: Hedge Funds Expect Pensions To Up Their Allocations in 2015

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State Street has published a new report, titled The Alpha Game, which analyzes a survey that quizzed 235 hedge fund managers on what the future holds for pensions investing in hedge funds, and other industry trends.

The majority of managers think pension funds will increase their hedge fund holdings over the next few years.

Some key points, from ValueWalk:

The State Street report points out that hedge fund managers are expecting increased capital flows over the next few years. The survey highlighted that nearly two-thirds (65%) of hedge fund managers anticipate ultra-high-net-worth investors will increase their hedge fund holdings, and almost the same number (63%) expect institutional investors will also up their alternative positions. Furthermore, over half (55%) of managers believe pension funds will increase their allocations to alternatives as they look for improved performance and greater diversification

Hedge fund managers also think the main reason for pension funds reducing exposure to Hedge Funds will be disappointment with returns. Nearly half (47%) noted this as their primary concern. The report noter: “This highlights the sharp focus on hedge funds’ ability to deliver value and align with institutional needs.”

Over half of the hedge fund professionals surveyed (53%) think the main reason why pension funds will invest more in hedge funds is to try and boost portfolio performance. Just over one-third (35%) think pension funds are mostly trying to improve portfolio diversification.

The full report can be read here.

 

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George Soros: Hedge Funds “Not a Winning Strategy” For Pensions

George Soros

Hedge fund guru George Soros said at the Davos Economic Forum last week that he doesn’t think pension funds should be investing in hedge funds. He cited the current market, management fees and recent under-performance as reasons for his view.

More from FinAlternatives:

George Soros echoed Warren Buffett’s concerns about the intersection of hedge funds and pension funds.

Speaking at the Davos Economic Forum last week, Soros said that pension funds should avoid investing in hedge funds and warned of increased risks and concerns about the global middle class and retirees. Soros cited hedge fund management fees in his argument that pushing public employee money into hedge funds is foolish.

“Current market conditions are difficult for hedge funds,” said Soros. “Their performance tends to be equal to the average plus or minus a 20 percent management fee.”

“You will always have some hedge funds that will provide outside performance …” he continued. “To put a large portfolio into a hedge fund is not a winning strategy.”

Soros founded Soros Fund Management in the late 60’s. For decades, it was one of the best-performing firms in the hedge fund industry.

 

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Preqin: Hedge Funds Grew More Than Any Alternative in 2014

balanceHedge funds experienced the most asset growth of any alternative asset class in 2014, according to a Preqin report.

Despite scrutiny over low returns and high expenses, investors put more money into hedge funds in 2014 than private equity, infrastructure or venture capital.

More from Chief Investment Officer:

Despite a disappointing year for returns and some high-profile withdrawals from the sector, Preqin’s “2015 Global Alternatives Report” showed that hedge fund industry assets grew by roughly $360 billion during the year.

This accounted for more than half of the $690 billion increase in total assets invested across hedge funds, private equity, venture capital, private real estate, and infrastructure. In total, Preqin estimated $6.91 trillion was invested across these sectors.

“The recent news of CalPERS cutting hedge funds and reducing the number of private equity partnerships within its portfolio does not reflect the wider sentiment in the industry,” said Mark O’Hare, CEO of Preqin.

“From our conversations with investors, the majority of investors remain confident in the ability of alternative assets to help achieve portfolio objectives.”

However, Preqin predicted that investors would continue to scrutinise hedge fund performance and fees during 2015.

Preqin’s “2015 Global Alternatives Report” can be bought here.

Chart: Institutional Investors’ Planned Allocation To Hedge Funds Over the Next Three Years

Investors planned hedge allocation

An Ernst & Young survey asked institutional investors how they were planning to shift their hedge fund allocations over the next three years.

The 2014 responses can be seen above, paired with responses to the same question from 2012 and 2013.

Chart credit: Ernst & Young 2014 survey

Yves Smith on CalPERS’ Private Equity Review: Is It Enough?

magnifying glass on a twenty dollar bill

On Thursday, Pensions & Investments broke the story that CalPERS was putting its private equity benchmarks under review.

Beginning with the end of last fiscal year, the fund’s private equity portfolio has underperformed benchmarks over one year, three-year, five-year and ten-year periods [see the chart embedded in the post below].

CalPERS staff says the benchmarks are too aggressive – in their words, the current system “creates unintended active risk for the program”.

Yves Smith of Naked Capitalism has published a post that dives deeper into the pension fund’s decision – is the review justified? And is it enough?

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By Yves Smith, originally published at Naked Capitalism

The giant California pension fund roiled the investment industry earlier this year with its decision to exit hedge funds entirely. That decision looked bold, until you look at CalPERS’s confession in 2006 that its hedge funds had underperformed for three years running. Its rationale for continuing to invest was that hedge funds delivered performance that was not strongly correlated with other investments. Why was that 2006 justification lame? Because even as of then, it was widely acknowledged in the investment community that hedge funds didn’t deliver alpha, or manager performance. Hedgies nevertheless sought to justify their existence through the value of that supposedly-not-strongly-correlated performance, or “synthetic beta”. The wee problem? You can deliver synthetic beta at a vastly lower cost than the prototypical 2% annual fee and 20% upside fee that hedge funds charge. Yet it took CalPERS eight more years to buck convention and ditch the strategy. Admittedly, CalPERS did keep its investments in hedge funds modest, at a mere 2% of its portfolio, so it was not an enthusiast.

By contrast, CalPERS is the largest public pension fund investor in private equity, and generally believed to be the biggest in the world. And in the face of flagging performance, CalPERS, like Harvard, appeared to be rethinking its commitment to private equity. In the first half of the year, it cut its allocation twice, from 14% to 10%.

But is it rethinking it enough? Astonishingly, Pensions & Investments reports that CalPERS is looking into lowering its private equity benchmarks to justify its continuing commitments to private equity. Remember, CalPERS is considered to be best of breed, more savvy than its peers, and able to negotiate better fees. But look at the results it has achieved:

Screen-shot-2014-12-12-at-6.26.23-AM

And the rationale for the change, aside from the perhaps too obvious one of making charts like that look prettier when they are redone? From the P&I article:

But the report says the benchmark — which is made up of the market returns of two-thirds of the FTSE U.S. Total Market index, one-third of the FTSE All World ex-U.S. Total Market index, plus 300 basis points — “creates unintended active risk for the program, as well as for the total fund.”

In effect, CalPERS is arguing that to meet the return targets, private equity managers are having to reach for more risk. Yet is there an iota of evidence that that is actually happening? If it were true, you’d see greater dispersion of returns and higher levels of bankruptcies. Yet bankruptcies are down, in part, as Eileen Appelbaum and Rosemary Batt describe in their important book Private Equity at Work, due to the general partners’ success in handling more troubled deals with “amend and extend” strategies, as in restructurings, rather than bankruptcies. So with portfolio company failures down even in a flagging economy, the claim that conventional targets are pushing managers to take too many chances doesn’t seem to be borne out by the data.

Moreover, it looks like CalPERS may also be trying to cover for being too loyal to the wrong managers. Not only did its performance lag its equity portfolio performance for its fiscal year ended June 30, which meant the gap versus its benchmarks was even greater. A Cambridge Associates report also shows that CalPERS underperformed its benchmarks by a meaningful margin. CalPERS’ PE return for the year ended June 30 was 20%. By contrast, the Cambridge US private equity benchmark for the same period was 22.4%. But the Cambridge comparisons also show that private equity fell short of major stock market indexes last year, let alone the expected stock market returns plus a PE illiquidity premium.

The astonishing part of this attempt to move the goalposts is that the 300 basis point premium versus the stock market (as defined, there is debate over how to set the stock market benchmark) is not simply widely accepted by academics as a reasonable premium for the illiquidity of private equity. Indeed, some experts and academics call for even higher premiums. Harvard, another industry leader, thinks 400 basis points is more fitting; Ludovic Philappou of Oxford pegs the needed extra compensation at 330 basis points

So if there is no analytical justification for this change, where did CalPERS get this self-serving idea? It appears to be running Blackstone’s new talking points. As we wrote earlier this month in Private Equity Titan Blackstone Admits New Normal of Lousy Returns, Proposes Changes to Preserve Its Profits:

Private equity stalwarts try to argue that recent years of underwhelming returns are a feature, not a bug, that private equity should be expected to underperform when stocks are doing well. To put that politely, that’s novel.

The reality is uglier. The private equity industry did a tsunami of deals in 2006 and 2007. Although the press has since focused on the subprime funding craze, the Financial Times in particular at the time reported extensively on the pre-crisis merger frenzy, which was in large measure driven by private equity.

The Fed, through ZIRP and QE didn’t just bail out the banks, it also bailed out the private equity industry. Experts like Josh Kosman expected a crisis of private equity portfolio company defaults in 2012 through 2014 as heavily-levered private equity companies would have trouble refinancing. Desperation for yield took care of that problem. But even so, the crisis led to bankruptcies among private equity companies, as well as restructurings. And the ones that weren’t plagued with actual distress still suffered from the generally weak economic environment and showed less than sparkling performance.

Thus, even with all that central help, it’s hard to solve for doing lots of deals at a cyclical peak. The Fed and Treasury’s success in goosing the stock market was enough to prevent a train wreck but not enough to allow private equity firms to exit their investments well. The best deals for general partners and their investors are ones where they can turn a quick, large profit. Really good deals can typically be sold by years four or five, and private equity firm have also taken to controversial strategies like leveraged dividend recapitalizations to provide high returns to investors in even shorter periods.

Since the crisis, private equity companies have therefore exited investments more slowly than in better times. The extended timetables alone depress returns. On top of that, many of the sales have been to other private equity companies, an approach called a secondary buyout. From the perspective of large investors that have decent-sized private equity portfolios, all this asset-shuffling does is result in fees being paid to the private equity firms and their various helpers….

As the Financial Times reports today, the response of industry leader Blackstone is to restructure their arrangements so as to lower return targets and lock up investor funds longer. Pray tell, why should investors relish the prospect of giving private equity funds their monies even longer when Blackstone is simultaneously telling them returns will be lower? Here is the gist of Blackstone’s cheeky proposal:

Blackstone has become the second large buyout group to consider establishing a separate private equity fund with a longer life, fewer investments and lower returns than its existing funds, echoing an initiative of London-based CVC.

The planned funds from Blackstone and CVC also promise their prime investors lower fees, said people close to Blackstone.

Traditional private equity funds give investors 8 per cent before Blackstone itself makes money on any profitable deal – a so-called hurdle rate.

Some private equity executives believe that in a zero or low interest rate world, investors get too sweet a deal because the private equity groups do not receive profits on deals until the hurdle rate is cleared.

Make no mistake about it, this makes private equity all in vastly less attractive to investors. First, even if Blackstone and CVC really do lower management fees, which are the fees charged on an annual basis, the “prime investors” caveat suggests that this concession won’t be widespread. And even if management fees are lowered, recall how private equity firms handle rebates for all the other fees they charge to portfolio companies, such as monitoring fees and transaction fees. Investors get those fees rebated against the management fee, typically 80%. So if the management fees are lower, that just limits how much of those theoretically rebated fees actually are rebated. Any amounts that exceed the now-lower management fee are retained by the general partners.

The complaint about an 8% hurdle rate being high is simply priceless. Remember that for US funds, the norm is for the 8% to be calculated on a deal by deal basis and paid out on a deal by deal basis. In theory, there’s a mechanism called a clawback that requires the general partners at the end of a fund’s life to settle up with the limited partners in case the upside fees they did on their good deals was more than offset by the dogs. As we wrote at some length, those clawbacks are never paid out in practice. But the private equity mafia nevertheless feels compelled to preserve their profits even when they are underdelivering on returns.

And the longer fund life is an astonishing demand. Recall that the investors assign a 300 to 400 basis point premium for illiquidity. That clearly need to be increased if the funds plan slower returns of capital. And recall that we’ve argued that even this 300 to 400 basis points premium is probably too low. What investors have really done is give private equity firms a very long-dated option as to when they get their money back. Long dated options are very expensive, and longer-dated ones, even more so.

The Financial Times points out the elephant in the room, the admission that private equity is admitting it does not expect to outperform much, if at all:

The trend toward funds with less lucrative deals also represents a further step in the convergence between traditional asset managers with their lower return and much lower fees and the biggest alternative investment companies such as Blackstone.

So if approaches and returns are converging, fees structures should too. Private equity firms should be lowering their fees across the board, not trying to claim they are when they are again working to extract as much of the shrinking total returns from their strategy for themselves.

Back to the present post. While the Financial Times article suggested that some investors weren’t buying this cheeky set of demands, CalPERS’ move to lower its benchmarks looks like it is capitulating in part and perhaps in toto. For an institution to accept lower returns for the same risk and not insist on a restructuing of the deal with managers in light of their inability to deliver their long-promised level of performance is appalling. But private equity industry limited partners have been remarkably passive even as the SEC has told them about widespread embezzlement and widespread compliance failure. Apparently limited partners, even the supposedly powerful CalPERS, find it easier to rationalize the one-sided deal that general partners have cut with them rather than do anything about it.

 

Photo by TaxRebate.org.uk