As CalPERS’ $72.6 billion private equity portfolio recovers from its infamous Lost Decade of underperformance, twin themes are at the heart of its strategy: co-investments and reducing its acquisition bias.
Co-investments are favored for their structural alpha and potential big savings over traditional fund investments, and currently make up 40% of the portfolio. In contrast to the past two decades, when CalPERS prioritized large fund allocations, the majority of the pension fund’s private equity commitments are co-investments by 2023, which the portfolio’s managing investment director, Anton Orlich, projects could save the pension fund $25 billion over the next decade.
“For every $1 billion co-invested, not paying GP management fees and profit sharing translates into $400 million in savings. One-third of these savings are realized in the early stages of the investment and two-thirds in the late stages, meaning the savings accelerate through the portfolio,” he said at a recent board meeting.
Co-investing doesn’t just lower fees: Orlich told the board that it has helped CalPERS build its brand and trust with GPs, supporting key relationships that allow pension funds to access investments even when managers are oversubscribed.
“Co-investments tend to focus too much on cost reduction and neglect governance,” he said.
CalPERS has increased its allocation to co-investments despite a challenging environment for the asset class. A lack of deal flow and exits has reduced new co-investment opportunities. “As M&A levels have decreased, so have co-investment opportunities,” he said.
Another key benefit of the co-investment program was that it avoided accumulating large amounts of unfunded commitments, which increased cash demands (surging from $3 billion to $9 billion in 2023) as commitments evaporated quickly. But Orlich touted the benefits of deploying capital quickly, rather than through fund investments, where GPs would delay capital calls and LPs would risk having to meet unfunded commitments in a difficult market.
With trading activity down, portfolio cash flows are negative and CalPERS has seen little realized gains return to the portfolio, although the decline in cash flows has affected CalPERS less than other companies.
“There are insufficient quotas for the current harvest season so the impact will be minimal,” Orlich said.
He expects CalPERS to continue putting out more money than it takes back for the next four years, and only then will the fund start earning enough revenue to cover future investments.
The End of Big Acquisition Bias
For the past two decades, CalPERS’ strategy has been centered around large mega-buyout funds. Over the past two fiscal years, the team has reduced its allocation to buyouts from 80% of the portfolio (91% in 2020-21) to 67% (worth $48.9 billion). This shift has created opportunities to generate alpha in areas with greater variance in returns across other allocations, such as growth, opportunistic, credit and venture.
Additionally, within its acquisition portfolio, CalPERS has been shifting toward middle-market acquisition opportunities where managers are less reliant on leverage to generate returns.
But the strategy means manager selection (CalPERS invests in 126 managers and 363 funds) will be even more important. Key allocation themes include consistency in vintage years and increased allocations ($4 billion) to diversified managers that allow CalPERS to take advantage of enhanced diversity and return dispersion. Orlich cautioned that allocations to emerging managers require even more emphasis on manager selection because they offer greater upside and downside.
He also prioritizes a consistent pace. The team has successfully allocated $15.5 billion each of the past three years. Only a consistent pace will allow the fund to meet its recent goal of raising its allocation to private equity from 13% to 17% of the portfolio. “Consistency of commitment is key to making sure we don’t have another lost decade,” he said.
Another theme is that the team has selectively diversified the portfolio geographically over the past two fiscal years, with the program still being US-centric (approximately 75% exposure to the US) but with around 20% exposure to Europe.
