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What hath CalPERS Wrought? And Why?

September 30, 2014

06-18-09 © eldorado3dCalPERS’ recent announcement that it will close down its hedge fund operation raises a range of obvious and not-so-obvious questions.

This policy change mandates an exit from each of 24 hedge funds and six funds of funds, and in the process a re-allocation of approximately $4 billion.

The first thought that came to my mind when I learned of it was: Are they unhappy about fees?

Investment Beliefs

The statement [click] refers to a set of Investment Beliefs that the CalPERS Board adopted a year ago. It cites two of those beliefs as particularly pertinent to this decision: that “CalPERS will take risk only where we have a strong belief we will be rewarded for it,” and that “Costs matter and need to be effectively managed.”

Investors have long grumbled about the structure of fees in the hedge fund and private equity worlds. The whole notion of paying a management fee and a performance/incentive percentage strikes some as two bites of the same apple; and the way the size of the two bites stayed fixed for a long time at 2 + 20 itself seemed suspect. In a world where all other values are ever-shifting, why should the value of alpha-hunting talent be the only great constant?

Roger L. Martin, former Dean of the Rotman School of Management, University of Toronto, gave voice to some of this dissatisfaction over fees in the October 2014 issue of Harvard Business Review. The essay was written prior to the news from CalPERS, but much of it is devoted to the quite pertinent proposition that institutional investors, especially pension funds and sovereign wealth funds, ought to push back (or push back harder than they so far have) against the fee structure preferred by those they hire to manage their money.

Structure, Not Numbers

Of course, as Martin notes, there already has been some pushback – CalPERS didn’t start this. But he thinks there should be more, and that it should focus not so much on getting the number 2 (or 20) lowered, but on getting one or the other eliminated, so that managers will depend either upon their carried interest or on a straight asset management fee. Reading between the lines of his article a bit, he seems to be taking the view that CalPERS or some institution similarly situated should give its hedge funds an ultimatum: “we’ll continue to play ball if you go with one of these apple-bites or the other, but not if you continue to insist on both.”

With these thoughts in mind I contacted CalPERS soon after their announcement. I was referred to Joe DeAnda of the CalPERS Office of Public Affairs. I wasn’t able to arrange an actual telephone conversation with Mr. DeAnda: our communication remained limited to an email exchange.

The Exchange

In my email, I focused on three questions. First, I asked: where are the billions of dollars now part of CalPERS Absolute Return Strategies program going to go as ARS is closed down?

Second: how long might the wind-down take? Liquidating a hedge fund position isn’t exactly like drawing money out of a checking account.

Third (in the spirit of Mr. Martin and others who have expressed similar thoughts over the years): was the fee structure common to the hedge fund industry any part of the CalPERS analysis in the lead-up to this announcement?

The same day, DeAnda responded. Here is his responsive email in full: “We have yet to determine when those funds will be reallocated.  There is no timeline.  We are in no rush to wind down and will take as long as is necessary to do it in a manner that serves CalPERS’ best interests.”

Now, that offers an answer of a sort to each of the first two of my questions. It offers the sound of silence, though, in response to my mention of fees.

In the presence of silence, we’re entitled to reasonable guesswork. My own: CalPERS doesn’t have a principled objection to absolute return strategies, but it thinks they’re pricey. Its statement quotes Ted Eliopoulos, the interim Chief Investment Officer, saying, “Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at CalPERS’ size, the ARS program is no longer warranted.”

This all raises another question: if they are too pricey to be “viable” for CalPERS, are they also too pricey for the analogous pension funds in other states? Might the industry end up having to seek to win back this capital by doing something drastic with their fee structure?

Martin may prove a prophet here.