Retired DMV clerks, former firefighters and aging government bean-counters across California, put on your three piece suits: You might be getting into the banking business.
The California Public Employees’ Retirement System, which manages a nearly $400 billion basket of nest eggs for retired public workers across the state, is wading into the rollicking market for private debt.
It used to be that lending directly to small and medium-sized companies not traded on public stock exchanges was the business of big banks. But after the financial crisis of 2008, those traditional lenders were forced to park their money into less risky ventures. And that left behind a financial vacuum into which “shadow bankers” such as private equity financiers have been rushing ever since.
Now CalPERS, the nation’s largest pension fund, wants in on the action.
The pension fund staff calls it a “prudent” calculated risk. Critics call it a desperation move. Both agree that the fund — which faces hundreds of billions in unfunded future pension debt, persistently basement-scraping interest rates and now a pandemic-ravaged economy — is under pressure to perform.
“We need every arrow in the quiver we can get, and private debt is one of the critical ones,” said Dan Bienvenue, CalPERS’ deputy chief investment officer. “There isn’t a no-risk choice.”
Rather than simply invest the money with Wall Street firms that then dole it out to borrowers — something CalPERS has already started doing — CalPERS managers want to cut out the middlemen and begin making and holding those loans themselves.
The board-approved policy allows CalPERS to put up to 5% of its total value into “opportunistic” investments, which includes private debt. That works out to about $20 billion, though Bienvenue said he doesn’t “expect to grow this to anything like that anytime soon.”
CalPERS’ turn to direct lending is part of a broader rethinking of the pension fund’s money-making strategy, approved by the organization’s board last month. The plan also allows the fund to borrow up to $80 billion to goose potential profits — an 11-figure sum has generated skepticism from some financial experts and howls of protest from some corners of the political and financial commentariat.
“Hopefully it works and they’re lucky and the taxpayers of California will be lucky,” said Matt Gelfand, a managing director of the investment advising firm Moreland Associate. “But there’s a greater risk.”
Susan Webber, a longtime critic of CalPERS management who writes under the pen name Yves Smith on her widely read finance blog Naked Capitalism, summed up her point in the title of her post: “CalPERS Plans to Blow Its Brains Out.”
Bienvenue said the new leverage policy just consolidates how much individual departments across the fund were already allowed to borrow into one total, which is actually lower than the prior policy.
“What we’re doing is in fact far more boring than the headlines,” he said.
But both CalPERS’ money managers and its sharpest critics agree that the fund faces a daunting task: trying to earn sufficiently high returns to meet its future obligations without putting too much at risk.
A veil of secrecy?
Before CalPERS can start writing checks like a bank, the staff at the pension fund is asking for a little bank-like confidentiality.
Earlier this year, the pension fund sponsored legislation that would shield many of the documents and data related to its future private loans from California’s Public Records Act. The bill, authored by Elk Grove Democratic Assemblymember Jim Cooper, would make it impossible for journalists or anyone else to compel public pension funds to divulge any borrower’s personal identifying information, their financial statements, details about the collateral backing a loan and anything that might be considered a “trade secret.”
If the public pension fund is going to get into the business of making loans, CalPERS staff argued, it has to be able to assure borrowers that their closely guarded financial information remains secret.
“If we have to disclose it,” pension fund lobbyist Danny Brown told a February board meeting, “then they’re likely going to go to someone that doesn’t have to disclose it. So in order to make sure that we’re competitive in this market and getting the best opportunities, we need to (have) these similar rules that other folks will be playing by.”
Under the pending bill, the Public Records Act could still be invoked to learn who a borrower is, what the basic terms of a loan are, and whether a borrower has been in default for at least six months.
A central part of the pension fund’s new plan is to venture further from the well-trafficked coves of traditional stock and bond markets into the open, lightly-regulated waters of private investments. These include both private debt and private equity — in which the board purchases a direct ownership stake in a business.
These financial arrangements are unavailable to your average investor and are trickier to get out of. That makes them riskier, and as a result, investors can demand a higher return.
William Wang, emeritus professor of corporate finance at the University of California Hastings College of Law, warned that setting up a private loan-making operation inside the pension fund will require “hiring away the masters of the universe” who currently work at private equity and venture capital firms. “Those people make a lot of money.”
Margaret Brown, one of CalPERS’ 13 board members and one of six who is elected, said she worries the pension fund staff does not have enough experience in making and managing loans. And this is not the right time to be learning on the job, she said.
“CalPERS has a habit of jumping in the market at the wrong time,” said Brown. “It’s one thing if we do private debt and we take small steps, right? You don’t give your new puppy the big 32-ounce can of food. You don’t do it. He’ll choke on it.”
Brown, a regular contrary voice on the board, cast the lone dissenting vote on the idea last month. Earlier this year she also voted against sponsoring the Public Records Act exclusion bill.
(No love lost: Brown recently sued the organization and the rest of the board after it penalized her for her use of the CalPERS name on her social media accounts.)
Bienvenue, the deputy chief investment officer, insisted that although the pension fund’s investment team does not have direct experience extending loans, the “experience and expertise” of those who have worked with other debt-related investments “are very similar and analogous to what would be required for this.”
“Sense of desperation”
CalPERS, like most public pension funds in the country, does face a tricky math problem: The board expects the fund’s investments to grow at an average rate of 7% each year. That number is more than an aspirational target; it’s also a vision of the future with major financial and political consequences.
The less that CalPERS makes in from its investments, the more it has to draw from employers — that is, taxpayers via their state and local governments — and public sector employees to pay for current and future retirement benefits. Few in state government are eager to ask cities or workers to cough up high contributions. Especially not now.
But in a period of prolonged low interest rates, it’s tough to earn that 7% without parking your money in some chancy investments, said Matt Gelfand, a managing director of the investment advising firm Moreland Associates. That puts pension fund managers in a bind.
“Either they generate a (lower rate of) return and it’s not enough to fund benefits, so somebody’s got to cover the cost of those benefits,” he said. “Or they do what CalPERS is aiming to do now…taking on a risk that might or might not work out.”
The story of public pension officers scrambling for increasingly scant financial opportunities is four decades in the making.
According to an analysis by the Pew Charitable Trust, beginning in the 1980s pension fund managers began to diversify away from the safe, steady and thoroughly boring world of highly rated bonds, choosing to ride the stock market’s roller coaster. After the turn of the century, with ever-lower interest rates making it even harder for investors to make money from traditional bonds, pensions ventured further into the Wild West of “alternative investments” — private equity, one-off infrastructure projects and real estate. Each step took the funds into potentially more profitable, but also more perilous, terrain.
“It’s completely driven by the accounting rules and the accounting rules themselves are driving people to these choices,” said Tom Sgouros, a policy advisor who has argued that the fiscal threat of unfunded pension liabilities is overstated. “The sense of desperation makes people make policy decisions that are unwise.”
Private credit appears to be the latest target for high-return seekers. According to the London-based financial data company Preqin, the total value of the global private credit market has ballooned from roughly $263 billion at the end of 2009 to $854 billion by the end of last year.
Too much money chasing too little opportunity?
Following the global financial crisis, “a lot of banks began to stop offering loans to middle-market firms and that created a large kind of chasm in that space,” said Ash Chauhan, a Preqin analyst. “When you’re looking at institutional investors like CalPERS, it was only a matter of time before they started investing.”
In fact, CalPERS may be a little late to the party.
The Arizona State Retirement System has been investing in private debt since 2013. Alabama’s state pension fund followed suit and has since emerged as a kind of cautionary tale. The Retirement Systems of Alabama lent directly to iPic, a perk-ified theater chain known for its reclining chairs and menu of sweet potato fries and sliders. When iPic went bust last summer, Alabama’s state retirees ended up owning the chain outright. These are hardly boom times for movie theaters.
Given the amount of interest in private lending, “the question now is whether there is too much money there chasing too few opportunities,” said Wang of UC Hastings.
Before CalPERS can find out, the pension fund’s staff is counting on state legislators and Gov. Gavin Newsom to sign off on its transparency exemption bill. It passed the Assembly with Marin County Democrat Marc Levine casting the lone “no” vote.
“It’s hypocritical for Democrats in the Legislature to allow CalPERS to hide the critical information about investments and investors while seeking disclosure from the president on his investments,” Levine told CalMatters. “Can you look more dopey than that?”
Nonetheless, the California Newspaper Publishers Association has moved from opposed to neutral on the bill.
“We recognize that when dealing with information in this area there is going to be a concern about the privacy of borrowers, notwithstanding that this is a government agency involved in a lending program,” said Jim Ewert, the association’s general counsel. “To the extent that there is questionable decision-making that’s going on, we may revisit this issue and attempt to tighten things up a bit more.”