In This Issue

  • Public pension plans: it’s an “Absolute” future
  • Management transition two ways
  • Goldman Sachs wants to be your only outsourcer


Management transition one way:

I drove down to Menlo Park last week to watch Makena Capital Management transition from one CIO to another and there wasn’t much to see.  And that’s the point.  When you manage $13 billion of other people’s money, you want to do this kind of thing as quietly and seamlessly as possible.

Mike Ross brought a cup of coffee to his successor, Eric Upin, then strolled on down the hall to another office.  Then Eric sat down in Mike’s chair without spilling a drop.

This isn’t the first time they’ve done this drill.  Mike Ross was CIO at the Stanford Management Company until December 2005 when he was succeeded by… Eric Upin.  Déjà-vu all over again.

Makena is one of the top-tier outsourced-CIO firms.  Along with peers like Investure and Commonfund, and other outsource managers such as Global Endowment Management and Morgan Creek Capital Management, they offer world-class endowment-model management to institutions, allowing them to avoid staffing their own internal offices.  A great idea if you can actually execute and Makena’s customers seem to think they can.  More than half of that $13 billion comes from international investors, including five big sovereign wealth funds.

Eric and Makena founder Michael McCaffery have been a double-act for a long time.  McCaffery ran the boutique investment bank Robertson Stephens for twelve years, with Eric as managing director and senior equity research analyst.  Then they both moved to the Stanford Management Company, with McCaffery as CEO.

McCaffery left Stanford in 2006 to found Makena.  In late 2008 Eric followed his old boss to Menlo Park.  Two other Makena founding principals are also Stanford vets: David Burke was the private equity director at SMC, and Susan Meaney ran their real estate portfolio.  These are members of the core team which pushed Stanford up into third place among U.S. endowments, close behind Harvard and Yale.  It’s not hard to get attention from investors when you can point to a track record like that.


Management transition another way:

Hedge Fund Alert reported last week that a founding partner of Morgan Creek Capital Management stomped out of the North Carolina firm after coming close to a “full-blown fight.”  Marketing head Dennis Miner initially threatened to sue the firm, but is now negotiating his severance.  Things may be a little tense after legendary hedge investor Julian Robertson pulled out a large investment last year and they were roughed up by the financial crisis.  Morgan Creek still has $9 billion AUM.  And CEO Mike Yusko is a talented guy who is widely respected in the industry, so I have no doubt the firm will restructure its marketing and forge ahead.  Still, these kinds of messy management issues are exactly what investors don’t want to hear about.


A heavyweight competitor steps into the ring:

Speaking of outsourcing, Gillian Wee, writing for Bloomberg/Business Week, just filed a story noting that Goldman Sachs is recruiting endowment CIOs to staff up their own 50-person asset-management group.  They’re using a Boston headhunter to approach candidates at pension funds, endowments and competitor asset managers.  She mentions a recent Casey Quirk study estimating that outsourcing of institutional portfolio management could more than double from $195 billion in 2008 to $510 billion by 2012.

Full article here:


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Trillions in trouble: Public pension meltdown bodes well for alternatives:

Here in California we have the biggest public pension fund in captivity: CalPERS, with $200 billion in assets, and lately we’ve been hearing that it (and its siblings) are underfunded by $500 billion.  And when anybody in California says “underfunded,” what we all hear is “taxes incoming.”  Then another thousand of us saddle up and move to Nevada.

But, for once, Sacramento is not the leader of the pack for fecklessness.  Pension-wise, we’ve been out-feckled by states like Illinois, Ohio, Colorado, New Jersey, and many others.  Public pensions have been stress-tested good and hard recently, and it’s now clear that many of them have big cracks in their foundations.  Maybe $3 trillion worth.  And, since they invest in everything on a big scale this will affect the whole spectrum of money managers who do business with them.

When the public pension herd gets moving in the same direction, everybody further down the food chain is going to feel it.  If they shift their allocations by as little as 1% in any category, it’s going to affect something like $30 billion on the books of hundreds of their external managers.  This is good news for funds vying for the money.

Some of the pensions with the biggest holes already have the largest exposure to riskier and less-liquid assets.  But, as perverse as it sounds, I suspect that they’re the ones who will be pushed hardest todouble down or get out of the game, and they can’t get out of the game.

The Pew Foundation has said that 21 states are already (as of FY 2008) operating under the danger-line of 80% funding, and that total underfunding may be $1 trillion.  But they use last year’s numbers and politely accept the pensions’ own ROI assumptions.  Officially, that they’ll earn about 8% on their investments going forward.

Me, I’m going with Professor Robert Novy-Marx at my alma mater, University of Chicago/Booth.  With Kellogg/Northwestern’s Joshua Rauh, he argues that that 8% is, well…, bogus.  They theorize that the discount rate on those future liabilities should be much lower.  Crank that into the equations, and out comes underfunding closer to $3.2 trillion.

There’s a summary of their paper here:

…And a paper from a Stanford University think tank which confirms their methodology and comes up with a riskless discount rate of 4.14% for the big California plans, increasing their unfunded liabilities to over $400 billion!:

You don’t have to be a theorist to agree.  A practitioner like BlackRock’s CEO Larry Fink (who’s done business with CalPERS) says: “You’ll be lucky to get 6 percent on your portfolios, maybe 5 percent.”  In fact, most funds have averaged only a little over 3% ROI for the past decade.  The plan officials seem to be dreaming of a reversion to the “norm” of the Great Moderation of the 80s and 90s.  Good luck with that.

Or consider Warren Buffett’s opinion.  He assumes that the corporate pension fund of Berkshire Hathaway can make just 6.9%.  But that’s 6.9% under the uniquely talented Mr. Buffett and his hand-picked lieutenants, not a board reporting to state politicians.  He wrote to his shareholders in 2008:

“Public pension promises are huge and, in many cases, funding is woefully inadequate.  Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that the problems will only become apparent long after these officials have departed.”

Illinois is among the worst of the worst.  Its major fund was just 46% funded as of FY 2008 (i.e., 54% underfunded).  The professors think their funds will be dry in eight years.  That’s if they fire all their workers tomorrow and don’t accrue any more liabilities going forward.  So, in 2019 they’ll have to pay those retirees directly from the state’s general revenue, which could eat half of all tax receipts.

Wait, it gets worse.  The Center for Retirement Research at Boston College, using FY 2009 numbers, says funding of Illinois’ major pension fund dropped again from 46% to 44% year-to-year

But, even as their funding level was dropping, their board in 2008 doubled the policy target for hedge funds (via fund of funds) from 5% to 10%.  HFs are up in absolute dollars from $599 million to $881 million year-over-year. [Illinois SERS 2009 annual report]

The size of the problem won’t be officially acknowledged until those fictional ROI numbers have to be lowered.  California is thinking about lowering the 7.75% rate at CalPERS.  And they plan to keep thinking about it until the next election is over.  The CIO of Wyoming’s pension fund admitted: “Nobody wants to adjust the rate, because liabilities would explode.”

Harley Rogers, CEO of private equity consultant Hamilton Lane (which does business with CalPERS) put the matter succinctly last year: “…you have three choices: You can live underfunded for a while, you can make it up by raising taxes…, or you can earn your way out of it.”

(Or, as Governor Schwarzenegger suggested, new and mid-career employees can be shoved into a lower pension-trajectory, using defined-contribution plans.  That proposal lasted as long as it took the unions to speed-dial their legislators.  But, unlike the Governator, it will be back.)

All three of Mr. Rogers’ choices will be tried; and Governor Schwarzenegger’s, too.  But the Boston College study concludes that, realistically, only a rising stock market is going to re-fund the pensions.  In other words, all we can do is wait for “beta”.  That’s probably true for the system as a whole, but individual boards and CIOs can try to improve returns, and are coming under increased pressure to do so.

So, squeezed between the rock of underfunding and the hard place of mediocre returns, exactly how are they going to do that?

Early in the decade, after the dot-com bust destroyed their equity returns, the pensions turned envious eyes to the “Endowment Model” portfolios which were generating good returns even as the S&P slumped.  Encouraged and abetted by some of the same consultants who served the Ivys, the herd slowly formed up and moseyed in that direction, leavening their 60/40 portfolios with alternatives.

In 2005, just 13 percent of all public pension funds had hedge fund investments; by 2008, 40 percent did so.  Their total HF investment is now $78 billion – nearly 3%.  About half of them now invest in private-equity funds.

See New York Times:]

Consider New Jersey, which is just 56% funded, according to the Boston College researchers. They had zero alternative investments in 2005.  By 2008, 12% of their portfolio — $9.5 billion – was in alternatives (including both absolute return and private equity), with offsetting cuts to domestic equity.  Massachusetts, which is in better shape, and actually pushed up their funding level a bit last year, had no hedge fund exposure until 2005, when they dialed in a 5% target.  They’ve had about 10% in private equity for years – 200 partnerships through 92 managers – and it’s done very well for them, generating 11.8% for ten years through 2009.

But if all the pensions lunge toward hedges and private equity at the same time, won’t they just crowd each other out as they fight for the good stuff, and just succeed in keeping fees high?  It’s pretty well-known that if you aren’t dealing with the top tier of PE, then you might as well stay in stocks.  Unlike the children of Lake Wobegon, all the alternative funds can’t be above average, no matter what their salesmen tell you.

I called a colleague who runs the investments at a major municipal pension, and asked him whether he thought the they would become even more endowment-like as they struggled for higher returns.  He said absolutely; it’s a done deal.

I talked to another contact who’s now a university endowment CIO, but who used to work at a public plan, and who knows both worlds very well.  He agrees with all of the above. “Charles, the hedge fund guys who are talking to me, are telling me exactly the same thing.  They are re-tooling their marketing to reach the pensions in light of their current troubles, offering themselves as a solution.”

There’s more to say about this large topic.  I’ve been in touch with Steve Drobny, cofounder of Drobny Global Advisors, about his new book (published just this week)  “The Invisible Hands: Hedge Funds Off the Record”.  The lead chapter is all about public pension money and he has an interesting take on where they’ve been and where they’re going.  When I’ve had a chance to digest it, we’ll see what light Steve can throw on the situation.


Hedging in the Big Valley: Arrowhawk lands in Stockton:

When I last spoke to Michael Litt he was on a train in Switzerland, out raising money for his new Arrowhawk Capital Partners Durable Alpha Fund.  Now, I note that he recently got a mandate a little closer to home.  The San Joaquin County pension fund announced in February that it had committed to a $100 million slice of Durable Alpha.

Up above, we pondered the direction of public pensions’ investments, and here’s another data point.  In recent years, $2 billion San Joaquin County Employees Retirement System (SJCERA) had no explicit hedge fund allocation.  They did use a “portable alpha” overlay product in their equities bucket; and, for a while, had a small position in a FrontPoint fund which they dumped when Morgan Stanley acquired FrontPoint in 2006.

Annette St. Urbain was a 20-year veteran of CalPERS and CalSTRS, before moving down to SJCERA in Stockton in 2002 as the fund’s investment analyst.  She was promoted to CEO in 2007, and then persuaded the board to create a new CIO slot, which she filled with Nancy Calkins, also a CalPERS vet.  Last year, after doing their homework, Ms. St. Urbain and her board set a 7% allocation to a global multistrategy fund, which it filled with Arrowhawk.  Michael had worked with SJCERA when he was with FrontPoint and they apparently liked what he brought them.  Arrowhawk built Durable Alpha to meet the needs of its customers in a tough market.  There are no redemption gates and no side pockets for illiquid assets.  The management fee goes down to 1% for a two-year commitment and the 20% performance fee isn’t levied until the fund beats it benchmark.

Michael and his partners picked a lousy time to start a new fund.  In the last quarter of 2008 shell-shocked institutional investors seemed barely able to make a decision.  But, after some tough months, they finally got airborne, with $25 million of partner money and $500 million from institutions, including SJCERA’s $100 million and $200 million from the Kentucky Retirement System.  The $12 billion KRS fund made its first hedge allocation – 5% of its fund – in February of last year, then filled it with a $200 million direct investment in Durable Alpha in October.


Thank you:

To readers who answered my query about what qualities make exceptional investment managers.  I received many thoughtful and provocative replies and I will be sharing some of them in an upcoming letter.


Parting Shot: Bill Lockyer not make benefit glorious state of California?

California, floundering in the fiscal bed it made for itself, has decided that the evil Wall Street bankers must be at fault.  Goldman Sachs, which as a market-maker, permits people to bet against California’s bonds, received a tart letter from California Treasurer Bill Lockyer.  Mr. Lockyer complains that the pricing of credit default swaps for California bonds have “wrongly branded our bonds as a greater risk than those issued by such nations as Kazakhstan.”

The Financial Times helpfully noted that, in fact, Kazakhstan’s $100 billion debt may be more manageable than California’s $85 billion.  Kazakhstan has the world’s 11th – largest oil reserves and, unlike California, their government permits people to extract them, which produces a fat revenue stream for the glorious nation of Kazakhstan.  And Kazakhstan has 6.7 percent unemployment and 8 percent GDP growth.  Whereas California has….oh, never mind.  Suffice it to say that Goldman’s CDS traders might possibly know their jobs.  There is rather less evidence that Mr. Lockyer and California’s governing class know theirs.

See Financial Times story here:

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