CalPERS: On the Way to Becoming the World's Largest Hedge Fund

The Financial Times reported today that the nearly $400 billion CalPERS pension fund will start employing leverage up to 20% of the fund's assets. (https://www.ft.com/topics/organisations/California_Public_Employees'_Retirement_System, paywall) Ben Meng, the chief investment officer, outlined his view that leverage was required to achieve its 7% required return in a Wall Street Journal op-ed. The leverage would be used to finance illiquid private equity, yield curve arbitrage (On the old Salomon Brothers trading floor that trade trade was described as the "widow-maker".) and purchase equity futures.

All of these moves can rightly be characterized as risky hedge fund trades. Then why is is a public pension plan doing this? Simply put Meng does not believe that the fund's normal asset allocation can deliver the 7% required return needed to fund its liabilities which is exacerbated by a 71% funding level for the nearly two million beneficiaries of the plan. Instead of lowering the required rate of return assumption which would require politically unpalatable moves to increase contributions from employees and governmental sponsors, CalPERS is betting the ranch on a series of risky trades. What can go wrong? 

Ten years ago I posted a blog entitled "An Uneasy Look at Leverage." (https://shulmaven.blogspot.com/2010/03/uneasy-look-at-leverage.html) I argued there that pension funds were fooling themselves by not by not fully consolidating the debt associated with private equity and leveraged real estate investments. For example today CalPERS has about $70 billion of investments in private equity and real estate. If that were likely leveraged at say 3:1, then a fully consolidated balance sheet would show an additional $210 billion of assets on the books an a concomitant $210 billion of debt. Thus CalPERS is already leveraged with about one-third of its assets supported by debt. ($400 bil. of assets plus $210 bil. grossing up private assets yields a total balance sheet of $610 bil. funded in part with $210 bil. in debt.) 

Although Meng rightly argues that CalPERS is a perpetual organization, it lives in a series of short-run environments. So if interest rates increase, credit spreads widen and the economy enters a sustained downturn, will a future board had courage to stay the course? Further in a downturn leveraged investments suffer severe bankruptcy risk, from which there is minimal recovery. I would also note that in 1999, near the market peak, the New Jersey pension fund made a leveraged bet on ever rising equity values that did not turn all that well.

To sum up, I believe that CalPERS is engaging in a very dangerous strategy that should give its beneficiaries and the California Legislature great pause.