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Marching Orders for the Next Investment Chief of CalPERS: More Private Equity

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Ben Meng got the job of chief investment officer of CalPERS by convincing the trustees of the nation’s largest public pension fund that he could hit their target of a 7 percent annual return on investment by directing more of the fund’s billions into private equity.

Now, Mr. Meng is gone — only a year and a half after he started — and CalPERS, as the $410 billion California Public Employees’ Retirement System is known, is no closer to that goal. The fund is consistently short of the billions of dollars it needs to pay all retirees their pensions. And it continues to calculate that it can meet those obligations only if it gets the kind of big investment gains promised by private equity.

The strategy involves putting money into funds managed by firms such as the Blackstone Group and Carlyle, which buy companies and retool them with the goal of selling them or taking them public. Even as some of the fund’s trustees have misgivings — they say the private equity business is opaque, illiquid and carries high fees — they say they have little choice.

“Private equity isn’t my favorite asset class,” Theresa Taylor, the chair of the CalPERS board’s investment committee, said at a recent meeting. “It helps us achieve our 7 percent solution,” she said. “I know we have to be there. I wish we were 100 percent funded. Then, maybe we wouldn’t.”

CalPERS, like many other pension funds, began putting money into private equity funds decades ago. But its reliance on such funds has increased in recent years, as low interest rates have made bonds less attractive and stocks have proven too volatile. Adding to the urgency are an aging population, expansive pension benefits that can’t be reduced and a major funding shortfall.

Mr. Meng’s abrupt departure in August, and CalPERS’s slow-moving search for a replacement, are delaying its plans to increase its private equity investments. Mr. Meng resigned after compliance staff noticed that he had personal stakes in some of the investment firms that he was committing CalPERS’s money to, most notably Blackstone. California state officials in that situation are supposed to recuse themselves, but Mr. Meng did not.

Some of the fund’s stakeholders, including cities, school districts and other public employers, worry that in the meantime, CalPERS’s trustees could react by putting new restrictions on investment chiefs, discouraging top candidates from applying for the job or otherwise making it harder for CalPERS to achieve its target rate of return. If investment returns fall short, local officials know they’ll have to make up the difference, dipping into their budgets to free up more money to send to the fund.

Credit…Salgu Wissmath for The New York Times
Credit…Salgu Wissmath for The New York Times

“It gets harder and harder each year,” said Brett McFadden, the superintendent of a large school district northeast of Sacramento. He has cut art, music and guidance counselors to get more money for the state pension systems every year. “These policies are being made in Sacramento, and I’m the one left holding the bag,” he said.

Marcie Frost, the chief executive of CalPERS, said that Mr. Meng’s departure would not prompt the board to change CalPERS’s investment strategy. She said a study by CalPERS and its outside consultants showed that private equity and distressed debt were the only asset classes powerful enough to boost the fund’s overall average gains up to 7 percent a year, over time.

“So we have to have a meaningful allocation to those,” she said, adding: “There are no guarantees that we’re going to be able to get 7 percent in the short term or, frankly, in the long term.”

Data show that CalPERS’s private equity returns are consistently lower than industry benchmarks, but private equity has still performed better than other assets and “has generated billions of dollars in additional returns as a result of our investments,” said Greg Ruiz, CalPERS’s managing investment director for private equity.

Mr. Meng was a big proponent of private equity, telling trustees that “only one asset class” would deliver the returns they sought and that the fund would need to direct more money into it. But while CalPERS sought, under him, to increase its private equity allocation to 8 percent of total assets, the holdings fell to 6.3 percent, in part because the private equity managers were returning money from previous investments and CalPERS did not jump to reinvest it. Overall, the fund had about $80 billion — or 21 percent of its assets — in private equity, real estate and other illiquid assets as of June 30, the end of its last fiscal year.

CalPERS has sometimes moved slowly on private equity partly because of its trustees’ qualms.

At one recent meeting, Ms. Taylor, the investment committee chair and formerly a senior union official, recalled that some of CalPERS’s private equity partners had bought Toys ‘R’ Us in 2005. The transaction loaded it up with $5 billion in debt just as the retailer’s bricks-and-mortar sales strategy was becoming antiquated, and the company went into a long, slow collapse that ended in liquidation and cost more than 30,000 jobs. “I’m hoping that we can get to a better strategy of mitigating some of these problems,” she said.

Other trustees questioned the validity of the internal benchmark CalPERS uses to evaluate its private equity investments, saying they didn’t believe the returns were all that good after fees were deducted.

ImageMarcie Frost, the chief executive of CalPERS, said a study showed that private equity and distressed debt were the only investments that could boost the fund’s average gains to 7 percent a year.
Credit…Mike Blake/Reuters

“We’re going to be sold a bill of goods, and we’re going to believe what they say, because we want to believe it and we want to make higher returns,” said Margaret Brown, a trustee and retired capital investments director for a school district southeast of Los Angeles.

Still, the marching orders for CalPERS’s next investment chief are apparent: find ways to increase the pension giant’s investments in private equity funds.

Independent analysts have long urged public pension trustees to stop chasing higher returns and instead take a deep, hard look at how they got to be so underfunded in the first place. A growing school of thought blames the way they calculate their total obligations to retirees for understating the true number — specifically, how they translate the value of pensions due in the future into today’s dollars.

To do that, CalPERS uses the routine practice of discounting, which all financial institutions use and is based on the principle that money is worth more today than in the future. It requires the selection of an appropriate discount rate. CalPERS uses its target return on investment of 7 percent as its discount rate — a practice flatly rejected by financial economists, because 7 percent is associated with a high degree of risk, and CalPERS’s pensions are risk free. Economists say that CalPERS, and other public pension systems, should be using the rate associated with risk-free bonds like U.S. Treasury bonds. Doing it that way shows the tremendous intrinsic value of risk-free retirement income.

But by assuming a high so-called discount rate that matches its assumed rate of return, CalPERS makes its shortfall look much smaller on paper — which allows the fund to bill the state of California and its cities for smaller annual contributions than it would otherwise have to. That helps everybody balance their budgets more easily, but it has left the pension system chronically underfunded.

Public pension systems in California, including CalPERS, reported a combined shortfall of $352.5 billion as of 2018, using their high investment assumptions as discount rates, according to a compilation by the Stanford Institute for Economic Policy Research. But by replacing just that one assumption with what economists consider a valid discount rate, the institute showed that the funds were really $1 trillion short that year. If CalPERS suddenly started billing local governments accordingly, it would cause a crisis.

CalPERS stepped into this trap in 1999, at the end of a powerful bull market. On paper, it appeared to have far more money than it needed, and state lawmakers decided to increase public pensions after hearing from CalPERS officials it would not cost anything so long as the fund’s investments could produce 8.25 percent average annual gains.

Then the dot-com bubble burst, and the investment gains on paper that CalPERS had amassed melted away, leaving a shortfall. But the big pension increase was locked in because California law bars any reduction in public pensions. Similar things happened in many other states. Before long, the race was on for higher investment returns.

“Over the past 20 years, U.S. pension funds have set aggressive targets and failed to meet them,” said Kurt Winkelmann, a senior fellow for pension policy design at the University of Minnesota’s Heller-Hurwicz Economics Institute.

He recently compiled the investment returns of the 50 states’ pension systems from 2000 to 2018 and compared them with the states’ average targets during that period. It turned out that the actual returns were 1.7 percentage points per year less.

CalPERS’s investment results were even more off the mark, Mr. Winkelmann found. Its target averaged 7.7 percent over the 18-year time frame. But actual average returns were only 5.5 percent over that period, Mr. Winkelmann said.

“There were periods when public fund investments exceeded their targets,” Mr. Winkelmann said. “However, these periods were more than offset by periods with dramatic losses.”

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The Trump campaign celebrated a growth record that Democrats downplayed.

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The White House celebrated economic growth numbers for the third quarter released on Thursday, even as Joseph R. Biden Jr.’s presidential campaign sought to throw cold water on the report — the last major data release leading up to the Nov. 3 election — and warned that the economic recovery was losing steam.

The economy grew at a record pace last quarter, but the upswing was a partial bounce-back after an enormous decline and left the economy smaller than it was before the pandemic. The White House took no notice of those glum caveats.

“This record economic growth is absolute validation of President Trump’s policies, which create jobs and opportunities for Americans in every corner of the country,” Mr. Trump’s re-election campaign said in a statement, highlighting a rebound of 33.1 percent at an annualized rate. Mr. Trump heralded the data on Twitter, posting that he was “so glad” that the number had come out before Election Day.

The annualized rate that the White House emphasized extrapolates growth numbers as if the current pace held up for a year, and risks overstating big swings. Because the economy’s growth has been so volatile amid the pandemic, economists have urged focusing on quarterly numbers.

Those showed a 7.4 percent gain in the third quarter. That rebound, by far the biggest since reliable statistics began after World War II, still leaves the economy short of its pre-pandemic levels. The pace of recovery has also slowed, and now coronavirus cases are rising again across much of the United States, raising the prospect of further pullback.

“The recovery is stalling out, thanks to Trump’s refusal to have a serious plan to deal with Covid or to pass a new economic relief plan for workers, small businesses and communities,” Mr. Biden’s campaign said in a release ahead of Thursday’s report. The rebound was widely expected, and the campaign characterized it as “a partial return from a catastrophic hit.”

Economists have warned that the recovery could face serious roadblocks ahead. Temporary measures meant to shore up households and businesses — including unemployment insurance supplements and forgivable loans — have run dry. Swaths of the service sector remain shut down as the virus continues to spread, and job losses that were temporary are increasingly turning permanent.

“With coronavirus infections hitting a record high in recent days and any additional fiscal stimulus unlikely to arrive until, at the earliest, the start of next year, further progress will be much slower,” Paul Ashworth, chief United States economist at Capital Economics, wrote in a note following the report.

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Black and Hispanic workers, especially women, lag in the U.S. economic recovery.

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The surge in economic output in the third quarter set a record, but the recovery isn’t reaching everyone.

Economists have long warned that aggregate statistics like gross domestic product can obscure important differences beneath the surface. In the aftermath of the last recession, for example, G.D.P. returned to its previous level in early 2011, even as poverty rates remained high and the unemployment rate for Black Americans was above 15 percent.

Aggregate statistics could be even more misleading during the current crisis. The job losses in the initial months of the pandemic disproportionately struck low-wage service workers, many of them Black and Hispanic women. Service-sector jobs have been slow to return, while school closings are keeping many parents, especially mothers, from returning to work. Nearly half a million Hispanic women have left the labor force over the last three months.

“If we’re thinking that the economy is recovering completely and uniformly, that is simply not the case,” said Michelle Holder, an economist at John Jay College in New York. “This rebound is unevenly distributed along racial and gender lines.”

The G.D.P. report released Thursday doesn’t break down the data by race, sex or income. But other sources make the disparities clear. A pair of studies by researchers at the Urban Institute released this week found that Black and Hispanic adults were more likely to have lost jobs or income since March, and were twice as likely as white adults to experience food insecurity in September.

The financial impact of the pandemic hit many of the families that were least able to afford it, even as white-collar workers were largely spared, said Michael Karpman, an Urban Institute researcher and one of the studies’ authors.

“A lot of people who were already in a precarious position before the pandemic are now in worse shape, whereas people who were better off have generally been faring better financially,” he said.

Federal relief programs, such as expanded unemployment benefits, helped offset the damage for many families in the first months of the pandemic. But those programs have mostly ended, and talks to revive them have stalled in Washington. With virus cases surging in much of the country, Mr. Karpman warned, the economic toll could increase.

“There could be a lot more hardship coming up this winter if there’s not more relief from Congress, with the impact falling disproportionately on Black and Hispanic workers and their families,” he said.

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Ant Challenged Beijing and Prospered. Now It Toes the Line.

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As Jack Ma of Alibaba helped turn China into the world’s biggest e-commerce market over the past two decades, he was also vowing to pull off a more audacious transformation.

“If the banks don’t change, we’ll change the banks,” he said in 2008, decrying how hard it was for small businesses in China to borrow from government-run lenders.

“The financial industry needs disrupters,” he told People’s Daily, the official Communist Party newspaper, a few years later. His goal, he said, was to make banks and other state-owned enterprises “feel unwell.”

The scope of Mr. Ma’s success is becoming clearer. The vehicle for his financial-technology ambitions, an Alibaba spinoff called Ant Group, is preparing for the largest initial public offering on record. Ant is set to raise $34 billion by selling its shares to the public in Hong Kong and Shanghai, according to stock exchange documents released on Monday. After the listing, Ant would be worth around $310 billion, much more than many global banks.

The company is going public not as a scrappy upstart, but as a leviathan deeply dependent on the good will of the government Mr. Ma once relished prodding.

More than 730 million people use Ant’s Alipay app every month to pay for lunch, invest their savings and shop on credit. Yet Alipay’s size and importance have made it an inevitable target for China’s regulators, which have already brought its business to heel in certain areas.

These days, Ant talks mostly about creating partnerships with big banks, not disrupting or supplanting them. Several government-owned funds and institutions are Ant shareholders and stand to profit handsomely from the public offering.

The question now is how much higher Ant can fly without provoking the Chinese authorities into clipping its wings further.

Excitable investors see Ant as a buzzy internet innovator. The risk is that it becomes more like a heavily regulated “financial digital utility,” said Fraser Howie, the co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise.”

“Utility stocks, as far as I remember, were not the ones to be seen as the most exciting,” Mr. Howie said.

Ant declined to comment, citing the quiet period demanded by regulators before its share sale.

The company has played give-and-take with Beijing for years. As smartphone payments became ubiquitous in China, Ant found itself managing huge piles of money in Alipay users’ virtual wallets. The central bank made it park those funds in special accounts where they would earn minimal interest.

After people piled into an easy-to-use investment fund inside Alipay, the government forced the fund to shed risk and lower returns. Regulators curbed a plan to use Alipay data as the basis for a credit-scoring system akin to Americans’ FICO scores.

China’s Supreme Court this summer capped interest rates for consumer loans, though it was unclear how the ceiling would apply to Ant. The central bank is preparing a new virtual currency that could compete against Alipay and another digital wallet, the messaging app WeChat, as an everyday payment tool.

Ant has learned ways of keeping the authorities on its side. Mr. Ma once boasted at the World Economic Forum in Davos, Switzerland, about never taking money from the Chinese government. Today, funds associated with China’s social security system, its sovereign wealth fund, a state-owned life insurance company and the national postal carrier hold stakes in Ant. The I.P.O. is likely to increase the value of their holdings considerably.

“That’s how the state gets its payoff,” Mr. Howie said. With Ant, he said, “the line between state-owned enterprise and private enterprise is highly, highly blurred.”

China, in less than two generations, went from having a state-planned financial system to being at the global vanguard of internet finance, with trillions of dollars in transactions being made on mobile devices each year. Alipay had a lot to do with it.

Alibaba created the service in the early 2000s to hold payments for online purchases in escrow. Its broader usefulness quickly became clear in a country that mostly missed out on the credit card era. Features were added and users piled in. It became impossible for regulators and banks not to see the app as a threat.

ImageAnt Group’s headquarters in Hangzhou, China.
Credit…Alex Plavevski/EPA, via Shutterstock

A big test came when Ant began making an offer to Alipay users: Park your money in a section of the app called Yu’ebao, which means “leftover treasure,” and we will pay you more than the low rates fixed by the government at banks.

People could invest as much or as little as they wanted, making them feel like they were putting their pocket change to use. Yu’ebao was a hit, becoming one of the world’s largest money market funds.

The banks were terrified. One commentator for a state broadcaster called the fund a “vampire” and a “parasite.”

Still, “all the main regulators remained unanimous in saying that this was a positive thing for the Chinese financial system,” said Martin Chorzempa, a research fellow at the Peterson Institute for International Economics in Washington.

“If you can’t actually reform the banks,” Mr. Chorzempa said, “you can inject more competition.”

But then came worries about shadowy, unregulated corners of finance and the dangers they posed to the wider economy. Today, Chinese regulators are tightening supervision of financial holding companies, Ant included. Beijing has kept close watch on the financial instruments that small lenders create out of their consumer loans and sell to investors. Such securities help Ant fund some of its lending. But they also amplify the blowup if too many of those loans aren’t repaid.

“Those kinds of derivative products are something the government is really concerned about,” said Tian X. Hou, founder of the research firm TH Data Capital. Given Ant’s size, she said, “the government should be concerned.”

The broader worry for China is about growing levels of household debt. Beijing wants to cultivate a consumer economy, but excessive borrowing could eventually weigh on people’s spending power. The names of two of Alipay’s popular credit functions, Huabei and Jiebei, are jaunty invitations to spend and borrow.

Huang Ling, 22, started using Huabei when she was in high school. At the time, she didn’t qualify for a credit card. With Huabei’s help, she bought a drone, a scooter, a laptop and more.

The credit line made her feel rich. It also made her realize that if she actually wanted to be rich, she had to get busy.

“Living beyond my means forced me to work harder,” Ms. Huang said.

First, she opened a clothing shop in her hometown, Nanchang, in southeastern China. Then she started an advertising company in the inland metropolis of Chongqing. When the business needed cash, she borrowed from Jiebei.

Online shopping became a way to soothe daily anxieties, and Ms. Huang sometimes racked up thousands of dollars in Huabei bills, which only made her even more anxious. When the pandemic slammed her business, she started falling behind on her payments. That cast her into a deep depression.

Finally, early this month, with her parents’ help, she paid off her debts and closed her Huabei and Jiebei accounts. She felt “elated,” she said.

China’s recent troubles with freewheeling online loan platforms have put the government under pressure to protect ordinary borrowers.

Ant is helped by the fact that its business lines up with many of the Chinese leadership’s priorities: encouraging entrepreneurship and financial inclusion, and expanding the middle class. This year, the company helped the eastern city of Hangzhou, where it is based, set up an early version of the government’s app-based system for dictating coronavirus quarantines.

Such coziness is bound to raise hackles overseas. In Washington, Chinese tech companies that are seen as close to the government are radioactive.

In January 2017, Eric Jing, then Ant’s chief executive, said the company aimed to be serving two billion users worldwide within a decade. Shortly after, Ant announced that it was acquiring the money transfer company MoneyGram to increase its U.S. footprint. By the following January, the deal was dead, thwarted by data security concerns.

More recently, top officials in the Trump administration have discussed whether to place Ant Group on the so-called entity list, which prohibits foreign companies from purchasing American products. Officials from the State Department have suggested that an interagency committee, which also includes officials from the departments of defense, commerce and energy, review Ant for the potential entity listing, according to three people familiar with the matter.

Ant does not talk much anymore about expanding in the United States.

Ana Swanson contributed reporting.

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