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CalPERS Embraces Leverage

Image via Loic Leray on Unsplash

In April we wrote about the bad timing at the California Public Employees’ Retirement System (CalPERS). CalPERS removed one of its two hedges against tail-risk just a few weeks before the coronavirus caused the stock market to plummet.

Although the hedge CalPERS did maintain generated "several hundred million dollars" for the pension, the hedge CalPERS exited would've generated more than $1 billion.

With CalPERS underfunded and its assets amounting to just over 70% of its future liabilities, the CalPERS investment committee has now decided to take its risk up a few notches in an attempt to achieve its 7% target rate of return.

After approving a new investment policy last September that allows for leverage to reach an aggregate level of up to 20%, Meng said the fund now plans to "deploy leverage gradually." Based on CalPERS' current assets under management, the amount of leverage could reach as high as $80 billion.

So what will CalPERS use leverage to purchase? It appears CalPERS' focus is turning to opportunistic strategies and private equity. The investment committee voted to recommend the maximum target for its opportunistic strategies increase to 5% from 3%.

"These types of opportunities tend to be the result of extreme market dislocations and the transitional in nature," Yeng said. "It's important to be ready to act quickly to capture such opportunities."

The investment committee also increased CalPERS' buyout target allocation by 5% to 70%, with a range of 60% to 80%. According to Steven Hartt, who is CalPERS' private equity consultant, buyouts are expected to become a more prevalent part of their strategy.

"I think that the continued deployment of capital in private equity is going to be continued to be focused on the buyouts area," Hartt said.

Yeng, who presumably knows the push into leverage will receive criticism, tried to convince skeptics that CalPERS has thought it through.

"We have carefully factored in these risks and had implemented a comprehensive forward-looking plan," Yeng said. "Over the last several months, we have meticulously planned a major shift, improving liquidity management, installing of proper controls and a centralized government framework."

However, one of CalPERS' twelve board members voted against the move and wasn't shy about speaking out about the use of leverage.

"I don’t agree with leveraging the fund up to $80 billion by investing more in private equity and private debt. It is way too risky," Margaret Brown said. "It reminds me what CalPERS did back in 2008 when we used leverage and lost close to $100 billion. We had to pony up money to get out of positions. I see a possible repeat of what happened after the markets crashed in 2008 when we lost a lot and never recovered."

In the same way CalPERS figured it could eliminate hedges with stocks at all-time highs right before the market crashed, we now wait to see if its decision to embrace leverage with markets mostly back to their highs turns out to be another poorly-timed decision.

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