Bloomberg and other publications criticized CalPERS for using leverage schemes to increase returns, while lacking other types of borrowing


The financial media is furious about CalPERS’s efforts to pursue higher returns in a systemic low-return market, and now plans to borrow at CalPERS levels based on the leverage used in many of its investment strategies, especially private equity and real estate.

These generally respectful publications are worth worrying about. This leverage on leverage is not only dangerous, because it can lead to crashes and fire sales, magnify damage and may cause systemic stress, but CalPERS’s debt situation is even worse than the accounts they describe. They did not consider another layer of borrowing from private equity funds and some real estate funds, called subscription line financing, which we will introduce later.

As we have often pointed out, the borrowing of horticultural varieties, even on a broad basis, can create a world of harm in the form of bankruptcy and severe recession. But the cause of the financial crisis, especially in the modern era, is leverage, which then damages the banking system or other systemically important participants. Recall that during the crash, not only did the level of margin borrowing for stocks far exceed the level allowed now, but there was also leverage in the form of trusts, that is, the purchase of stocks, the sale of shares in these trusts, and the use of other trusts. .

Even if CalPERS and other public pension funds that follow CalPERS implode (you can be sure it will happen; the withdrawal of CalPERS is legal), this is not very comforting. California taxpayers who support huge funds will ultimately bear the responsibility. Any imitator in a jurisdiction without strong government guarantees will impoverish their beneficiaries.

Please note that borrowing at the investment fund level is not always a bad idea. We even advocate for CalPERS as an alternative to investing in private equity. German institutional investors are allergic to private equity. In order to obtain a higher level of risk, they invest in public securities and borrow from their entire portfolio. This approach makes sense, because German investors can determine the level of borrowing and other risks in their securities portfolios, and thus can estimate how much leverage-related risks they bear overall.

However, this is not what CalPERS does. Institutional investors summarize the new plan:

At a meeting in mid-November, the California Public Employees Retirement System revealed its plan to manage these changing market dynamics. The fund intends to change its strategic asset class allocation, inject more funds into private equity, and add a small amount of leverage to the investment portfolio…

CalPERS will increase its private equity portfolio from 8% of its total assets to 13%, or approximately $25 billion. CalPERS is selling some U.S. Treasury bonds and stocks to further promote privatization…

The pension fund plans to add leverage (borrowed funds) of up to 5% to its investment portfolio. CalPERS argued in a recent speech that leverage will improve diversification and reduce risk.

For those with little financial knowledge, CalPERS’s assertion that borrowing will increase diversification and reduce risk is completely wrong, so that the institution is not qualified to manage any higher bets than church sweepstakes.

CalPERS tells other less obvious lies, such as trying to describe private equity as essential to success, so much so that it needs to invest more money on that number on roulette. Remember, the name of the game in the investment field is not absolute performance, but risk-adjusted performance. Private equity not only did not generate additional returns to compensate for its additional risks, at least while we have been kicking these tires (since 2012), academic experts such as Ludovic Phalippou, Richard Ennis, and Eileen Appelbaum have concluded that private equity has already Since the financial crisis, stocks have not even been beaten.

Let us emphasize that unlike German investors, they have a good grasp of all leveraged bets in their portfolios, so they can reliably estimate their increased risk by borrowing in all investments, while CalPERS blindly Respect to private equity. It cannot access the balance sheets of portfolio companies in its various private equity funds.

Although owning a balance sheet will be a considerable improvement from today, it does not tell the whole story. CalPERS also needs to consider operating leverage. When I was a kid of Goldman Sachs, whenever we analyzed leverage (like all time), we had to delve into the footnotes of the financial statements, find out the amount of operating lease payments, and capitalize them, just like in The same lease payment and the same amount of borrowing are included in the annual total, so we can view different companies on a more comparable basis.

Operating leases are a widely used method of withdrawing cash from private equity investments. Many retail companies have their own stores because the retail industry is known to be cyclical. No need to pay rent reduces fixed costs and helps them through difficult times.

Unlike self-employed operators, private equity companies can make money regardless of their investment performance, so they are not very sensitive to bankruptcy risks. As Eileen Appelbaum and Rosemary Batt describe in detail in their classic Private Equity at Work, private equity firms will sell the real estate of the investee company to a third party. The value of the split real estate depends on the level of rent payment. This gives private equity managers an incentive to provide companies with expensive leases, because if it can obtain a lot of value from the company through real estate sales, then the company’s subsequent bankruptcy will not matter much.

Another source of hidden leverage is subscription credit. Unlike the customary practice of taking on debt to portfolio companies, private equity fund managers here instead borrow at the fund level. What is supporting this debt? Not the assets of portfolio companies, but clumsy investors. These credit lines are guaranteed by limited partners’ unfulfilled promises.

Investors like CalPERS are blind again. Although their promise is to ensure the safety of this loan, they don’t know how much they have used. But they were warned that they might get into trouble because of this kind of thing. This is the typical term used in recent limited partner agreements:

Under the fund credit arrangement, there shall be no loans that would cause the total principal of such loans to exceed 50% of the total amount promised by investors.

As one expert said about their deployment:

The situation varies greatly in terms of the degree to which managers attach importance to it. Sometimes you will see that they almost pull the line to its limit; other times, it is used so cautiously that the fund bears the fixed cost of the line (for example, the origination fee) is almost meaningless.

Please note that almost all funds now use subscription quotas to increase returns. Our source also stated that they were also acquired by real estate funds.

There are other reasons for the volatility on CalPERS. Among all participants, it should recognize the risk of excessive risk taking, because it has fallen into a financial crisis and has to sell stocks at low prices to meet the requirements of private equity capital.

Bloomberg’s article, Leverage Leverage is a big danger for investors and their lenders, Even if he did not realize the additional danger of hidden leverage, he was shocked. It makes CalPERS a typical representative, starting with its subtitle:

Calpers decided to use the borrowed cash to increase returns, which shows that everyone is taking more risks to make money.

pivotal parts:

Calpers is a California public employee pension fund with a market capitalization of US$495 billion. It plans to invest in financial assets by assuming up to 5% (or approximately US$25 billion) of its fund value to invest in financial assets, thereby investing more money to chase returns. It does this because it does not see another way to achieve its long-term return target of 6.8% to achieve its promised expenditure.

This seems remarkable to me: a very large pension plan invested in many different funds, including many funds that use leverage to increase returns, will now start using its own leverage to increase returns. It emphasizes how various investors must take more risks to make money.

Calpers’ strategy may eventually be self-defeating: the more money you invest in any asset class, the lower its yield, and the more difficult it is for anyone to get a good return…

Another problem is that the leverage ratio in the financial market is very high-and it is rising-which makes things riskier and potentially unstable…

Guess what: The valuation and leverage of acquisition deals have also risen. According to consultants from Bain & Co., more than two-thirds of US acquisitions last year were more than 11 times Ebitda. At the height of the last acquisition boom in 2007, only about a quarter of US acquisitions were at such a high multiple.

At the same time, according to Bain & Company data, nearly 60% of transactions have total debt more than seven times that of Ebitda; in 2015, it was less than 20% of transactions.

However, in order to distribute dividends at a record rate this year, private equity firms are adding more debt to these companies.

Institutional investor accounts also gave reasons for the suspension. For example:

Ludovic Phalippou is a French financial economist and researcher. His work has been highly critical of private equity. He warned against the use of leverage in investment portfolios. “Most people think that increasing leverage will increase returns. This is a mistake,” he said via email. “As simple as possible: If you invest in AAA bonds, suppose you will definitely get a 2% return. If you increase your stock portfolio, [you may, let’s say,] There is a 50% chance to get a 20% chance and a 50% chance to lose a 10% chance. In this example, the expected return is higher, but you are not getting the expected return, [and] This is where the error lies: you either win more or lose more. If you are a pension fund and increase leverage, you are doing the latter-basically, betting on the house. You risk losing a lot of money because you want the opportunity to be a solvent. ”

Like CalPERS, the board did not properly understand the risks. As far as its board members are concerned, this is after they approve the strategy through such news reports. As CalPERS board member Margaret Brown said:

Employees, Meketa or Wilshire have never raised or discussed this impact on leverage risk with the board of directors.

The ancients believed that God protects children, fools, and drunks. Perhaps CalPERS is such an obvious liar, betting on God’s intervention. But considering how many naive investors give their heads to them, God clearly sees investment as a rigid image field that is not protected by him.

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