I recently had a chance to attend a talk by Dennis Johnson, who is the Director of the Corporate Governance program at Calpers. Some of the points I garnered from his talk…..

Small Portfolio, Big Returns

The CG portfolio in Calpers is only $12B, which is only a twentieth of their total portfolio; despite its small size its performance is 50% better than the entire portfolio. The interesting thing is that only $5B of the fund is actually committed, of that $5B only $1B is invested internally. Now the $1B internal investments have shown almost 26% return in the last few years which is, to my astonishment, terribly high. My view of CG investing was that these are fairly passive and tend to manifest in the form of long term results rather than short-term. The remaining $4B is invested in private CG funds (whose names I dont remember, but one of them is run by a former SEC chairman). The CG group is still trying to commit its full portfolio but has had a hard time trying to come up with suitable vehicles.

Shareholder Proposals and the Focus List

Another misconception I had was that the much hyped focus list published by Calpers each year is based on their entire portfolio, but in reality it is the work of the CG group. Stan’s group, made of just 17 staff members, gleans the under-performers from their overall portfolio, applies a bunch of CG-related checklists and generates a list of 50 or so companies that have poor CG. All of these companies are given advance notice several months before the list is published (the next list is due in March 2008), and are given opportunity to implement a list of changes. While many of these companies succumb to the pressure of being named to the focus list, and subsequently make many of the proposed changes, the remaining ignore the warnings.

Now Calpers is a permanent investor i.e. they don’t pull out of an investment even if it underperforms for a prolonged period, one reason being the huge transaction cost associated with their typically large investments (several 100 millions many times). The only option left on the table for them is “shareholder proposals”…… these can range from access to proxies, to declassifying boards, to changes in executive compensation committees. Calpers proposals have been fairly strong in garnering support and have passed over 60% of the time; typically, they try to convince boards to make the requisite changes before making the proposals themselves. A common misconception is that these shareholder proposals are expensive, but in reality they are not, the bulk of the cost is born in proxy solicitation which is outsourced to specialized firms that do this (this typically costs $20-30K per proposal). Not too expensive considering that a shareholder proposal or being named to the focus list can convert a typical under-performer (-10%) to an out-performer (+2%) within 3-5 years.

Negative cash flows grow each year

Calpers portfolio has grown tremendously over the last 10 year, more than doubling in value to almost $300B. Each year the agency pays about $9.2B towards retired employees pensions and health plans, which is expected to grow significantly as the baby boomers start retiring in droves. On the other hand, Calpers generates over $9B in revenue each year through their investments, the resulting negative cash flow of $200M is covered though various means – dividend collections, divestments, portfolio rebalancing, etc. While I don’t know the projections for the growth of this negative cash flow, I am sure Calpers’s investments are flowing to more liquid high-growth vehicles in the recent years.

Calpers own executive compensation comes to light

Talk about a coincidence, on the same day of the talk, I read a front page article on WSJ about how public pension fund managers are demanding higher pays each year. Russel Read, Calpers CEO, apparently took home close to a million dollars in compensation last year; WSJ didn’t chastise calpers for this, because despite being a public passive fund, the pressures of managing one of the largest portfolios in the world are tremendous. If hedge fund managers could take home up to a billion dollars in compensation, the one million Read takes is chump change. Nonetheless, calpers is a state agency with its own board, and it does make us taxpayer wince every time we hear about million dollar state employee salaries.

CG and oversees investments

Its one thing to compare CG of US listed companies, but its a whole different game when dealing with foreign investments. Each country, especially in emerging markets has a varying level of CG enforcement – while the general concurrence is that they keep improving each year, there being no global watchdog agency like SEC and no global standards like SOX, result in varying levels of trust in foreign companies’ disclosures. Calpers investments are currently 55% domestic and 45% foreign, but they are expected to reverse in the next three years to 45% domestic and 55% foreign. This illustrates two things – firstly, when Businessweek reports the tremendous FDI in emerging markets, we can safely assume Calpers has some part in it and secondly, this reveals how distrusting public funds are of domestic returns. While I don’t argue that money always flows where there are returns, I still believe that a public fund must have some moral and fiducial duty towards the domestic market. Even if Calpers hedges all its exchange-rate risk through swaps, and it invests indirectly through other money managers, given the risk of rising negative cash flows, it must exercise much caution in emerging markets.

Sudan and Iraq

Another eye-opener for me – divesting in outlawed countries. Apparently, Arnold has been kind enough to sign off on bills that would require retraction from any investments in firms doing business in Sudan and Iraq for obvious reasons. I have to express my sympathies to Dennis’ 17-member team that has to dig through thousands of its investments in order to determine which companies have operations in these outlawed nations. While noble in its cause, this is a sure shot way to divest from oil companies (which are most assuredly operating in every problem country). Nonetheless, despite the bill, my gut feeling is that such divestments will take a rather long time to implement, by when these nations should have stabilized anyway.

Passive or Passive-Aggressive

Each year, when Calpers releases its annual statements, the general notion that is moving from passive investing to aggressive investing is more than resounding. While the CG group is still domestic and more-or-less passive, the share of funds that are committed to alternative investments (private equity, mezzanine funds, LBOs, etc) are only increasing. Makes me wonder, if in a few years, we will be seeing Calpers as more of a mutual fund than a pension fund. Another thing that constantly bothers me is that, with recent beatings in giants like Merrill, Citi and Bear Stearns over CDOs and SIVs, I an not hearing anything from Calpers as to how much it needs to take down from its value because of its alternative investments. Agreed that there will be some reported losses from its investments in home-builders and mortgage firms, but I wonder if they are ever going to be able to account for the losses from their alternative investments.