Getting a Read on things
An exclusive interview with CalPERS’ chief investment officer
At a recent CalPERS investment committee meeting, there was a report that after an unprecedented run-up in real-estate values, the decline in the U.S. market is going to cause a major re-evaluation of CalPERS’ real-estate strategy. Are you able to give us any indication of what that means?
For real estate, and I believe private equity also, we have enjoyed tremendous returns over the past two decades. As with most markets, opportunities change, and the real-estate business is no exception. Institutional investment in real estate, particularly U.S. real estate, has involved the purchase and management of office buildings—hotels, residential projects and other commercial real-estate investments. So, simply owning the buildings and managing the buildings.
We believe that many of the returns from these types of projects have diminished in prospect for the coming years. What this will mean is that to achieve the same type of success in our real-estate investment program will require us to identify those opportunities with better prospects, including international real-estate projects and domestic projects which involve real-estate operating businesses.
One example of a shift in our priorities represents a serious consideration of low- and middle-income home-building projects in Mexico or China or even Africa. This represents a material shift in the types of opportunities that we’ve evaluated. In the past, that program was much more limited to conventional large buildings in the United States. So we view successful investing, particularly in those sectors, as the ability to identify where capital is most needed in the world economy and structuring our investments best to meet those needs.
You’ve earlier mentioned investing in startup projects, with ethanol as an example, as an area where CalPERS can earn a return that would be greater than investing in stocks or bonds right now.
We are looking very hard at clean technology and alternative-fuel technologies, in particular. This is an area that requires a great deal of capital, but where, if done right and done early, we believe exceptional returns can be earned by the fund. Clean technology in general has become one of the most profitable and promising investment areas in the entire portfolio and now represents more than $1 billion in private equity investments alone. We believe that our investments [in clean and alternative-fuel technologies] across all of our asset classes will multiply over the next several years.
Are you able to give me an example of a clean-energy project that CalPERS is already invested in?
We are a major investor, for example, in the largest ethanol-producing facility in the world, which is located in Brazil using sugar cane as feedstock. For the U.S. market, we are evaluating several projects that we believe could create meaningful scale as the U.S. attempts to increase its ethanol production, from 8 million gallons per day to 35 million or more gallons per day, over the coming decades.
There was a presentation at the investment committee meeting of the Wilshire Index about nations that are graded, based on a point score, as to whether they’re investment worthy, across a wide range of things—from transparency of financial transactions to freedom of the press. How should people understand CalPERS’ choices about investments in countries or international companies?
Since 2002, we have had a policy regarding our investments in publicly traded stocks that sought to identify those developing markets in which we believed there were unacceptable risks due to social, political and environmental policies and practices. This list is called our “Permissible Countries List.” The ministers of finance for many of these countries have taken the scoring seriously and have improved those conditions, such as child-labor laws, environmental policies and the rule of law. We believe that this positive engagement is improving the investment conditions for us and for all major investors.
We’re in the process now of re-evaluating our approach to the emerging markets, based on the success that we’ve had in improving some of these core market factors. We believe that the emerging markets will represent an increasingly important percentage of our overall investment portfolio, across every major market, over the next several years. This represents something very different.
For 55 years after World War II, professional investors in the OECD [developed countries] could have largely ignored the emerging markets and still succeeded as professional investors. Over the next 10 to 20 years, it is inconceivable we can succeed as a major investment institution without critical success and scale in our emerging-market investments. So this represents a sea change in our perspective in the importance of these markets.
How do these ministers of finance approach CalPERS about their score? I remember at the committee hearing that they “remonstrate.”
It’s very interesting. We don’t go to them at all. When we began this in 2002, the Oxford Analytica, who we engage as one of our consultants in the calculation of our scoring, sent the ministers of finance letters stating that CalPERS intends to invest billions of dollars in the emerging markets and will be using this scoring mechanism to evaluate whether or not to invest in their countries. The letter then asked, “Are they interested in seeing the evaluations for their countries?” Virtually every country said yes.
There’s an annual process that takes place, in which raw scores are calculated in February, and the basis for those scores are delivered to the embassies for each of the investable emerging-market countries. They can formally respond back if they have concerns regarding their scores, which are used by CalPERS, but also are looked at much more broadly by private-sector investment organizations, development banks, as well as pension plans.
Am I accurate that China remains below investment score?
That is correct. Now, we’re taking a very hard look at the nature of the scoring to ensure that the positive intent of the policy for creating healthier markets, healthier companies and better conditions for economic development are achieved in the best possible way. So, over the next several months, we’ll be working with our consultants and the board of trustees for an important re-evaluation of how best to achieve these goals going forward.
Can CalPERS invest in a company in a country where the country is below an investment grade score?
We have made two important changes in our Permissible Equity Markets Policy over the past six months. The first change allows us to invest in those good actors, in companies with sound practices in countries in which sound practices may not always prevail. Good companies in restricted countries. That’s one change. The other change is that we’ve had leverages off of our success as a corporate governance and activist investor. That is, it allows us to invest with partners in funds whose goal is to achieve healthy returns by strengthening the governance and operating principles by which companies are run. We believe that improving corporate governance materially in the emerging-market countries can, in fact, be even more effective from an investor standpoint than many of our objectively successful efforts have been in the OECD [developed countries].
You mentioned corporate governance. Do you see the corporate-governance program making a big difference, or are the problems so embedded in the corporate structures that it’s a matter of just continually bailing out water from a leaky ship?
I actually am very optimistic that trustees of major corporations want to act as shareowner representatives. I think their hearts are in the right place. So I think that gives me an inherent cause for optimism, despite the prevalence of practices of, for example, options back-dating, paying executives inordinately for failure and other practices that are clearly not aligned with the interests of the shareowners. But even with the most difficult and intransigent boards of directors that we’ve engaged with, we’ve noticed an inherent understanding and likemindedness on the alignment-of-interest principle: that ownership interests and management-trustee interests in a corporation need to be aligned to have healthy companies and capital markets.
If their hearts are in the right place, what then hasn’t been in the right place that’s blinded them to some of these problems?
I think there have been important things that we’ve seen, such as the ability for long-term major shareholders to be able to nominate directors, as an important mechanism even when it’s not employed. Just for it to exist means that directors know they’ll be evaluated and held accountable by their actions.
Do you think it’s needing an accountability mechanism so that their hearts come to the fore?
I think that’s exactly right. Options back-dating is just such a good example of something where it was so widespread that trustees couldn’t have realized that it was actually bad practice. If it had occurred at five or six companies, you could say that was criminal behavior that occurred on a small scale. When the practice occurs at hundreds of companies, it implies a failure to understand a principle.
That principle being the impact on the shareholders?
Yes. Exactly. Undisclosed back-dated options had a material impact on the earnings that were available to the [shareholders] of those companies.
The CalPERS Web site mentions that it is taking an inventory of the potential impact of global warming on companies it holds shares in. What’s the nature of that initiative, and how do you see it playing itself out in the near future?
We know that global warming will have a very important economic and financial impact across all of the capital markets in which we are invested. Unfortunately, it is difficult to know how industries and particular companies will be affected financially by global warming and by greenhouse-gas emissions. We are looking to play an active role in the carbon markets as they are developed—because we ourselves will have important carbon footprints based on our many investments—in capital markets, with our real-estate holdings and timberland. The major message is that understanding the carbon impact of these investments will be critical to evaluating the financial prospects of these investments going forward, in a way that we haven’t seen in the past.
Are you asking companies to provide you with an analysis of some kind, or information, or are you doing your own analyses?
We are not going to individual companies and asking them questions yet on their carbon footprints, because we wouldn’t know exactly the best questions to ask yet. Rather, that will be clarified over the coming months and years. What we are certain is that it will be important. And it will be important for every company to evaluate their carbon footprint, to evaluate their future attractiveness for investment.
In some of our international investments we have already seen the impact that carbon credits, for example, can have on the expected returns of our projects. Thus, already, some of the international investments we make are already sensitive to carbon emissions and sequestration. We anticipate that the impact we’re seeing internationally will be felt among U.S. investments over the coming five years.
Is that impact the returns being lower because of the need to deal with greenhouse-gas emissions?
They can be lower, or they can be higher if they get carbon-sequestration credits for reforestation. So the return prospects can be better or worse.
Turning to the benefits side for a moment: There’s been much discussion about people living longer and retiring earlier. Is there a change in the demographics of retirement that is placing greater demands on pension funds like CalPERS and thus increasing pressure on achieving investment returns to fulfill its obligations?
We feel from a general perspective that the actuarial risks of better health and longer lives are roughly being met by our investment program for pension benefits. Our actuaries, we believe, are charged with and do an excellent job with evaluating the nature of future pension benefits that will be funded over the coming decades.
What we are more concerned about is health care, which has generally not been pre-funded in the way that pensions have. Health care is a concern not only for CalPERS, but clearly will entail some important decisions on national, state, county and company levels. So while we feel good about the health of our pension system, we do believe that the actuarial concerns that you expressed in terms of longer life and better health will have to be figured out much better for the funding of health-care benefits. So it’s kind of double-edged: feeling good about the pension side, but on health care it’s a big problem. We’re all getting our arms around it and there’s a long way to go.
A couple of years ago there was a major move to redefine CalPERS as a defined-contribution plan rather than a defined-benefit plan. Although that effort was beaten back, are there still pressures in that direction?
There is still some discussion that the existence of any defined-benefit plan can create the potential for tax hikes in the future if long-term investment returns are not met. But this has been reduced somewhat by the improvement in the capital markets since 2002. 2001 and 2002 were particularly difficult years for professional investors, and it led to a downgrade in the funded ratios of pension plans across the nation. However, pension plans are long-lived in nature. Two under-performing years did not imperil the inherent solvency of these programs in large measure. Defined-benefit plans are the major financial resource for tens of millions of working-class Americans. Their eradication or conversion wholesale to defined-contribution plans would not serve the best interests of most of these working Americans.
How do you handle the responsibility for nearly a quarter of a trillion dollars in investments and the lives of more than 1.5 million people?
The short answer is: I sleep like a baby—I wake up every two hours screaming.
For me, I think along with others who invest money in major state pension plans, it is an absolute honor and pleasure to be able to invest with such a public purpose in mind. So, from our perspective, although we believe there is great responsibility, the service that we can perform by achieving great returns for our members is the big payoff. And I actually do sleep really well at night.
What is it that allows you to sleep so comfortably when the world of investment is changing so fast?
You know, markets are inherently dynamic. The opportunities change constantly. That dynamism is inherently compelling and interesting. But the most important thing is being motivated by who you are investing for and what you’re investing in. I love who I’m investing for—the one and a half million public employees of the state of California whom we represent. And I love what we’re investing in as a major positive propellant for development in the emerging markets and across the OECD (developed countries).