THE BUY SIDE - The Next Generation

CalPERS rethinks a key program designed to discover talent.

Employees’ Retirement System, the country’s biggest public pension fund, is renowned for its skill in identifying top money managers. But a program designed to boost returns by cultivating a farm team of boutique investment firms with less than $2 billion in assets has foundered, tarnishing the fund’s reputation and prompting a fresh take on the effort.

“There have been some disappointments,” admits Mary Cottrill, a senior portfolio manager at CalPERS who oversees the initiative.

The Manager Development Program, or MDP, was launched in 2000 as a way to profit from the emergence of small investment managers with strong growth potential. By injecting venture and investment capital into target firms over a four-year period, CalPERS reckoned it could help them expand -- and earn strong returns for itself in the process.

Vetting asset managers is a labor-intensive process, so CalPERS partnered with consultants Progress-Putnam Lovell Advisors and Strategic Investment Management. Thanks to growth at two MDP firms -- Cambridge, Massachusettsbased Arrowstreet Capital, which now has $18 billion, and Charlotte, North Carolinabased Golden Capital Management, which runs $4 billion -- CalPERS’s $31 million venture portfolio earned internal rates of return of as much as 49 percent through June 2006, the most recent data available.

But overall investment performance from the 16 MDP managers -- which is far more important to CalPERS’s $232.5 billion portfolio -- has been lackluster. Progress-Putnam Lovell, which oversaw firms with $550 million of CalPERS’s money at the end of February, has fallen short of its custom benchmark by an annualized 2.27 percentage points since inception. Strategic Investment Management, which managed $1.35 billion, has barely beaten its benchmark.

As a result, CalPERS is making some changes. Although it will continue to rely on consultants to pick managers, it is conducting its own due diligence and requiring them, along with principals of the managers it invests with, to put their own capital in the program. And CalPERS is no longer tying its hands by committing to invest billions of dollars over a four-year cycle. “We want to be opportunistic,” says Cottrill.

In March, CalPERS made the first investment in the second phase of MDP, a $100 million commitment to Piedmont Investment Advisors, a Durham, North Carolina, quantitative equity and fixed-income manager with $1.5 billion in assets. CalPERS and a new adviser, Legato Capital Management, jointly purchased about 10 percent of Piedmont’s equity for an undisclosed sum.

Along with consultant Mosaic Investment Advisors, CalPERs is also going beyond its original long-only mandate and will allocate up to $1 billion to emerging fund-of-funds managers. When it comes to finding new sources of returns, hope springs eternal.