Office of the Treasurer TO MEMBERS OF THE COMMITTEE ON ...

I-2 Office of the Treasurer TO MEMBERS OF THE COMMITTEE ON INVESTMENTS / INVESTMENT ADVISORY GROUP: ACTION ITEM For Meeting of September 25, 2012 UNIVERSITY OF CALIFORNIA RETIREMENT PLAN / GENERAL ENDOWMENT POOL INVESTMENT POLICY AND GUIDELINE REVIEW AND RECOMMENDATIONS RECOMMENDATION The Chief Investment Officer, with the concurrence of the Regents’ General Investment Consultant, Mercer Investment Consulting, Inc., recommends that the Committee on Investments recommend to the Regents that the changes to the University of California Retirement Plan (UCRP) Investment Policy Statement (as shown in Attachment 1), the University of California General Endowment Pool (GEP) Investment Policy Statement (as shown in Attachment 2), and the Appendices to Investment Policy Statements of UCRP and GEP (as shown in Attachment 3), be approved, effective November 15, 2012. BACKGROUND Following the adoption of a new Investment Policy Statement for the UCRP in 2004 and GEP in 2005, the Office of the Chief Investment Officer has conducted an annual review of investment policy each spring. The purpose of this review is to review investment policies and guidelines in the context of changes in capital markets and investment practices, and, where appropriate, recommend any changes to guidelines that would better achieve the return and risk objectives of the Funds. A summary of changes is found below: 

LOOSENING CONCENTRATION LIMITS ON FUND OWNERSHIP 

Public Manager Concentration Guidelines: Increase the percent that UC’s investments can be in a particular product from 10 percent of the assets of that product to 25 percent. However, set a limit on the size of an investment in a single manager to be no more than 12 percent of each equity class aggregate (US Equity and Developed Non-US Equity) and 15 percent (Emerging Market Equity). This limitation would not apply to passive (index) managers.

COMMITTEE ON INVESTMENTS/ INVESTMENT ADVISORY GROUP September 25, 2012

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A. Why: This would allow UC to have larger positions in products with small Assets Under Management, which are typically new products launched by existing managers or products launched by teams spun out of a larger organization. The limit on percent of fund in a single manager would ensure diversification. B. Impact: higher expected return. Note that risk is limited by the fact that public market assets are typically custodied by State Street, and thus under UC’s direct control. Real Estate Guidelines: Provide more flexibility by loosening concentration limits on fund ownership. A. Changes 1. Increase limit on size of investment in any one fund from 20 percent to 25 percent of the total capital being raised for that fund, not to exceed $75 million 2. Apply requirement for Separate Account managers to co-invest in UC deals 3. Increase limit on size of investment in club deals and co-investments, in aggregate, from 7.5 percent to 15 percent of total Program market value, up to a limit of $300 million on any one deal. B. Why: Concentration limits are designed to diversify the portfolio and limit potential losses. However, restrictions can also limit flexibility to take advantage of opportunistic investments. C. Impact: Higher expected return. Given the current degree of portfolio diversification, additional risk is expected to be minimal. Private Equity Guidelines: Provide more flexibility by loosening concentration limits on fund ownership. A. Changes 1. Standardize language regarding permissible investment structures. Permit publicly-traded assets. 2. Delete guideline relating to Fund of funds (superfluous). 3. Increase limit on size of commitment to any individual partnership is from 20 percent to 30 percent of the total capital raised by the partnership, up to a maximum of $150 million. 4. Delete quantitative restriction on portfolio diversification across time 5. Increase limit on size of a single co-investment deal from $20 million to $200 million. 6. Delete guidelines regarding limitations on direct investments. B. Why: Concentration limits are designed to diversify the portfolio and limit potential losses. However, restrictions can also limit flexibility to take advantage of opportunistic investments. Restrictions on direct investments were established four years ago before staffing in this area was adequate. C. Impact: Higher expected return. Given the current degree of portfolio diversification, additional risk is expected to be minimal. Real Assets Guidelines: provide more flexibility by loosening concentration limits on fund ownership


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A. Changes 1. Delete guideline regarding “equity orientation” of investments. 2. Increase limit on size of a single partnership commitment as a percent of the current real assets allocation from 10 percent to 15 percent. 3. Delete guideline limiting size of a single investment to 20 percent of the total capital being raised for that investment. 4. Increase limit on size of investment with any single investment manager or GP from 15 percent to 20 percent of the overall Portfolio. 5. Increase limit on size of investment with any single investment manager or GP from 20 percent to 30 percent of that manager’s total assets under management, up to $100 million. 6. Delete restriction on US focus (must be at least 65 percent of portfolio). 7. Delete quantitative restriction on portfolio diversification across time. B. Why: Concentration limits are designed to diversify the portfolio and limit potential losses. However, restrictions can also limit flexibility to take advantage of opportunistic investments. C. Impact: Higher expected return. Given the current degree of portfolio diversification, additional risk is expected to be moderate. 

ELIMINATE TARGET PERCENTAGES FOR SUBSECTORS 

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Private Equity Guidelines: Eliminate target percentages for different Private Equity sectors. A. Eliminate specific targets for buyouts, venture, and co-investments. Set an upper bound for Venture Capital to be no more than 40 percent of the entire Private Equity portfolio. B. Why: There are no natural targets for venture versus buyout; the current targets were established many years ago when the buyout strategy was first implemented and less familiar. C. Impact: no change from current practice Real Assets Guidelines: Eliminate target percentages for different real assets sectors. A. Eliminate the “Long Term Target Allocation” to individual strategies, and increase all ranges from 20/30/40 percent to 50 percent. B. Why: There are no natural targets for the various categories of real assets; the current targets were established three years ago before investments were actually made in this area. C. Impact: no change from current practice

BENCHMARK CHANGES 

Emerging Market Debt Guidelines: Modify composition of Emerging Market Debt policy benchmark to emphasize dollar-denominated (“hard currency”) debt. A. In 2009, benchmark became 2/3 local currency (LC) debt + 1/3 hard currency (HC).


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B. However, given the volatility of Emerging Market currencies, the Committee has indicated a preference for dollar-denominated debt, delegating to the Chief Investment Officer the decision to invest tactically in local currencydenominated debt. C. Why: Strategy in this asset class is to add value from security selection within dollar-denominated markets and by tactical tilts between dollar-denominated and local currency debt; the policy benchmark used for performance evaluation should be consistent with the strategy. D. Impact: Prospective change in measurement of value added in this asset class. 

UPDATING FOR CHANGES IN MARKETS / CLARIFICATION 

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UCRP/GEP Investment Policy Statement: Clarify and update restriction on use of leverage. (Add new asset classes.) A. Currently leverage is allowed in Private Equity, Real Estate, Absolute Return Strategies, and Securities Lending. 1. In Real Estate, we recommend that the limit on aggregate gross leverage be raised from 65 percent to 90 percent. (All real estate leverage is explicitly non-recourse to the Regents.) B. In addition, we recommend allowing the use of leverage in the following asset class: 1. Real Assets: Commodity futures managers may be short as well as long. C. Why: This documents that new strategies, which typically use leverage, have been added to the portfolios since the guidelines were originally drafted. D. Impact: no change from current practice Derivatives Guidelines: Add unlevered Structured Notes to the list of permitted securities. A. Why: Structured notes which are transparent and avoid leverage are used by fixed income and equity managers to gain access to foreign markets with high transaction costs. This is an example of a change in capital markets since the Policies and Guidelines were first established. B. Impact: no change from current practice High Yield Debt Guidelines: Change the average credit quality of the portfolio from B to B-, and loosen restriction on Rule 144A securities. A. Why: The credit quality of the policy benchmark is currently BB/B. The current guideline limits the ability to earn higher expected returns by going down the quality spectrum. As Rule 144A securities become a larger portion of the High Yield universe, this restriction limits opportunity. B. Impact: moderately increase risk and expected return Short Term Investment Pool (STIP) Guidelines: Modify guideline on issuer concentration in Commercial Paper (CP) portion of STIP, by allowing temporary deviations from the 5 percent issuer limit when unusual cash flows impact the size of the portfolio. In such cases, the limit on individual issuers in the CP program is no greater than 10 percent, for a period of up to one month.


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A. Why: Since 2009, as State funding declined, the University has asked the Chief Investment Officer to maintain more one-day liquidity in STIP. Even so, large or unexpected cash flows are more frequent, and the portfolio size is more volatile. B. Impact: avoid costly trading of very short-dated securities Cash Collateral Guidelines: Remove the Cash Collateral guidelines from the Appendices to UCRP and GEP Investment Guidelines, since these are established by the Chief Investment Officer (retain as internal guidelines). A. Why: The investment Policy Statement (section 2.l.) states that these Guidelines are established by the Chief Investment Officer. Furthermore, they can change frequently, as market, credit, and liquidity conditions change. B. Impact: no change from current practice

Attachments: Attachment 1: UCRP Investment Policy Statement Attachment 2: University of California GEP Investment Policy Statement Attachment 3: Appendices to Investment Policy Statements of UCRP and GEP Attachment 4: Slides