The words "headline risk" are frequently invoked by public pension funds to warn against potentially adverse news relating to portfolio investments. But the kind of media attention the California Public Employees' Retirement System has recently drawn to itself might prove to be a pension fund's worst nightmare.

Ever since New York Attorney General (and gubernatorial candidate) Andrew Cuomo lifted the lid on pay-to-play investigations last year, CalPERS has struggled to stay on top of the fray as former top executives at CalPERS were ensnared in state and federal probes. Several lawsuits have been filed, tarring CalPERS' vaunted reputation as a leading corporate governance advocate.

Under a great deal of pressure, it adopted new policies against potential influence peddling and pushed for tough state laws. It also conducted a sweeping review of its private equity managers, including New York buyout giant Apollo Management LP, CalPERS' single largest private equity general partner, whose payments to a placement agent were cited in investigations.

Leaving aside the ethics issue, CalPERS may have a separate problem: what to do with megabuyout funds. As the country's largest public pension fund, with $200 billion, it has to deploy large dollar amounts to achieve target returns on the one hand. On the other hand, the post-financial crisis private equity market is shrinking. If it's not going to write large checks to large funds, "you're talking about coming up with a different model than what CalPERS has been doing," says one West Coast investment adviser. "I simply don't think that's been addressed."

CalPERS' board is due to meet on Dec. 13 to discuss a new asset allocation strategy for 2011. "We continue to believe that private equity is a promising sector, but the extent of future commitments will depend on what the board does," says CalPERS spokesman Clark McKinley.

On the investing side, there's been one casualty in the fallout. Leon Shahinian, the senior investment officer overseeing alternative investments, resigned in August after being put on administrative leave in May. Shahinian, who joined CalPERS in 1998 and was promoted to senior investment officer for alternatives in 2004, was a veteran executive who is widely respected in the private equity industry. McKinley says Shahinian resigned of his own accord and didn't give reasons, though some observers believe he was the fall guy.

The future of another senior portfolio manager, Joncarlo Mark, who likewise figured in a civil suit filed by California Attorney General Jerry Brown but has not been charged, remains unclear. Sources say it's likely he, too, may be edged out.

Joseph Dear, chief investment officer, has taken over Shahinian's duties until a replacement is appointed, which McKinley says could take several months. For now at least, decision making seems to be pretty much stalled. "Right now people just don't know what's going on with their investment strategy," says the West Coast adviser. "They're basically on freeze mode. If you're afraid that something might be construed as wrong, the easiest thing is not to do anything."

The turmoil couldn't have come at a worse time. CalPERS posted nearly $70 billion in losses in 2008 after peaking at $253 billion in gains in 2007. It dropped a further $14 billion in market value in the first quarter of 2009 but recovered ground by year's end, according to a Wilshire Associates Inc. review. The fund rose to $210.2 billion in the first quarter of this year before taking a further $10 billion hit in the second quarter. At June 30, the fund stood at $200 billion, just about where it was in 2005.

Given California's parlous fiscal position, the losses have only added to worries over the pension fund's growing unfunded liabilities. The public relations debacle hasn't helped.

Last April, CalPERS was drawn into investigations into money managers and placement agents using ties to public officials to gain access to public pension systems. The trail of investigations has led to several high-profile officials, including former New York State Comptroller Alan Hevesi, who recently pleaded guilty to a felony charge.

Allegations spread to California. Among several targets was a consultant linked with a California intermediary that allegedly received fees from funds in which CalPERS had invested. The California firm, Wetherly Capital Group LLC, was not charged with wrongdoing, but a former employee later pleaded guilty to a securities fraud charge in New York, and Wetherly itself ceased operations.

A month later, Sean Harrigan, a former CalPERS president, resigned from the board of the Los Angeles Fire and Police Pensions after the Securities and Exchange Commission sent a letter inquiring into his financial disclosures and dealings with Wetherly and other consultants. Harrigan, a former union executive and an aggressive corporate activist during his time at CalPERS, from 1999 to 2004, denied wrongdoing.

Subpoenas were also issued to fellow board member Elliott Broidy, who later pleaded guilty to a felony charge in New York in December. Broidy's former firm, Markstone Capital Group LLC, a Tel Aviv-based private equity firm, had a $50 commitment from CalPERS.

Things went from bad to worse. In May this year, Brown's office filed a civil lawsuit against Alfred Villalobos, a former CalPERS board member who was said to have made more than $47 million in fees after he left the system to work as go-between for private equity funds hoping to score commitments from CalPERS. Villalobos' business associate, Federico Buenrostro Jr., who served as CalPERS' CEO until 2008, was also named in the suit, which claimed that they received gifts intended to influence board decisions. Villalobos and Buenrostro have denied the allegations. Two other current and former CalPERS officials, Charles Valdes, who stepped down as a board member in January, and Shahinian, were named in the suit as recipients of other gifts that were not publicly disclosed as required by state law. Valdes and Shahinian were not charged. Shahinian was placed on a leave of absence following the filing of the lawsuit against Villalobos.

The pension fund has been dogged by allegations of impropriety in the past. Part of the problem is that until recently it had few restrictions against private equity firms using placement agents to win CalPERS' business. Unlike the California State Teachers' Retirement System and other large pension funds, CalPERS had not instituted a policy on how firms should report their use of placement agents and disclose any fees paid to them until last year.

It also had few restrictions on gifts in the form of travel expenses. For example, partnership agreements typically state that for annual general meetings, the private equity fund manager will pay expenses such as hotels and airfare. Shahinian was implicated in the civil suit against Villalobos because his trip to New York to meet Apollo's Leon Black was underwritten by Villalobos. CalPERS says that prior to 2008 CalPERS allowed trips to take place only if the pension professional was travelling to attend a mandatory advisory board meeting, or if the PE or real estate manager paying for the travel was a firm in which CalPERS owned a stake.

Pension policies vary. Says one fund officer, "We would refuse such an offer simply because we want to ensure there's no appearance of impropriety."

Soon after Cuomo unveiled his investigations, CalPERS laid down a policy governing the use of placement agents and the payment of fees. It also agreed to sponsor legislation requiring placement agents to register as lobbyists, among other provisions.

No criminal accusations have been leveled against any current or former CalPERS officials. But critics say the problems run deeper than perhaps the state pension fund might care to admit. They say to really clean up house and undo the business culture that engenders unethical behavior, it needs a complete overhaul at the top. "It's been well known in the industry for some time now that a number of CalPERS board members are what one would call America's guests," says the pension fund officer who requested anonymity. "I have a healthy degree of respect for Joe Dear and the investment staff, but it's their board that gets them into trouble."

The same officer says that Dear, who was executive director of the Washington State Investment Board for seven years until assuming the CIO post at CalPERS, is "the right guy at the right time," adding that he "understands how to deal with state politicians and the politics and knows enough about investments to be effective." Dear declined to be interviewed.

All this has been a tremendous distraction for CalPERS on the investment side in a period of great challenges. Still unclear is what CalPERS ought to do with future alternative asset investments, particularly on the megafund side. It recently changed management of a portion of its real estate investments, which have taken a much bigger hit than its private equity investments, and severed ties with investment adviser Pacific Corporate Group as part of an ongoing review.

In 2005, CalPERS decided to prune its private equity program, reducing the number of relationships to ease its administrative burden. It had commitments to several hundred funds then. By the time the markets collapsed in late 2008, it had already sold about 26% of its private equity interests at reasonably high values. It was a shrewd move that probably saved CalPERS from posting larger losses.

It also allowed CalPERS to focus on a core group of top-tier buyout groups. But because of the outsized distributions PE firms were producing during the buyout boom, CalPERS, like many other pension funds, tried to stay within its target allocations, in effect, by overcommitting to funds. It wrote very large checks to Apollo, Blackstone Group LP, Carlyle Group, Kohlberg Kravis Roberts & Co. and TPG Capital. CalPERS has a huge exposure to Apollo entities alone, with about $5 billion committed or invested as of April.

In 2007, CalPERS committed some $15 billion into private equity, venture capital and other alternatives (not including real estate), compared with roughly $9 billion the year before. Between 2006 and 2008, CalPERS poured about $8.4 billion into 15 of the 20 largest buyout funds raised during that period, according to public disclosures. CalSTRS wasn't that far behind, with about $8.3 billion.

Currently, it has 14% allocated to alternatives, slightly more than a 13% target, in part due to the denominator effect of the decline in stock market values. It has a total exposure of about $46 billion, of which $22 billion comprise unfunded commitments. Unless all the funds called all the capital at the same time, CalPERS should not have a liquidity issue, as distributions from funds have improved.

However, the market for megabuyout deals has evaporated, and funds have downsized. CalPERS, which is stuck with its commitments, now has a high concentration of funds that were at the center of the bubble. It is too early to predict how those megafunds will perform. PE funds generally have a five-year investment window, but they basically took a hiatus for two years.

Some of those funds that invested heavily during the bubble "will look stupid," says one adviser. Portfolio valuations have recovered from their troughs last year, though many of those megafunds remain underwater. Across the alternatives portfolio, private equity now looks much better than its real estate portfolio. CalPERS posted an 11.4% return for the year ended June 30.

In the short term, CalPERS is being cautious. It made only $985 million in new private equity commitments in 2009, and $675 million so far this year. "They're putting out very little money and only making investments to the crème de la crème," says another investment adviser.

At the end of the day, CalPERS still needs private equity to hit the fund's actuarial targets, but continuing to write large checks may be constrained by the market. It could face resistance from some fund managers and other LPs if CalPERS ends up holding supermajority voting rights. The question is how to deploy sufficient dollars in individual funds to move the needle.

Still, what it has to contend with on the investing side may not be as challenging as what it's facing on the ethical front. For now perhaps all it can do is hope against more bad publicity and try to keep its nose clean by adhering to the old newspaper test, as one longtime CalPERS watcher calls it: "If you don't want to read about it in the local papers, don't do it."