The land deal that tripped up the nation's largest pension fund also is proving to be a rare misstep for MacFarlane Partners, a real-estate investment firm known for pioneering urban development.

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The California Public Employees' Retirement System, known as Calpers, is the main investor in a partnership that could lose much of its $970 million investment in the LandSource venture, if it goes bankrupt, as some predict. While that loss would represent a fraction of the $250 billion Calpers manages, it would be an embarrassing public miscue for a fund with a reputation as a shrewd investor.

The deal has caused friction between some within Calpers and Victor MacFarlane, the founder of MacFarlane Partners, who has invested the pension fund's money for 16 years, according to a person familiar with the matter. Most of his deals have been home runs, such as Calpers's investment in Manhattan's Time Warner Center and a Los Angeles shopping center that is considered a test case for a development that is both profitable and serves a social good.

MacFarlane Partners continues to work with Calpers, although the pension fund has brought in Morgan Stanley to help it negotiate with the land venture's lenders, while relegating MacFarlane Partners to a secondary role in LandSource, according to people familiar with the situation. A Calpers spokeswoman declined to comment on MacFarlane Partners' future with the pension fund, citing its policy not to speculate on possible future investment or partnership proposals. She said Morgan Stanley is an "adviser-consultant," and it hasn't replaced MacFarlane Partners in the deal.

MacFarlane Partners New York's Time Warner Center and its retail shops (inset) were a success for MacFarlane Partners. The real-estate investment firm made a misstep into California land.

The appraised value of LandSource, a venture that owns thousands of acres of undeveloped residential land north of downtown Los Angeles, shrunk to $1.8 billion as of the end of February from $2.6 billion; the project also received a default notice on $1 billion in debt. The deal, completed in February 2007, only months before land values plummeted, was one of many speculative acquisitions during the housing boom of huge tracts of land by investors who thought they could resell it to home builders for big profits. But like many of these deals, LandSource's assets collapsed in value amid the credit crunch and housing crisis.

Raised in a cramped Ohio apartment where he had to sleep on a pullout couch with his sister until he was 13, Mr. MacFarlane expanded his firm into the nation's largest African-American-owned real-estate investment firm, with $21 billion in real-estate assets under management at the end of last year. Mr. MacFarlane, 57 years old, also is the majority investor in D.C. United, Washington's professional soccer team.

Mr. MacFarlane said he still believes that LandSource, which includes the largest parcel of undeveloped land outside Los Angeles, eventually will prove a good real-estate investment when property values rebound. He declined to comment on his role in future Calpers deals.

"It can't fail from a real-estate perspective," Mr. MacFarlane said. "The question is what return you are going to get. Do I wish I had been buying today instead of last year? Sure, hindsight is always 20-20."

Mr. MacFarlane worked for years to break into Calpers's inner sanctum of real-estate managers. He lobbied Calpers staff and board members every six weeks for three years until they finally gave him $60 million to invest in a Los Angeles shopping mall in 1992.

His breakthrough came in 1995 when Calpers contributed $50 million to a partnership between Mr. MacFarlane's firm and former professional basketball star Earvin "Magic" Johnson. Their first big project was the purchase and redevelopment of the Ladera shopping center in a predominantly African-American and Latino part of Los Angeles. The project had annual returns of 30%. Tenants included Starbucks and a TGI Friday's, according to MacFarlane Partners.

"Victor had a fire in his belly to convince the board that the inner city was the proper place to be invested in," said Willie Brown, a former San Francisco mayor and onetime Calpers trustee.

Since inception, MacFarlane Partners' California Urban Investment Partners have generated a total nominal return after fees of 30.5%, according to Calpers. "He was very successful," said Michael McCook, who headed Calpers's real-estate investment group from 2001 to 2006, which was before the LandSource investment. "He hasn't had many projects that didn't make money."

Mr. MacFarlane's success investing Calpers's money provided a calling card for winning business with other big pension funds, including the California State Teachers' Retirement System, the Illinois State Board of Investment and the Teacher Retirement System of Texas.

But not all of MacFarlane Partners' urban deals have flourished. MacFarlane Partners made a $180 million commitment to The Grand, a mixed-use redevelopment project in downtown Los Angeles being planned by Related Cos. But late last year, MacFarlane pulled out of that development and the pension fund was replaced partly by Istithmar World Capital PJSC, of Dubai. MacFarlane Partners declined to comment. Calpers didn't lose any money on the deal, according to two people familiar with the matter.

MacFarlane Partners began investing Calpers money in land in 1995, teaming up with another real-estate investment adviser, Weyerhaeuser Realty Investors, a unit of timber giant Weyerhaeuser Co. Over the years, the two advisers, under the name MW Housing Partners, invested $2.7 billion for Calpers in single-family housing and raw land across the country and posted over a 30% internal return on about 186 completed projects through March 31, according to MacFarlane Partners.

But that figure doesn't include LandSource, one of MW Housing's most ambitious undertakings. In February 2007, MW Housing acquired a majority stake in the venture, which includes 15,000 acres, for $970 million in cash and property. The plan was to sell the land to builders over 12 to 15 years as Los Angeles's development moved north.

But new housing development screeched to a halt, leaving LandSource with $1.2 billion in debt and little way to generate cash to meet certain requirements from the lenders. With creditors demanding payment, Calpers is trying to negotiate a restructuring of the LandSource debt, using Morgan Stanley for advice. Calpers's alternatives also may include sinking additional equity into LandSource or filing for bankruptcy-court protection for the venture.

Write to Michael Corkery at michael.corkery@wsj.com and Craig Karmin at craig.karmin@wsj.com

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