Guest Post: A Private Equity Quagmire?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Bloomberg reports pension plans’ private equity cash depleted as profits shrink:

U.S. pension funds contributed to the record $1.2 trillion that private-equity firms raised this decade. Three of the biggest investors, state pensions in California, Oregon and Washington, plunked down at least $53.8 billion. So far, they only have dwindling paper profits and a lot less cash to show the millions of policemen, teachers and other civil servants in their retirement plans.

The California Public Employees’ Retirement System, the Washington State Investment Board and the Oregon Public Employees’ Retirement Fund — among the few pension managers to disclose details of their investments — had recouped just $22.1 billion in cash by the end of 2008 from buyout funds started since 2000, according to data compiled by Bloomberg. That amounts to a shortfall of 59 percent. In total, they haven’t reaped a paper gain from funds formed in the past seven years.

The wisdom of those investment decisions hangs on the remaining value private-equity firms assign to companies they snapped up in 2006 and 2007, during the peak of the buyout boom. For the California, Oregon and Washington plans, that figure totaled $15.8 billion at the beginning of the year.

While some investors say they’re confident the private- equity industry’s traditional practice of taking over companies will pay off, others have been shaken by a credit contraction that froze deal-making, eroded the value of the assets on private-equity firms’ books and prevented them from cashing out in public share sales.

‘Can’t Eat IRRs’

Now pension managers on both ends of the spectrum are looking skeptically at the so-called internal rate of return buyout firms calculate to gauge their results.

“I work for over 400,000 employees, and they can’t eat IRRs,” said Gary Bruebaker, the chief investment officer of the Washington State Investment Board. “At the end of the day, I care about how much do I give you, and how much money do I get back.”

Private-equity firms pool money from so-called limited partners — pension funds, endowments, wealthy families and sovereign wealth funds — and use that cash, along with money borrowed from banks, for corporate takeovers. The buyout managers aim to boost profits through cost cuts, acquisitions or added lines of business, then reap a return for themselves and their investors in a public stock offering or a sale to another buyer.

The buyout firms also levy fees, typically 2 percent of the assets they oversee annually and 20 percent of profits from successful investments. That’s helped make the titans of the industry into billionaires.

Avago IPO

Stephen Schwarzman, the 62-year-old co-founder and chairman of Blackstone Group LP, the biggest private-equity firm, ranked 261st on the 2009 Forbes list of the world’s richest people, with an estimated net worth of $2.5 billion. KKR & Co. LP co- founder Henry Kravis, 65, topped that with $3 billion, while Carlyle Group co-founder David Rubenstein, 60, weighed in at $1.4 billion.

Buyout managers, and some pension funds, downplay their cash returns so far this decade and counsel patience, saying that investments often look worse in the years immediately after they’re made. Blackstone’s Schwarzman told backers on an Aug. 6 conference call he expected his New York-based firm to take some of its companies public in 2010. KKR, also in New York, sold shares in Avago Technologies Ltd. through an IPO earlier this month, raising $648 million.

Harvard’s Sales

Pension funds also say that over time, private-equity returns compare favorably to the Standard & Poor’s 500 Index, which declined 28 percent from the beginning of 2000 through the end of last year. Bruebaker says his Washington fund had an 8.2 percent average annual gain from its buyout investments in the past 10 years, compared with a 3.9 percent drop in the S&P.

While investors can sell publicly traded stocks as needed, buyout funds keep money tied up for years, said Steven Kaplan, a professor at the University of Chicago’s Booth School of Business.

“With private equity, you’re taking on a liquidity risk, which people did miscalculate,” said Kaplan, who has studied takeover returns.

University endowments and philanthropic foundations hurt by the worst economic crisis since the Great Depression have struggled to sell their stakes in private-equity funds to raise cash. Investors including Harvard University, in Cambridge, Massachusetts, planned to raise more than $100 billion through so-called secondary sales of limited partnership interests, some at discounts of at least 50 percent, people familiar with the effort said last year.

‘Money in the Ground’

Rubenstein, of Washington-based Carlyle, acknowledges that the buyout industry faces tough questions.

“People have a lot of money in the ground and today it’s probably not worth what they had intended, but a turn-around in valuations is now beginning,” Rubenstein said in an interview. “You’ll probably see general partners and limited partners focused more on multiples of equity rather than just IRRs.”

Representatives of Washington, Calpers and Oregon all said they remain committed to private equity, and pointed to the long-term nature of the investments.

“The market is in a trough,” Oregon spokesman James Sinks said. “The picture would’ve looked different at the end of 2007.” Calpers spokesman Clark McKinley noted that Calpers in June raised its target commitment to private equity to 14 percent of assets from 10 percent.

“That’s an affirmation of our confidence in the asset class,” he said.

Schwarzman and Kravis declined to comment for this article.

‘A Snapshot’

“We are hopefully toward the end of the absolute worst recession of our lifetimes,” said Washington’s Bruebaker. “If you take a snapshot right now, things might not look good. These are 10- to 12-year investments and we believe they’ll be much better than what we see today.”

Bruebaker’s fund and the Oregon Public Employees’ Retirement Fund warmed to buyouts during the 1980s, and Calpers joined in 1990. Today, among U.S. pension plans, Calpers is the largest investor in private-equity funds, while Washington and Oregon are the third- and fourth-biggest, respectively, according to San Francisco-based consulting firm Probitas Partners Inc.

The three state funds, which serve more than 2 million people, collectively more than doubled their buyout commitments in 2005, to $8 billion from $3.1 billion. They ramped up even more the next year, when commitments climbed to $18.7 billion, the data show.

Chrysler, TXU

All told, private-equity firms raked in $1.2 trillion from 2000 through 2008, according to London-based researcher Preqin Ltd. The influx of money, coupled with cheap debt-funding from Wall Street banks eager to collect fees, fueled record-setting takeovers. Nine of the 10 biggest deals were announced from 2005 to mid-2007 as buyout firms acquired the likes of hotel operator Hilton Hotels Corp. and power producer TXU Corp.

The buyouts ground to a halt after the subprime-mortgage market collapsed in late-2007, extinguishing investor demand for high-yield, high-risk debt. The dollar value of deals has dwindled to $42.2 billion so far this year from $212.2 billion in 2008, according to data compiled by Bloomberg.

Private-equity firms unable to cash out of investments have spent much of the credit crisis reworking the capital structures of their debt-laden companies. Chrysler LLC, the carmaker that Cerberus Capital Management LP bought in 2007 for $7.4 billion, and doormaker Masonite International Corp., which KKR purchased in 2005 for C$3 billion ($2.4 billion), filed for bankruptcy this year.


At the same time, changes in accounting rules have cast a spotlight on the current value of private-equity investments.

The Financial Accounting Standards Board’s so-called Statement No. 157, which went into effect at the end of 2007, requires investors, including private-equity managers, to gauge the fair value of holdings that aren’t traded. While most buyout firms typically carried their investments at cost, FAS 157 mandates quarterly assessments of current value.

Such marking-to-market means private-equity funds must tell investors how much their stakes are worth at that moment, even if the managers are planning to hang onto them for years.

“Getting carried away by looking at mark-to-market in my personal view can lead you to an incorrect conclusion for the longer term,” Blackstone’s Schwarzman said on the Aug. 6 conference call.

Blackstone spokesman Peter Rose says it’s premature to judge recent investments, such as those made by the $21.7 billion fund the firm set up in 2007.

‘Profound Losses’

Schwarzman, who created Blackstone in 1985 with Peter G. Peterson, has said their unspent capital — about $29 billion — will enable them to buy companies at depressed prices and generate profits as the global economy recovers.

Others see signs that the private-equity business is undergoing a transformation. Carlyle’s Rubenstein predicted that deals in the current environment will be smaller and less reliant on debt. Individual funds already being marketed to investors won’t top $10 billion, and subsequent efforts won’t exceed $5 billion to $6 billion, he said.

“These are major structural changes taking place,” said Dayton Carr, founder of VCFA Group, a New York-based firm that buys interests in private-equity and venture-capital funds. “The basic economy has had huge issues. A lot of the funds will be smaller.”

The upheaval is reflected in the attitudes of pension-fund investors, who are watching and waiting for cash to come in the door.

“When managers are forced to put a hard value on their holdings, we’re seeing some profound losses,” said William Atwood, the executive director of the Illinois State Board of Investment, an $9 billion pension fund. “The rubber hits the road when cash is returned.”

Let me share with you some thoughts on private equity. First of all, many of these large pension funds got carried away from 2005 to mid 2007, shoveling billions into private equity. Why did they do this? They will tell you because private equity offers diversification benefits (it doesn’t, it’s highly correlated to public equities) and true alpha (once you strip away leverage ad liquidity risk, the returns over public equities are not that half as great as they report). The real reason is that pension funds can game their private market benchmarks allowing them to reap big bonuses based on bogus benchmarks.

Second, there are very few private equity funds that are worth investing in. The large pension funds are all trying to get into the latest buyout funds of a handful of general partners. A monkey can write a cheque for $100 or $200 million to get into a “top” buyout fund. Why do they focus on large buyouts instead of venture capital? Because if you need to allocate billions into PE, it doesn’t leave you much choice but to try to get into the biggest and (hopefully) the best U.S. and European buyout funds (to a lesser extent Asian funds). The top VC funds are much smaller, typically capped at $300-500 million, and there are only a handful in the world (Sequoia and Kleiner Perkins Caufield & Byers come to my mind but good luck getting an allocation with them). Importantly, there is evidence of performance persistence in private equity and VC, so if you can’t get into the best funds, you are better off investing in public equities.

Third, in private equity, vintage year diversification matters. When you are tying up your money for up to ten years, you better make sure you are diversifying properly in terms of strategy, geography and vintage year. A lot of big pension funds are going to get creamed from those 2004-2007 vintage years and some of them are very exposed to particular vintage years.

Fourth, mark-to-market and IRRs are a total waste when it comes to PE returns. What ultimately counts in how much money you put in and how much money you get out (cash on cash returns). For reporting purposes, mark-to-market will just exacerbate the swings, underestimating the true value at market troughs and overestimating the true value at market tops. I understand the new accounting rule is needed to ascribe a value at any point in time, but it does not necessarily reflect the value at which the GP will sell the asset.

So what is the current state of private equity? I think everyone should carefully read Coller Capital’s Global Private Equity Barometer – Summer 2009. In note the following points:

  • The global downturn has reduced investors’ overall private equity returns. 37% of LPs now report overall net returns of 16% or more from the asset class, compared with a high of 45% of LPs in Summer 2007.
  • Three quarters (74%) of private equity investors expect distributions from their portfolios to deteriorate over the next year. This is the most gloomy LPs have been since the
    Barometer began in 2004.
  • For the time being at least, investors are almost equally pessimistic about distributions from funds focussed on different regions.
  • For the first time in years, a significant number of private equity investors are planning to decrease their target allocation to private equity – 20% of LPs plan a reduced allocation in the coming year. (This compares with just 3-6% planning a decrease in previous Barometers.)
  • However, in general, LPs remain strongly committed to the asset class – 80% plan to maintain or increase their target allocation over the next 12 months.
  • A large majority (84%) of LPs have declined to re-invest with one or more of their existing GPs over the last 12 months. Just 45% of LPs had refused re-ups in the Summer 2005 Barometer.
  • Almost all (92%) North American LPs have declined to re-invest with some of their GPs over the last 12 months, compared with 82% of European and 70% of Asia-Pacific LPs.
  • Around half of LPs believe that changes to regulation and/or taxation are likely to damage private equity’s wealth-creating potential in developed markets over the next two years. Just over half (55%) of LPs expect a negative impact in North America and almost half (48%) expect the same in Europe. Fewer investors (just 17%) anticipate a negative impact in Asia-Pacific.

As you can see, private equity is in the doldrums. Is it a bottom for this asset class? That all depends on where public equities are heading. You need robust stock markets, mergers and acquisitions to pick up, the IPO market to open up (so that exits are in place) and last but not least, you need strong bond markets willing and able to finance large buyout deals.

Some large funds are committing more money to private equity over the next year. In early June, the National Post reported that Alberta’s investment fund plans $1-billion spending spree:

Canada’s fifth largest investment fund manager, Alberta Investment Management Corporation, has been largely flying under the radar since its inception as a Crown corporation at the beginning of last year. But the pension funds manager is gearing up to create some noise.

After 10 months on the job, chief executive Leo de Bever, plans to make Edmonton-based AIMCo Canada’s premier investment fund manager, and in the past two months the firm has made some eye-opening investments. These include a 20% stake in Precision Drilling Trust, the Canada’s largest oil-and-gas well driller, and a substantial stake in the country’s biggest grain handler, Viterra Inc.

“Expect more transactions like Precession Drilling and Viterra,” Mr. de Bever told a Bay Street gathering hosted by the Empire Club of Canada in Toronto Thursday.

AIMCo was converted into an independent Crown corporation in January, 2008, to manage the investments of a number of Alberta’s public sector assets, the majority of which involve pension plans and provincial endowment funds.

The company plans to allocate about $1-billion in the next year on private-equity investments as stocks rebound. The firm, which manages about $70-billion in assets, plans to make three to four transactions in the next year valued between $100-million to $250-million. Mr. de Bever said the value may exceed that if conditions are right.

Mr. de Bever has served as the chief investment officer for Australian public sector pension fund Victorian Funds Management Corp., as well as the executive vice president at Manulife Financial Corp. and senior vice president of the Ontario Teachers’ Pension Plan.

He said the fund, which strives to become the “go-to” partner for high-quality investment projects, concentrates its attention on a narrow list of 40-50 stocks that it can gain an in-depth understanding of.

At present, AIMCo’s portfolio has moved to an overweight position in materials, energy as well as agriculture to reflect an expected increase in related prices as the global economy recovers. Mr. de Bever said the global economic downturn was currently bottoming, but it was likely the stock market would take another run lower before conditions improved.

“Stocks, I think in a relative sense on aggregate in the next 10 years, I’ve no problem,” he said. “What they’re going to do in the next six months, I have no idea. I still have a suspicion we’re in a bear market rally and that there may be one more leg of this because the market has gone up a lot on really not a lot of information.”

The funds portfolio is relatively evenly balanced between equities and debt, with corporate bonds beginning to account for a larger portion of assets as government treasuries, which account for about a quarter of AIMCo’s managed assets, begin to become a less attractive investment as yields rise.

“Government bonds are starting to be a real problem,” Mr. de Bever said. “I think the market’s finally waking up. There’s so much issuance coming on line.”

He said the bond market was concerned the U.S. government will allow inflation to run at above normal levels once the economy begins to recover in order to help it bring debt under control. Higher inflation through wage increases, house price gains, and income tax hikes would increase government revenue and aid the repayment of government debt.

As I stated before, Leo de Bever is one of the smartest guys I’ve met in the pension industry, so I pay close attention to what he says. If he is right, vintage year 2010 might turn out to be an excellent year for private equity.

But if deflation sets in over the next few years, then all bets are off and private markets are screwed (especially real estate). They will be in a deep freeze that could last years. That prospect terrifies many large public pension funds that have allocated billions into these asset classes.


Reuters reports pension funds support PE on bank takeover issue:

A coalition of U.S. state pension funds is supporting the private equity industry’s opposition to new rules on takeovers of troubled lenders, the Financial Times reported on its website.

The measures would have “a chilling effect on private capital participation in the acquisition of failed banks,” the state pension funds said in a letter to the U.S. Federal Deposit Insurance Corporation, according to the paper.

The warning by funds from states including New York, New Jersey and Oregon is
expected to strengthen the buy-out industry’s lobbying against the proposed measures, the paper said.

The FDIC will meet next week to vote on a proposed policy that would force private equity groups to maintain high capital levels and put a large amount of their own money at stake when investing in failed banks.

The FDIC provoked a backlash when it proposed the guidelines in July and is expected to soften the policy when it meets on August 26.

The FDIC, the New York State Office of the State Comptroller, the New Jersey Division of Pension and Benefits and the Oregon Public Employees Retirement System could not immediately be reached for comment outside regular U.S. business hours.

The PE industry is trying to muscle into banking industry because they see ways to make huge profits and have Uncle Sam bail them out if things go awry. No wonder pension funds are backing them up.

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  1. Michael Fiorillo

    Great, so now the public pension funds are not only capitalizing the private equity parasites who strip wealth from the productive economy – and for a generation have screwed other union and non-union workers in the process – loading up on debt in order to engorge their wealth, but now they're not even getting the fictional returns they expected.

    The time is long overdue for rank-and-file union members to insist that they're pension funds be used to rebuild the country, rather than strip its wealth away and redistribute it upward.

  2. skippy

    Pension fund or homage to the wealthy? In comparison squirrels have a better strategy, with the un-recovered wealth becoming trees of the future, gift to the future of all living things in the woods, shezz.

  3. Anonymous

    Since when did nakedcapitalism become a pension blog? Leo, no offence but I fall asleep by about the third sentence when reading your articles, but by all means keep polluting the blog with pages upon pages of material that could be summarized in a paragraph. Where is yves? This blog sucks without her.

  4. Anonymous

    Yes, I'm sure there's some interesting info here, but there's just too much to read. I mean, this ain't the only blog. Is pensions the only game in town ? And does it need to be 10,000 words every time ?

  5. Leo Kolivakis

    Why don't some of you stop whining and skip over to the next post if pensions do not interest you? You remind me of why I stopped carrying comments on my blog. For every one good one, there are ten dumb ones. Go read a cartoon but if you want to really understand "naked capitalism" at its core, you'd better look at the bigger picture and trends in private equity, real estate, hedge funds and pension funds are critical.

    I said it many times: any twit can take anonymous swipes on at someone writing a blog but very few offer any critical comments that merit to be read.

    Finally, a message to Yves. Any time you want me to stop posting on Naked Capitalism, you let me know. I will continue posting on my blog on issues that I think are important.



  6. Anonymous

    "Why don't some of you stop whining and skip over to the next post if pensions do not interest you? You remind me of why I stopped carrying comments on my blog. For every one good one, there are ten dumb ones. Go read a cartoon but if you want to really understand "naked capitalism" at its core, you'd better look at the bigger picture and trends in private equity, real estate, hedge funds and pension funds are critical."

    Funny, that was my impression too. I personally prefer posting as anonymous, but I'm beginning to think that the advantages are heavily outweighed by the disadvantages.

    In any case, I appreciate your posts, FWIW.

    "very few offer any critical comments that merit to be read."

    IMO, your posts about pensions, which are not widely reported upon, mean that most people wouldn't know enough to contribute much. Therefore, people who appreciate your posts but who don't have much intelligent to add to them will not post comments, while people who feel don't know anything but who want to whine will still comment. The high ratio of negative comments to your posts probably reflects this (ie, non-random sample of opinion)


    As for "understanding NC to the core"–this site is really pretty amazing :)

  7. Anonymous

    I also find it pretty funny that people complain about having to read too much in order to get information. Are these the same people who whine about there not being enough disclosure to make informed investment choices?

  8. Leo Kolivakis

    My ex-employers use to complain that the articles I sent them were too long. I use to read and highlight important passages for them, always focusing on the risks that lie ahead. Too bad they did not pay attention to what I sent them. It ended up costing them billions. If you are managing money at a pension fund (or any shop), you should be continuously reading and thinking about the risks that lie ahead. Ask Leo de Bever how many articles and books he reads. He probably reads more in a month than most pension parrots have read in their entire life.

  9. Anonymous

    "My ex-employers use to complain that the articles I sent them were too long. I use to read and highlight important passages for them, always focusing on the risks that lie ahead."

    LOL–I used to (still do, actually) work around similar complaints by adding lots of charts and graphs and irrelevant pictures. People seem happier to read a 20pg report with 12 pages of pictures than a 7pg report with text. I never really understood it, but I guess that I would have much more competition if people were less lazy and were better at processing data. *shrug*

  10. asphaltjesus

    Leo, the irony is too rich for me.

    1. What you cover is important, but most people with pensions are not of the mind to pay attention. As your posts clearly show, it's mostly over but for the crying.

    2. I don't think many NC readers have pensions. Your posts are irrelevant AND long at the same time. This is a big negative to the vast majority of people who are being robbed and don't want to hear it.

    3. Your position of canary in the coal mine is thankless and mostly viewed as a negative in organizations from workplaces to general society. It's a career limiting move for those of us in the workplace. Crazy? sure, but those are the times we are in.

    4. About 10 years from now, someone in MSM will mimic your general content and style while obscuring the responsible parties and be heralded as 'influential.'

    Keep going!

  11. Ed

    I appreciate Leo's posts even though I don't have a pension and will often scroll through them. Admittedly the short version of just about all these posts is pretty much "we're f—–!"

    There is another blogger, Larry Littlefield, who writes much in the same vein about pension plans for government employees.

  12. mannfm11

    Leo, this is one of the prime subjects of this time and it will be one of the great catastrophes as well. Unlike some of these guys, the pension question is the prime driver of what goes on in the stock market and the bond markets. Most pensions are underfunded and have been looted by their corporations, their governments or by wall Street with actuarial formulas that cannot be mathematically supported. The current standard is merely one more of them.

    There is an inflation/deflation debate that rages on every page. The point being that it takes debt accumulation to create inflation and we have reached the point where additional debt can no longer be carried in the private sector. It won't be long before the trend in government finance reveals that only a fool would lend to support the government in its drunken sailer form of spending. Clearly we will deflate and clearly, as evidenced by 135 years of stock data published by Robert Shiller that stocks are 100% over normal average price at this time, utilizing the true financial valuation of dividend payouts. These rocks lying just below water level are going to rip the bottoms out of these funds.

    As long as inflation has a grip, these PE and hedge fund leveraged scams can appear to work, as rising multiples allow for resale of assets at higher prices. Has anyone ever really priced risk and realized how much 2% over a bench mark is? Being the managers are getting the first 2%, that takes the risk of treasuries to BBB level at best. So, in order to reap a long term return above treasury level, one has to venture into the risk level of junk. Having high leveraged government guaranteed bank credit or pension money involved in such a scheme is scandalous. Ones record can look good when they are dealing from the bottom of the deck or using loaded dice. Thus we have billionaires who have been using loaded dice for so long that I doubt they will last long now that the normal dice are in the game. It is clear that the pension system of the country is going to be the next $1 trillion bailout.

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