If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:
Senior Private Equity Officers at CalPERS Do Not Understand How They Guarantee That Private Equity General Partners Get Rich
CalPERS Staff Demonstrates Repeatedly That They Don’t Understand How Private Equity Fees Work
CalPERS Chief Investment Officer Defends Tax Abuse as Investor Benefit
CalPERS, an Anatomy of Capture by Private Equity
Although private equity limited partners offer plausible-sounding rationalizations for the many ways that they allow the general partners to extract fees from and shift risks onto them, one justification stands above others. The One Excuse That Rules Them All of private equity is that it is essential because it provides a level of returns that cannot be achieved elsewhere.
It does not reflect well on limited partners that this excuse is not even remotely true.
Nevertheless, this justification is particularly potent, since both public and private pension funds have too often set return targets that made sense historically but have become increasingly unrealistic as prevailing interest rates have fallen and are now in negative real interest rate territory. As a result, many retirement plan sponsors like CalPERS are now desperate to make up for investment shortfalls.
If you believe that only one strategy (or set of strategies, such as private equity, hedge funds and infrastructure investments, which are often referred to as alternative investments or “alts”) provide outsized returns, and you are behind your targets, it then becomes imperative that you have meaningful investments in these strategies.
Combine this need with the closed nature of private equity and you can see how private equity general partners prey on the limited partners’ fears. They play up the notion that the limited partners might be denied access to private equity funds if they get too uppity.*
We’ll see this dynamic play out in classic form at the CalPERS Investment Committee meeting, from Chief Investment Officer Ted Eliopoulos:
Chief Investment Officer Ted Eliopolous: And as was highlighted in last December’s Private Equity Program review, private equity does have, and clearly has, some characteristics that are clearly aligned with CalPERS Investment Beliefs, such as our long-term time horizon, and our willingness to take risk where we expect to be adequately rewarded. Over the long term, our Private Equity Program has generated absolute returns in line with our expectations. Currently, private equity is the only asset class in our portfolio that is expected to exceed our seven and a half percent target rate of return on a net basis. As such, private equity remains an important component of our portfolio and the overall sustainability of the CalPERS system.
The statement, “….private equity is the only asset class in our portfolio that is expected to exceed our seven and a half percent target rate of return on a net basis,” is tantamount to telling the Investment Committee that CalPERS absolutely has to be in private equity in a significant way. This is the investor version of TINA: “There is No Alternative.”
Independent experts don’t buy that viewpoint. Eileen Appelbaum, economist and co-author of the highly regarded book Private Equity at Work, is skeptical of the assertion that private equity returns are outsized. As she said via e-mail:
It would be useful to know on what basis CalPERS’ CIO Ted Eliopoulos expects future PE returns to exceed seven and a half percent. Using the yardstick favored by finance academics, the median fund in every vintage since 2006 has failed to outperform the Russell 3000. While top quartile funds do beat the stock market, choosing top quartile funds has turned into a crap shoot: since 2000, the follow-on fund to an earlier PE fund that was in the top 25% of fund performers has only a one in four chance of being a top performer. Picking funds turns out to be no more reliable than picking stocks for sustainable performance.
Similarly, Oxford professor Ludovic Phalippou questions Eliopoulos’ claim that only private equity can exceed CalPERS’ 7.5% mreturn target:
The return for CalPERS is 1.6 times the amount invested, which is 12% per annum. That is the same as the average PE fund return documented in all academic studies I know of.
I am surprised that it is the only asset class that they claim will perform above their 7.5% target. Maybe CalPERS needs to redefine what it views an asset class to be. Many asset managers would be upset at that statement. For instance, the S&P 500 has returned 8% and DFA [Dimensional Fund Advisors] among many other passive investors focusing on smart beta type strategies has e a long track record at 12%-14% per annum. The average stock in the US, i.e., the small and mid-cap which is the type of stocks/companies targeted by PE have a 12-14% per annum return over past 10, 15, 20 years. Mid-cap, value, low volatility strategies (called smart betas) target companies similar to those of PE and they returned 12-14% per annum. So CalPERS’ statement is strange.
It is also important to risk adjust. Saying that the best performing asset in a portfolio is the levered equity one is almost a tautology. I bet within the fixed income part of the portfolio of most investors, junk bonds have had the highest returns!
It could be that PE is a good investment for CalPERS but there is a wedge between the amount invested on the one hand and the depth of analysis on the other hand.
As we’ve stressed, the idea that private equity provides superior performance is a myth. You’ll notice that Eliopoulos tries to position private equity as being consistent with CalPERS’ “Investment Belief” that returns be commensurate with risk. Yet the returns for CalPERS private equity portfolio have failed to meet its benchmark over the past ten, five, three, and one years.
And private equity does not fall a little short of CalPERS’s benchmarks. It’s a lot below: 344 basis points (3.44%) for 10 years, 222 basis points (2.22%) for five years, 394 basis points (3.94%) for three years, and 484 basis points (4.84%) for the year to date as of May 31, 2015. And remember that CalPERS is widely perceived to have better access to private equity funds and have a more disciplined selection process than other limited partners.
That is why Eliopoulos focused on “absolute returns” in his defense of private equity, so as to divert attention from the fact that private equity has fallen short for CalPERS on a risk-adjusted basis, which most investors set at a 300 basis point premium over a comparable stocks to allow for the illiquidity of private equity.**
So the only way to beat the actually-not-good-enough return in private equity, as Appelbaum pointed out, is to invest in top quartile funds. But that is a fool’s errand. As we wrote earlier:
Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity. The investment consultants go through the shooting-fish-in-a-barrel exercise of convincing their institutional clients that each of them is prettier, smarter, and more charming than average, and therefore capable of achieving sparking results. Needless to say, flattery is an easy sell…
Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.
So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
I asked Michael Flaherman, the former head of CalPERS’ Investment Committee, later a private equity managing director, if he thought that limited partners would jeopardize their private equity returns if they bargained for better terms. His response:
If you talk to private equity LP investors, it is clear that almost all of them believe that they are living some version of “the prisoner’s dilemma” with respect to their bargaining power vis-à-vis the fund managers. By this, I mean that individual LPs tend believe that, if they act to promote their own interests, they will be punished by the PE managers by being denied access to “hot funds” during fundraising.
This argument undoubtedly has a very small amount of truth to it. However, its impact tends to be vastly overestimated, in my opinion, to the point of leading to a sub-optimal LP posture of passivity in negotiating terms. Statistics show that most prospective “hot funds” won’t won’t turn out to be top quartile performers, while some funds that are not “hot funds” will be. Given that an LP has little better than a random chance of picking top quartile performing funds based on the prior track record that gives rise to “hot funds,” there is a strong argument for focusing one’s investment activities on “non-hot-funds,” where the fund manager has little leverage to resist demands for better terms and little ability to “punish” LPs that insist on them.
In other words the limited partners have overvalued what they might lose by bargaining hard with private equity general partners, and appear not to value at all what they stand to gain: a real improvement in economic terms for the funds in which they invest, which will translate into higher returns.
The sorry reality is that CalPERS continues to commit a significant portion of its investments to a private equity, a strategy that is almost totally at odds with its “Investment Beliefs.” Despite Eliopoulos’ efforts to spin to the contrary, CalPERS’ own data shows that private equity does not provide returns in keeping with the risks involved, one of CalPERS’ purported requirements. Staff and the board continue to ignore CalPERS’ own data which shows indisputably that private equity returns have consistently fallen well below the risk-adjusted performance level needed for private equity to be a sound investment.
Finally, private equity does not even conform to CalPERS’ “Investment Belief” of long time horizons. Eliopoulos bizarrely tries to spin the illiquidity of private equity funds as a benefit to CalPERS, when in fact not being in control of when CalPERS can get its money back is a decided negative; that’s why the return benchmark is 300 basis points higher than comparable stocks. And general partners, despite their patter, are not long term investors except when their deals turn out badly. The average investment life of a fund is four years and quick flips of companies are associated with the highest returns. The fund managers thus have incentives to favor a shorter, rather than a longer-term focus, contrary to the impression that Eliopoulos gave to the investment committee.***
Thus private equity is completely out of synch with what CalPERS claims it seeks in an investment strategy. Senior staff members dissemble to the board, and presumably themselves, to justify continuing to commit funds to it.
* There are only two cases where that has ever occurred, namely, when two venture capital funds huffily said they would not allow investors who might publicize fund performance data to invest after CaLPERS agreed to do just that after it agreed in a 2002 settlement to publish the returns for all of its private equity funds on a quarterly basis. What is less often said is that this threat was empty. The two funds were venture capital fund, and public pension funds like CalPERS have not been important sources of funds for venture capital firms.
** Troublingly, this 300 basis point premium is a mere rule of thumb that warrants more scrutiny than it gets. A fund like CalPERS could not begin to sell its private equity portfolio on the secondary market in anything but a very attenuated time frame so for CalPERS to think in terms of an “illiquidity premium” of a mere 300 basis points is all wet. Limited partners have given the general partners what amounts to a very long-dated option regarding when they return the money. Long dated options are extremely costly.
*** As Florence Lopez de Silanes, Ludovic Phalippou, and Olivier Gottschalg document, private equity funds appear to target a 2.5 times gross return, measured as cash-in versus cash out. If you plot fund returns against the average investment life of a fund, you see a sharply declining line.