CalPERS’ Chief Investment Officer Invokes False “Superior Returns” Excuse to Justify Fealty to Private Equity

If you have not had the opportunity to do so yet, please read the earlier posts in our CalPERS’ Private Equity, Exposed, series:

Executive Summary
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.

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  1. Jim Haygood

    ‘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.’ — “Steady Teddy” Eliopoulos

    To the extent this was ever true, it was largely an illusion of leverage. Like high fructose corn syrup in processed food, leverage is an ingredient in almost every PE deal to bulk up returns with empty calories. As the WSJ reported last year:

    Still, 40% of U.S. private-equity deals this year have used leverage above the six-times EBITDA ratio deemed the upper acceptable limit by regulators, according to data compiled by S&P Capital IQ LCD.

    That is the highest percentage since the prefinancial-crisis peak of 52% of buyout loans in 2007. Such lending all but disappeared during the crisis but has risen each year since 2009.

    These loans, provided by a group of banks, are often sold to a wider group of lenders and investors. Regulators are concerned that in the event of a financial downturn and diminished demand from investors, banks may find themselves stuck with large pipelines of risky debt.

    In all the well-justified controversy over private equity fees, are board members even asking about embedded leverage?

    As credit spreads lurch higher, leverage is about to become a very big deal indeed, both for PE partnerships and for the usual-suspect anencephalic banks who got stuck with their crapulous paper.

  2. Lambert Strether

    Readers, this is an easy one. If you can handle the carry fees post — and readers liked that one — you can handle this one! (Either that, and I’m wrong, and it’s not easy, in which case please explain why.)

    1. ekstase

      It gets easier and clearer with each one you read. This material is an important part of understanding what has gone wrong in our society.
      I think a lot of people are intimidated by the subject of economics, (and these articles are illuminating some of the ways in which that intimidation has been perhaps, encouraged.) But this material, (and the human interactions involved,) is really fascinating.

  3. Jim A

    The thing is, pension fund managers don’t need 7.5% returns….What they DO need is a plausible (but not legally binding) promise of 7.5% returns….The fact that they can put an implausible claim for future returns means that they don’t have to budget more TODAY for future pension costs. Because the future is somebody else’s problem.

    1. Larry

      Bingo! I get the sense that the managers of the funds are spinning at least three plates that keep themselves fat and happy.

      1. Buy into investments that are desired policitally (donor$) or personally (revolving door$).

      2. Pa$$ the buck. Our portfolio is targeted to hit x% return over 5, 10, 15, etc. years. Our portfolio is healthy and will deliver. When it doesn’t, that won’t really be our problem, will it?

      3. Be lazy. It’s easier to hit the golf course at 4pm and leave the office on Thursday for skiing when you’re not doing your job rigorously. And buying into the PE mantra about returns expected gives the fund manager a set-it-and-forget it approach to work. Reading a PE fund agreement document probably takes a lot of time. Better to look at historical data and say we got preferential access to a “winner” than to perform due diligence and negotiate down the weeds for the best possible deal for your fund.

  4. flora

    Yves, the rational that CalPERS must invest in PE because it provides outsized returns has been thoroughly debunked in your series.
    ” …private equity does not fall a little short of CalPERS’s benchmarks. It is a lot below: 344 basis points (3.44%) for 10 years,….”

    So why continue with PE? Is it because the Board is comfortable to go on as they have gone on; it’s too hard to do the homework and take in new information; or they’re intellectually captured? One other possibility is that in large organizations, and especially organizations that make a claim to special expertise, it is professionally safer for both the organization and the individual to only do and say what other peer organizations do and say. Even if they are all wrong, it is safer to go along with the crowd. In some sense, going along with the crowd is considered a “reasonable man” defense. To step out ahead of the generally accepted practices can be daunting. “Being right too early is as bad as being wrong.” In a sense, they must all move together, or agree to pivot in a given order. CalPERS, considered the premier pension fund, is exactly the fund that has the respect and clout to step away from PE and lead by example. I hope they have the moxie to do that. Keep the pressure on.

    Thanks for this very important reporting.

    1. flora

      By “agree to move together” I don’t mean officially communicated decisions. There is a “new understanding” that everyone “suddenly has” that communicates itself in bits and pieces over some time frame. These NC reports are very important to shift the general thinking away from myth to reality re: PE.

    2. steelhead23

      One of the theses presented in Yves fine book, Econned, is that individuals do not make spending decisions based on a thorough analysis of “maximizing their marginal benefit” of each and every dollar. We are emotional beings, not computers. This piece, and indeed the entire series, is based on straight-forward, rational “benefit maximization” as the absolute goal of fiduciaries like CalPers. I object. In my mind, even if PE beat the socks off the market, I would prefer that any fiduciary of mine not invest my money in PE. My argument is that maximizing the pecuniary benefit of investments should not be the sole driver of CalPers investment decisions. Considerations should include non-monetary values. For example, if PE makes money by destroying companies (e.g. capturing the equity value of companies through borrowing, potentially leading to bankruptcy), investing in PE would encourage this behavior to the detriment of labor. I have argued that the business model of PE firms is diametrically adverse to the interests of workers. It is simply immoral for CalPers to invest in PE whether or not it is highly profitable. I am not suggesting that fiduciaries ignore the monetary bottom line, I am simply arguing that fiduciaries should respect the non-monetary interests of the investors they represent, particularly when all the investors share common interests as is the case with pension funds.

      I suspect that Randy Wray or others could put some meat on these bones, but when criticising CalPers for blindly investing in PE we should not ignore moral considerations. I provide one above, but there are others – bribery anyone?

      1. Lambert Strether

        Your claim is actually even more powerful. Humans are not only emotional, their emotions are adaptive. So what the neo-liberals and rational actor dudes are really doing is creating a social environment were previously adaptive behaviors are maladaptive. So what happens when their environment collapses, “When the Machine Stops”?

  5. vlade

    I’ve always found this fascinating.
    Mr. Flaherman just restates “fees matter, especially in long term” – which is why index investing now often outperforms active (on average).
    Also, the believe that PE is the only one that can generate outsized returns (relatively speaking) – hahaha. PE is the least transparent in returns of them all (cue fees), hence the least transparent in returns. It has also the highest selection bias so…

    I still claim PE can be a very good investment, even for LPs (it very often is for GPs), but it suffers from the general financial industry problem – everyone wants the winning sauce, so everyone pretends to have it – when only few have, and even those can’t be really objectively identified (since we can’t run controlled experiment which would rule out luck).

    And, when I though about it some time back (when Yves took me to task re size of PE funds vs. return), the most successfull PE funds I know really operate more like real, very long-term (open ended) owners, not 5 year churn machines. So it’s a question whether one can still call them PE.

    1. Yves Smith Post author

      Your claim, which is merely your pet belief, is inconsistent with evidence. No one has “the winning sauce”. As we said, there is no such thing as persistent top quartile performance. There was some time ago but that is no longer true.

      And you choose to ignore CalPERS’ experience. CalPERS is widely perceived to be more sophisticated and disciplined than other PE investors and has better access to funds. Yet over the last ten years, it has fallen hundreds of basis points short of its benchmarks for PE. That means that PE does not deliver enough in the way of returns to justify the risks.

  6. RUKidding

    If PE investments are so great, why, then, are CalPers returns so low? And this was showing returns through April when the stock market was kinda/sorta going crazy last year. Of course, the market has been “adjusting” lately due to issues in China (amongst other things).

    So whereohwhere are these fabulous PE investment returns? Oh, right – done got eaten up in carry fees, I guess.

    As a current CalPers contributor and a future (hopefully) CalPers annuitant, thank you very much for shining the spotlight on this very disturbing investment practice.

  7. washunate

    return targets that made sense historically

    And even that, at a deeper level, is problematic. The historical claims made by the finance sector are mostly nonsensical. We are dealing with a rather small sample size, and CAGR hasn’t worked out so simply over longer time horizons.

    Plus, the social challenge we face is that the trillions of dollars worth of actual human labor we have thrown at housing and healthcare and national security and prisons and fossil fuels and agribusiness and cars and so forth over the past few decades did not create sufficient real wealth with which to pay those workers either their past wages or their future retirement promises. At an aggregate level, no amount of investment return can solve the problem of malinvestment itself. It’s like trying to address malnutrition by consuming more sugar. The problem is not the aggregate level of consumption. Rather, the problem is in the type of consumption.

  8. Andrew Silton

    If a public fund believes that private equity is one of the only ways to exceed its investment hurdle, it should borrow money in the municipal market and invest in public equities. Why? The fate of private equity investments is inextricably tied to the public markets (accounting and the dynamics of fund management make it appear that they aren’t closely linked. They are taking a bullish longterm view on equities.

    In addition, public pensions can borrow far more cheaply than their private equity managers (CalPERS is a better credit [and enjoys tax exemption] than a PE portfolio company). Finally, the 2 and 20 fee structure would disappear. However, public funds prefer to hire PE managers and pay huge fees, because it hides their accountability for making a leveraged bet on equities.

    Trustees at every public pension should read Naked Capitalism’s series of posts, because most of them are committing the same mistake as CalPERS. Congratulations to Naked Capitalism for a great series of posts.

    1. Jim Haygood

      ‘public funds prefer to hire PE managers and pay huge fees, because it hides their accountability for making a leveraged bet on equities.’

      Same with hedge funds [after the next bear market]: ‘We warned them not to leverage up, but they just wouldn’t listen.’

    2. tegnost

      What are the chances that the revolving door has become so pervasive that the majority of pension employees ( I’m aware andrew silton appears to have not done this to his credit) are thinking they will be on both sides of the deal as their career progresses?

  9. griffen

    I commend you all on this endeavor. Private equity exists largely to benefit…private equity, first and foremost. It is not the mid 1990s where only a few shops existed and excelled in this particular sector.

    Any board level member or executive committee of a leading pension in the US should be ashamed. You don’t pay for under performance. You fire for under performance.

    1. RUKidding

      As a long-time, very amateur investor, you make a good point about what PE used to be. Of course, investing back in the day – in general – used to be much less of a mug’s game than it is now. Tis true that PE had it’s day and was something worth considering.

      Now? Not so much.

      Then I tend to ponder: Cui bono? Who benefits from making these “investments” in PE in a giant fund like CalPers? Shenanigans afoot? One wonders… It’s MY money. I want to see CalPers behave more like CalSTRS, which, I believe, is moving far away from PE. That’s as it should be.

  10. vidimi

    CALPERS has an investment officer called wiley toilette? talk about dickensian.

    sorry i’ve nothing else to contribute here :)

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