Last week, we described how CalSTRS’ private equity consultant, Pension Consulting Alliance (PCA), made a mind-boggling suggestion as to how to address the fact that CalSTRS’ private equity program performance has undershot its performance targets by large margins over the past ten years: scrap the benchmark. That’s tantamount to telling an overweight person to get rid of their mirrors rather than go on a diet.
Mind you, PCA did that with a tad more finesse, telling CalSTRS that it should focus on “absolute returns.” We explained why that is bogus:
“Absolute returns” is a totally unsuitable framework for evaluating private equity. We’ve attached an article at the end of this post that debunks the myth of absolute return investing. A money quote:
Just because something is called an “absolute-return investment” does not mean it is granted an exception to the first law of financial gravity described in the previous section: The returns of any portfolio can be broken down into market (beta) components and an alpha [manager skill] component. So, here is the money question we are asking all hedge fund managers who fancy themselves absolute-return investors: Is the expected return you offer investors attributable to your expected average exposure to the beta (single or multiple) that characterizes your normal portfolio, or is it attributable to expected alpha generated through skillful beta timing or security selection?
It’s simply ludicrous, and therefore a sign of general partner and private equity consultant desperation, to try to fit private equity into an ‘absolute return” framework. “Absolute return” strategies, to the extent they ever could be achieved, sought to beat the market in good times and preserve capital in bad times, as in not lose money or at least lose less money than “the market” (however you wind up defining it) overalll.
As we stressed, the fact that two biggest public pension fund investors in the US that are widely seen as having preferred access to managers and a better selection process than most funds have fallen considerably short of their benchmarks over the past ten, five, three and one years means that private equity is not paying investors enough for the risks involved. It is thus not a sound investment strategy.
At CalSTRS, PCA made clear its intention to move that fund off those pesky benchmarks that are showing private equity to come up short on performance. By contrast, at the August Investment Committee meeting at CalPERS, PCA’s role in moving the goalposts was a tad less obvious.
There, as we recounted, the Chief Investment Officer, Ted Eliopoulos, tried to spin private equity’s persistent failure to meet CalPERS’ benchmarks as acceptable because it “has generated absolute returns in line with our expectations.” Huh? How could it do that when “absolute returns” were never a target? But the joint CalPERS/CalSTRS PCA consultant, Mike Moy, vouched for Eliopoulos’ misrepresentation by saying, “I thought Ted’s synopsis of what’s going on in the private equity space was excellent (starting at 11:48 here). It’s almost certain that PCA reviewed Eliopoulos’ overview in advance.
Andrew Silton, the former Chief Investment Advisor to the State Treasurer of North Carolina, was so appalled by Mike Moy’s remarks to CalSTRS that he again abandoned his decision to retire from financial blogging to issue a post saying that CalSTRS and CalPERS need to fire PCA as a first step in dealing with their private equity performance problems. Key sections of his piece, which I urge you strongly to read in full:
After thirty-five years in and around the money management business, I thought I’d seen every possible response to poor investment performance. Managers and consultants have blamed market conditions, a bit of bad timing, and particular benchmarks. Naked Capitalism has come through again with a disturbing piece of video showing a well-known consultant advising the second largest public pension plan to ignore its private equity benchmark altogether. I’ve never seen anyone advise an institutional investor to eliminate a benchmark as a response to poor relative performance….
In the most recent investment meeting at CalSTRS, Mike Moy, the consultant, stated that the pension plan had underperformed its PE benchmark for most reporting periods (see exhibit 1) and then suggested that the asset class shouldn’t be measured against any benchmark…In other words, Mr. Moy is suggesting that the trustees accept the performance from their PE portfolio so long as they are satisfied that it is helping them meet their financial objective….
Private equity is a major, mainstream asset class in most institutional portfolios. Moreover, as the name implies it is simply the ownership of common stock in companies that are not publicly traded. As a result, the benchmark is straightforward. Pick a major stock index like the S&P 500 and add a hefty premium (5% to 8%) to reflect the additional risk and illiquidity of PE. In other words, if large public stocks return 8%, you should expect PE to return 13% to 16% net of all fees over the long term.
There’s no doubt that the performance of a PE portfolio will vary from the returns of the public markets over short time periods, given the nature of PE accounting and the internal rate of return calculation used to calculate performance. However, if an institutional investor isn’t getting a big premium over the S&P 500 from its PE portfolio over ten year periods, it’s a sign that something is wrong, and the problem isn’t the benchmark. Ironically, the problem at CalSTRS is even more dire because their benchmark doesn’t have a big enough premium. They only require their PE portfolio to exceed the S&P 500 by 3% to 4%. It’s an expectation that you might be appropriate for small cap public stocks, but not private equity.
Notice that Silton supports another argument we’ve made, that the widely-used 300 to 400 basis point (3% to 4%) return premium for private equity over the S&P 500 is far too low, which means the underperformance problem is even greater than widely reported. Back to his post:
I’m not privy to the details of the CalSTRS private equity program, so I can’t tell you why it failed to beat its benchmark. However, the board ought to be considering one or more of the following causes rather than eliminating the benchmark:
• The fees and expenses charged by CalSTRS’s PE managers have consumed too big a portion of the returns. As best I can tell, CalSTRS’s fee disclosure for PE is among the worst in the country. The pension’s annual report doesn’t even disclose management fees, let alone carried interest.
• CalSTRS picked the wrong group of PE managers.
• CalSTRS didn’t properly pace its PE investments and has too big an exposure to certain periods of time when PE performed poorly. According to CalSTRS’s latest quarterly report on PE, this is certainly part of the story. CalSTRS invested far too heavily in 2005-2008 (see Exhibit 2).
• Its consultant has poorly advised CalSTRS….
A few weeks ago I wrote about CalPERS’s PE program. Now we have evidence that the operation and performance of CalSTRS’s PE program is also problematic. America’s two largest public pensions share PCA as their PE consultant. Both plans ought to be taking a critical look at their PE programs. Before that can happen they need to find a new private equity consultant.
Confirming the conflicted nature of consultants like PCA, that more complexity is in their interest because it justifies their fees, Pensions & Investments reported on September 2 that PCA was advocating that CalSTRS maintain its current level of private equity investments at 13% and increasing what PCA gives the Orwellian name of “risk mitigating” strategies and misleadingly calls it an “asset class” from 0% to 12%. From the article:
The risk mitigating strategy is not without controversy. PCA, in its Sept. 2 presentation, said the long U.S. Treasuries that would make up 35% of the asset class are also “very risky” because they have an estimated annual volatility rate of 20%. But the firm said the alternative investments would counter volatility.
Under PCA’s plan, systematic trend-following investments — which go long in rising markets and short markets that are falling — would make up 40% of the asset class. Global macro hedge fund strategies would comprise 15%, and alternative risk premiums would be 10%.
Introducing the risk mitigating strategy would also increase CalSTRS costs because of fees to be paid to alternatives managers. PCA estimates in one scenario that CalSTRS would pay $982 million in fees, up from the current $821 million, if risk mitigation were implemented.
Huh? It’s a stretch to depict global macro as necessarily a long/short strategy (although some macro players do operate that way); it’s at least as often a global hunt for value.
And that’s before you get to the elephant in the room: the Maryland Policy Institute has determined that public pension funds that invest more in high-fee strategies like private equity give up an average of 1.6% a year in net return versus investing in index funds that mimicked their typical asset allocation. So PCA is out to turn the wheel at CalSTRS hard in the direction of throwing fees at managers in a dubious reach for more return.
As Rosemary Batt, co-author of Private Equity at Work, said via e-mail:
CalSTRS ‘risk mitigation’ strategy by PCA would allocate more to global macro hedge funds and ‘alternatives’. The PCA plan estimates fees up from $821 million to $982 million – or a 19.6% increase. Great logic!
Unfortunately, that sort of “logic” does not even raise an eyebrow at CalSTRS.