We’ve described the important role that consultants play in defending and thus perpetuating dubious practices in private equity. As much as these advisors nominally serve limited partners like CalPERS and its Sacramento sister, CalSTRS, which is the second biggest public pension fund investor in private equity, their true loyalties are to the private equity industry.
As we discussed at length in a recent post, How CalPERS’ Consultant, Pension Consulting Alliance, Promotes Intellectual Capture by Private Equity, firms like Pension Consulting Alliance (PCA) are inherently subject to the biggest conflict of interest of all: that of needing to validate that the idea of investing in private equity is ever and always sound.
PCA is also CalSTRS’ private equity consultant. At CalSTRS’ September board meeting, PCA gave a vivid demonstration of how it is willing to prostitute itself intellectually to rationalize sustained private equity underperformance.
Recall that CalPERS has failed to meet its private equity benchmarks for the last ten, five, three, and one years. CalPERS is widely considered to have ready access to fund managers and to be disciplined about fund selection. It’s hard to think that many investors would do meaningfully better than CalPERS; indeed, PCA said in September that CalPERS did better than an industry peer group index.
But private equity is a high-risk, hoped-for high-return strategy. And yet the benchmarks that have been used in the industry for decades show that private equity hasn’t deliver the returns that go along with the risks.
The conventional benchmarks are equity indexes comprised of mid-to-smaller sized companies (private equity owned companies are much smaller than members of the S&P 500, so the use of the S&P 500 as a basis for comparison is flattering to private equity). The convention is then to add 300 to 400 basis points (3% to 4%) to allow for illiquidity risk (we’ve argued at some length that this rule of thumb is low).
CalPERS has not just fallen short of these targets. It has fallen short by a gaping chasm of several hundred basis points for the ten, five, three, and one years measurement periods.
The very fact that CalPERS’ private equity returns over the past decade have been hundreds of basis points below CalPERS’ benchmarks says that private equity falls massively short in giving enough return relative to the risks involved. Shorter: Private equity cannot be depicted as a sound investment.
So how does PCA propose to deal with this glaring problem? By refusing to measure it any more. No measurement, no problem, right? Here is the fix it recommended to CalSTRS:
Mike Moy, Pension Consulting Alliance: You will notice in the report the continuing difficulties that we have with the benchmark and your performance against that benchmark. I would argue that the problem is the benchmark, not the performance. But I think that’s, to me, an industry-wide problem, in finding an appropriate benchmark that really gives you the ability to measure success currently and in the long term. I think you really have to look at it on a absolute basis to make certain that it’s contributing to your expected performance that’s in your asset allocation.
If you are finance-literate, what Moy is trying to sell is utter sophistry. Whether by accident or design, he reveals what the benchmark gimmickry is really about. It’s not to measure performance, but to measure “success currently and in the long term.” Thus anything that conflicts with the real agenda, that of depicting private equity as a success no matter what, must be replaced with something that does.
“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, seek 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) overall.
As we wrote at some length in a post on how public pension funds that invest more in high fee strategies like private equity do worse overall, even those disappointing performance figures we mentioned earlier are exaggerated because:
¶ Private equity uses IRR (Internal Rate of Return), meaning comparisons with public equity benchmarks are a garbage in, garbage out exercise skewed to favor private equity
¶ Private equity uses valuations that are known to be questionable
But even with private equity feigning better performance than it really has by fudging its valuations in bad markets, private equity returns are, not surprisingly, very highly correlated with stock market returns. Despite all the fancy tax games and financial engineering general partners can perform when they obtain control of a company, they also have to bid in competitive markets to buy companies against other private equity buyers who know all the same tricks (as well as “strategic” buyers, meaning operators who see a fit between the target and their current businesses). Hence a lot of the potential “PE upside” is bid away in the purchase process.
As Oxford professor Ludovic Phalippou said via e-mail (emphasis ours):
I have commented on this issue of the need to benchmark private equity against public equities for years and made that point countless times. And I believe that financial economists are unanimous on this issue.
The simplest reason why PE returns need to be benchmarked against listed equities is because once a PE fund buys a company, the price is in line with similarly traded companies. The same is true when the PE fund sells it. Hence, a PE fund did nothing to create value if an investor would have earned the same return as similar listed stocks. That is why it is a benchmark.
A more elaborate answer is that all of the empirical evidence we have accumulated indicates that the correlation between listed equity and PE returns is very large (at least 80% correlation).
An absolute return benchmark, i.e. risk free rate, is absolutely unjustifiable on any ground.
From Eileen Appelbaum, co-author of Private Equity at Work:
Mike Moy notes PE’s “continuing difficulty with benchmarks” — an apparent admission that private equity is failing to meet CalSTRS’ benchmark. His conclusion is stunning — the problem, he says, “is the benchmark, not the performance.” Try telling that to your boss the next time you get a poor performance rating!
Unbelievably, Moy’s solution to the difficulty with benchmarks is to get rid of them altogether. Of course, he doesn’t say so outright. What he does say is that PE returns should be looked at “on an absolute returns basis.” The advantage of doing this? An absolute returns strategy is not benchmarked against a traditional stock market index but against a risk-free benchmark like US Treasuries, or against no benchmark at all. The goal of such a strategy is to avoid risky investments and preserve capital in the event of a market sell-off — obviously NOT what private equity is all about.
And why is PCA so keen to get rid of benchmarks now? The answer comes a few minutes later:
Christopher Ailman, Chief Investment Officer, CalSTRS: My most scary, frightening chart, chart number two. This is kind of the opposite of real estate. This is prices paid. What do you have to pay to invest and buy a company in the private market today? You can see that in the first half of ’15 it was it was 10.1 [times EBITDA]. That may go down now thanks to the summer, but basically, new investments in private equity are having to pay amongst the highest prices. Both, and PCA pointed that out in their other chart, that both private equity and real estate are priced almost to perfection, that’s a good way to put it. So it’s a tough time to make investments and hope we make money.
As Appelbaum concludes:
Why does Moy want to get rid of benchmarks? Probably because he knows that private equity is overpaying for the companies it buys, and thus funds of recent vintage are unlikely to outperform stock market benchmarks. Private equity is paying a 10.1x multiple to acquire a company. For context, at the peak of the last boom, in 2006, the multiple was 9.0x EBITDA. It’s a tough time for PE to invest and perform well — so let’s not measure its performance!
Former banker, now independent private equity researcher Peter Morris, puts this sorry picture in context:
What private equity managers actually do is quite simple. They buy companies, often with lots of debt; run them for a few years; then sell them. In between buying and selling the companies, they sometimes make big changes. But the main driver of private equity returns remains a combination of the stock market and financial steroids (meaning the high debt levels).
Once you understand how simple private equity really is, it becomes obvious how to tell if private equity has been a good investment or not. Private equity ought to outperform the stock market, for three reasons. It uses financial steroids (aka lots of debt). It is very illiquid (harder to buy and sell)*. And on top of this, buyout managers say they “create value” by running companies better.
So the key question becomes: Has private equity outperformed the stock market over the long term, net of fees, by a big margin — say, five percentage points a year or more? (Neither the cash multiple nor the internal rate of return accurately measures this.) If so, then there is a case for saying private equity was a good investment.
If private equity (net) failed to outperform the stock market by a big enough margin, then the exorbitant fees that investors have paid to private equity managers were a waste of money.
Investors like CalSTRS and their consultants, like PCA, mostly fail to address this simple question. They dance around it in several creative ways. They focus on inadequate return measures, such as cash multiples and internal rates of return, even though a better measure is readily available (the Public Market Equivalent). Instead of just comparing private equity to the stock market, they develop complex bespoke benchmarks. Then, when performance falls below these benchmarks, consultants like PCA recommend abandoning the benchmark and looking at “absolute return” instead. It is remarkable how much time and money gets spent on avoiding the central question: has private equity outperformed the stock market over the long term by a big enough margin?
The persistent failure of private equity to beat stock market returns by a meaningful margin, even when using leverage, shows that the answer to Morris’s last question is a resounding “no.” And funds like CalSTRS and CalPERS have other routes for achieving the returns they desperately need and are failing to get from private equity. They can use a stock market strategy that mimics private equity by focusing on smaller companies that are levered but have good enough growth and solid enough balance sheets so as not to be unduly exposed to bankruptcy risk. They can, as Professor Phalippou indicated, use other “smart beta” strategies that have delivered returns in the 12% to 14% range that these pension funds have targeted. Or they can take what would be the most logical move of all: Cut the middleman out by bringing private equity in house.
But any of these approaches would make the current private equity teams at these big pension funds, and their advisors at concerns like Pension Consulting Alliance, redundant. So you see the most perverse form of leverage of all: billions of dollars thrown at private equity investments that aren’t justifiable on a risk/return basis, all to preserve a comparatively small number of jobs.
* Some financial economists contend that the only risk investors ultimately get paid for is illiquidity risk. But most illiquid investments are illiquid by virtue of having high transactions costs and/or cumbersome sale processes (think of cases where a buyer needs to get approvals to close a deal). So with illiquid investments, the matter of costs and fees is critical to determining whether that type of asset is attractive all in. The fees and costs can easily exceed whatever return premium there might be.