CalPERS is a prototypical example of the Wall Street cliche, “Where are the customers’ yachts?,” except in the case of private equity, that saying needed to be updated to “megayachts”.
As we mentioned earlier this week, CalPERS reported preliminary investment results for its fiscal year ended June, 30, 2016 of 0.6%.. Its press release stated that its private equity returns were 1.7% based on data through March 31.
While CalPERS is likely to report somewhat better final results from private equity, given that US stock indices were higher at the end of June than the end of March, it’s a given that the private equity firms did better than they did.
Just consider management fees alone. Even though these are stated at the prototypical 2% of the “2 and 20” formula, most observers fail to understand that that 2% is not 2% of assets under management. For the first 5 years of the fund, it is 2% of the commitment amount. Remember that the general partner is in the process of buying companies and calls the capital from investors like CalPERS only when it needs it. After the investment period, the management fee level typically steps down. Most often it to a percentage of invested capital.
The net result is that the management fees as a percent of assets under management are much higher than 2%. Oxford Professor Ludovic Phaillpou has estimated them at 4%, based on typical patterns of capital calls and distributions. And don’t forget that the management fees are paid in full whether they are paid directly by the limited partners or shifted onto the portfolio companies via management fee offsets.
In recent years, CalPERS has been able to lower its management fees on new investments due to the size of its commitments. General partners have what amount to fee schedules, and investors that make commitments over certain size levels get breaks on fees. Mega funds also have lower management fees than smaller funds. And general partners also sometimes offer fee breaks for limited partners that make early commitments.
We checked in with Professor Phalippou to see if he thought his estimate applied to CalPERS. His comment by e-mail:
My best guess for fixed fees (management fees, organizational expenses etc.) for most funds CalPERS has invested in are about 4% of invested capital. It may be less for the new contracts they have signed; and it is less as a fraction of AUM when returns are positive. This total applies regardless of whether the fees are paid by the LPs or shifted to the portfolio companies.
Note that in its investment cost report in 2015, which was for fiscal year 2014, CalPERS claimed its private equity management fees were a mere 140 basis points of assets under management. Despite presenting a new, and supposedly improved investment cost report in 2016, it stopped breaking out private equity costs separately. CalPERS staff maintained in the 2016 report that this report included gross fees, not net fees.
We’ll return to this topic with a more detailed analysis in a future post, but we spoke to Phalippou last month about this claim. He found it to be “extremely unlikely”. First, CalPERS would have to be invested almost entirely very old funds to have such low fees. Second, it’s computationally difficult to figure out what the gross fees ought to be after the investment period. And on top of that, CalPERS would probably want to make sure its calculation of the gross management fee tallied with what the general partner actually charged, making the exercise even more laborious.
So to put it another way, Phalippou has considered CalPERS’ official stance on this issue and he does not buy it.
And let us not forget that the management fees are far from the sum total of fees charged. Private equity funds impose a raft of fees on portfolio companies, and in many cases, those fees are not fully offset against the management fees. Moreover, as the SEC and media have revealed, private equity firms also charge fees to portfolio companies that are not subject to management fee offsets, meaning those costs come fully at investors’ expense. Finally, despite last year being an overall crappy year for private equity, there still were no doubt some companies sold at high enough profits so as to have resulted in CalPERS paying some carry fees. That means that CalPERS’ general partners as as whole unquestionably profited more than the giant pension fund did last year. And this result gives a more vivd illustration than usual of the “heads I win, tails you lose” nature of investing in private equity.
Update 6:00 PM: Reader j3 pointed out by e-mail that CalSTRS whose preliminary reports show it doing better than CalPERS in private equity, at a 2.9% preliminary return versus CalPERS’ 1.7%, still fell below the 4% fixed cost level estimate of Phallippou. CalSTRS’ estimated net return of 1.4% was also better than CalPERS’. Interestingly, its press release shows private equity falling short of its benchmarks by 170 basis points, while CalPERS claimed its lower private equity return of 1.7% ” bested its benchmark by 253 basis points.”. We had found that to be implausible but don’t have access to the indexes they use (and yes, we did Google a bit). However, if you look at the table it lists the performance by asset class and says “Versus Indexes” and shows the same 253 basis point alleged outperformance. But the private equity benchmark is not the same as the indexes; CalPERS also adds a 300 basis point risk premium. sDid CalPERS omit the risk premium to make PE look better than it was? It seemed so implausible that CalPERS would dare lie so flagrantly in an official press release on such widely followed information that we assumed that they got lucky with their index choice and it delivered lower results than most equity indices last year, making PE look better. We’ll now have to give that a closer look….