Even CalPERS Admits Private Equity Returns Are Fizzling

ZIRP and QE victims like pensions fund, life insurers, and other long-term investors, responded as central banks knew they virtually had to super-low interest rates: commit even more funds to high risk strategies in the hope of eking out an adequate return.

But as these monetary ministrations merely produced more speculation, rather than investment and resulting growth, all the pursuit of more investment risk has done is bid down returns for strategies like private equity. And that’s before getting to the fact that private equity has generally not been delivering returns commensurate with its risks for the last ten years.

Even CalPERS, which like many public pension funds has clung to private equity as a possible salvation from its bleak investment landscape, is having to admit that its great hope was really hopium. From Bloomberg:

First it gave up on hedge funds. Now the largest U.S. pension fund isn’t sure how much it can count on private equity.

“We anticipate it may be moving from a gusher to a garden hose and then maybe even a trickle,” Wylie Tollette, chief operating investment officer of the $305 billion California Public Employees’ Retirement System, said this week in a telephone interview…

The private-equity industry, which makes long-term investments such as leveraged buyouts in operating companies, shows signs of coming off its best years after distributing a record $443 billion to global clients in 2015, according to Preqin.

Now investments are shifting to early-stage pools that throw off less cash. At the same time, buyouts, the majority of Calpers’s private-equity portfolio, are rising in cost as firms with an unprecedented $1.47 trillion in stockpiled cash, known as dry powder, compete for acquisitions — a trend that could further crimp returns.

CalPERS moved away from smaller private equity investments as part of a strategic review, deciding to greatly prune its total number of private equity investments so as to invest more in fewer funds. That pretty much rules out early-stage investments. The logic behind CalPERS move presumably is that private equity funds increasingly have tiered pricing, with investors that make larger commitments getting lower management fees.

We’ve also been pointing out for well over a year that general partners are paying record multiples for acquisitions, higher than the former peak, right before the onset of the crisis. Bloomberg draws the obvious conclusion, that this movie is not likely to have a happy ending:

Buyout funds paid a record 10.3 times cash flow in 2015 and a 10.1 multiple in the first half of this year for U.S. companies, according to S&P Global Market Intelligence. Deal leverage is lower than before the 2008 financial crisis because of regulatory restrictions, another factor likely to reduce returns, according to Marina Lukatsky, a director at the firm.

“If you pay a lot more these days versus a couple of years ago and you have to put a lot more equity in, in theory when you sell it, it does impact your ultimate return,” she said.

Last year, an MBA, Pamela Morris, pointed out in a statement at a CAlPERS board meeting that CalPERS’ own data showed that there was too much private equity money chasing pretty much the same number of deals, as private equity rose from 2.7% of global equity in 2005 to 5.6% in 2014.

And as we’ve pointed out, the heads of private equity firms have been warning not to expect great returns in the future:

Instead of 20 percent to 25 percent net internal rates of return, private-equity investors are now accepting closer to 15 percent, according to David Rubenstein, co-chief executive officer of Carlyle Group LP, which manages $176 billion.

As someone in a senior role at a private equity firm said by e-mail:

David Rubenstein is practically guilty of securities fraud to suggest that he is targeting 15% net returns with his fund. Almost certainly, he is promising a lower number privately to LPs, but he and they need for him to keep hyping the higher number publicly to keep public support.

The Wall Street Journal, in its Pro (even higher paywall) section, joined Bloomberg in presenting insider warnings of lower returns, including the inconceivable notion of urging investors to commit less to private equity right now. From the article The Pitfall of Private Equity’s Success:

When the head of private equity at one of the world’s biggest buyout firms says the biggest mistake investors can make is committing too much money to private equity this year, you know the industry is in a weird place.

Earlier this month at the WSJ Pro Private Equity Conference, Blackstone Group’s Joseph Baratta said that “overallocating to the vintage” was the biggest blunder an investor could make right now.

Another private-equity veteran shared a similar sentiment across the Atlantic. Marc St. John, head of investor relations at one of Europe’s biggest buyout firms, CVC Capital Partners, voiced concern at an industry event last week about the “scary” amount of money that investors are trying to put into private equity.

Investors are pushing money into the asset class at record rates and prices for assets are only going up, a recipe for falling private-equity returns.

The industry is slowly coming to terms with the effects of this supply and demand imbalance.

It’s revealing and predictable that none of these stories mentions the elephant in the room: private equity fees, costs, and pilferage. The estimated all-in cost of private equity of 7% is indefensible given that private equity has been failing to deliver enough in the way of return to justify its extra risks, and the situation is only getting worse. Yet private equity investors have conned themselves that they can somehow be a Warren Buffett and out-pick everyone else. That in turn is the justification for not ruffling the feather of general partners by insisting on better terms: they might exclude you, and “hot” fund managers have even more ability to say no.

The fallacy of this logic is that limited partners can’t identify winners based on track records; even if they could identify who a top quartile fund manager really was (limited partners are asked to invest in new funds years before the results are in for recent funds), they do worse on average by investing in them than by merely throwing a dart. So the randomness of performance says they’d do better to try to get back 1% to 2% of fund costs a year out of what they pay to general partners rather than engage in the fool’s errand of chasing illusory top managers. But that makes too much sense for that to ever happen.

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  1. Jim Haygood

    BAML cautions:

    Even excluding energy, small-cap leverage is more than double the lows of the cycle and close to a 25-year high.


    Here’s their chart of Russell 2000 leverage [net debt to Ebitda]:


    Even ex energy and materials, the only higher peak in Russell 2000 leverage was in 1990 — just as Mike Milken and Drexel Burnham Lambert blew out, after goosing the LBO market to the sky with unlimited junk bond financing.

    Obviously, now is an inauspicious time to put new funds into leveraged buyouts — in the 8th year of an economic expansion, with leverage already high, and interest rates having nowhere to go but up.

    Unfortunately the policy governance of pension investment allocates fixed targets to asset classes. After the next bust (penciled in for 2018), some brilliant MBA will propose that public and private equity really are the same asset class … and that leverage levels can be used as a criterion to determine which one to tilt toward in committing new funds.

    Valuation matters.

  2. John Wright

    Private equity appears to sell an assumption that the ratio of debt/equity in many corporations is incorrect and needs to be higher debt and lower equity.

    The PE companies also pitch that increased debt focuses management’s attention on the business as “fat is trimmed”.

    Of course the debt can only be covered if there is enough cash flow to cover interest payments, assuming the debt can be rolled over forever (at perhaps higher rates than now).

    At a 10.3/1 purchase price to cash flow, this means private equity must sell their debt at interest rates lower than 9.71% (1/10.3) in order to have complete interest coverage by cash flow.

    The existing debt holders in the company will see their debt become more risky as cash flow relative to interest expenses drops closer to 1 to 1, so they should be immediate losers in the LBO deal.

    PE is a metaphor for the USA economy, extract as much as one can from the equity of corporations built up over the past 60 years and leave many debt hobbled corporations as a result.

    I remember a story that the LBO/PE industry had their start in the mind of young college student Michael Milken when a Penn – Wharton professor remarked that a lot of companies could take on a lot more debt, but no one could raise enough money to take them over.

    Milken proved the professor wrong and the LBO –> PE industry was born.

    It took many years from Milken to now, but maybe the universe of suitable corporate targets has been largely mined.

      1. Sluggeaux

        Yes, they’re New Democrats! Not Trump! Bad Man, Trump! Democrats Good! Unicorns Leaping over Rainbows, Pooping-out Skittles!

        What’s a few felonies and a little prison time, when the Summit Chairman is “often said to have revolutionized modern capital markets by pricing risk more efficiently and expanding access to capital for growing companies that created millions of jobs?” Of course, those jobs are janitorial “independent contractor” gigs for folks who lost their pensions, but it’s a job, right?

    1. NY Union Guy

      Yup, after years and years of buying up companies, taking on massive debt, paying themselves massive bonuses, and then gutting the companies, perhaps they have run out of targets.

      Another thing to keep in mind is that there isn’t a ton of “fat” to cut these days. The jobs of the serfs are already crapified, production’s already been offshored, and the latest and greatest tech is already being leveraged.

  3. flora

    Good to see CalPERS is finally getting the message. Good to see PE is again being referred to as leveraged buyout. Yes, it’s central bank policy of ZIRP and QE that drives pension funds into higher risk. At least the pension funds are starting to figure out the higher risk of PE has not been a panacea for a zero interest rate environment. Hopefully, pensions won’t just exit one high risk strategy (PE) for another high risk strategy. (particularly any high risk investment strategy with a hidden “heads I win, tails you lose” fee structure that hurts CalPERS and other pensions.)

    Thanks for your reporting on CalPERS, pensions, and PE.

  4. John k

    ‘PE returns don’t justify the risk’…
    Where is a source for what avg annual returns have been each year since, say, 2000?

    1. Yves Smith Post author

      You can’t get that. There is no comprehensive industry-wide data source. That’s not an accident.

      You can infer that the risk-adjusted returns are not being met from a number of academic studies and the results of public pension funds, since many do publish their PE returns.

  5. Chauncey Gardiner

    Not to be heretical, but in looking at Junk Bond yields this morning I found myself wondering whether there might be the possibility of a structured finance solution to at least part of the pension shortfall dilemma that lies in the region between current special purpose tax exempt junk bond yields and actuarially determined pension payouts; ie.,”If you can’t beat ’em, join ’em?” After all, God didn’t invent ZIRP, CDO tranches and tax exemption from federal and state income tax for state bonds for nuthin’.

    Assuming they are salable, might the payment streams of the various Limited Partnership interests be separated into tranches based on seasoned probable cash flows, bundled, potentially levered to increase yield if necessary, and sold for a net gain as tax exempt special purpose revenue bonds?

    Don’t know if this proposal has merit. Just a thought by a concerned citizen in an effort to mitigate the pension shortfall.

    1. TheCatSaid

      Are you thinking of the middle-tier OTC stocks? It’s possible, but the danger is they are dependent on “market makers” selling PR. It would require careful vetting. In any case there would be a number of middle-men feeding off the investments, as in PE, adding to the risk to the investor and to the company.

    2. Yves Smith Post author

      You don’t need anything that complicated.

      1. Some academic studies have modeled pursuing a PE-like investing strategy with mid-cap stocks. It produces 12-14% returns but with more reporting volatility than PE, since PE can lie in down markets about what is companies are worth. That’s acknowledged by investors and consultants, but they call it “smoothing,” not lying.

      2. They could do PE in-house as Ontario Teachers does and save the 7% they are paying to PE. They might have to give 1% of that to staff but they’d come out ahead. Would take a while to implement.

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