We’ve said for the last couple of years that private equity has not been earning enough to compensate for its extra risks, that of high leverage and lack of liquidity.
One of the core tenets of finance is that extra risk-taking should be rewarded with higher returns over time. But for more than the last decade, typical investor portfolios of private equity funds haven’t delivered the additional returns, typically guesstimated at 300 basis points over a public equity benchmark like the S&P 500.
We’ve pointed out that even that widespread benchmark is too flattering. Private equity firms invest in companies that are much smaller than the members of the S&P 500, which means they are capable of growing at a faster rate over extended periods of time. The 300 basis point (3%) premium is a convention with no solid analytical foundation. Some former chief investment officers, like Andrew Silton, have argued that a much higher premium, more like 500 to 800 basis points (5% to 8%) is more appropriate. And that’s before you get to other widespread problems with measuring private equity returns, such as the fact that they are routinely exaggerated at certain times, namely right before a new fund is being raised by the same general partner, late in a fund’s life, and during bear markets, all of which goose overall results.
And that’s before you get to the fact that some investors use even more flattering benchmarks. As Oxford professor Ludovic Phalippou pointed out by e-mail, in the last two years, more and more investors have switched from using the already-generous S&P 500 to the MSCI World Index as their benchmark. Why? Per Phalippou: “Because the S&P 500 has been doing very well over the last three years, unlike the MSCI World Index.”
So why hasn’t private equity been producing enough over the past decade to justify the hefty fees? The short answer is too much money chasing deals. Private equity’s share of global equity more than doubled from 2005 to 2014.
And you can see how this looks in CalPERS’ latest private equity performance update, from its Investment Committee meeting last week (from page 14 of this report). In fairness, CalPERS does have a more strict private equity benchmark than many of its peers:
Since that chart is still mighty hard to read (by design?), let’s go through the sea of read ink.
The only period in which CalPERS beat its benchmark was for the month before the measurement date of December 31, 2016, and that by a whopping 3 basis points. In all other measurement periods, the shortfall was hundreds of basis points:
3 months (219)
Fiscal YTD (283)
1 year (994)
3 years (132)
5 years (479)
10 years (286)
To its credit, CalPERS has been cutting its private equity allocation. CalPERS had a private equity target of 14% in 2012 and 2013; it announced last December it was reducing it from 10% to 8%. Like so many of its peers, CalPERS hoped that private equity would rescue it from its underfunding, which came about both due to the decision to cut funding during the dot com era, when CalPERS was overfunded, and to the damage it incurred during the crisis. At least CalPERS is finally smelling the coffee.
However, even with these appalling results, CalPERS does have another avenue: it could pursue private equity on its own, which would virtually eliminate the estimated 700 basis points (7%) it is paying to private equity fund managers. CalPERS confirmed this estimate by Ludovic Phalippou in its November 2015 private equity workshop. Since at that point it had gathered private equity carry fee data, that means the full fees and costs are at least that high; it would presumably have reported a lower number or flagged the figure as an high plug figure. Getting rid of the fee drag would mean much more return to CalPERS and its retirees, and would make private equity more viable.
CalPERS has two ways it could go. One would be a public markets replication strategy, which would target the sort of companies private equity firms buy. Academics have modeled various implementations of this idea, and they show solid 12-14% returns. However, as we’ve discussed at length, and some pubic pension funds have even admitted, one of the big attractions of private equity is…drumroll…the very way the mangers lie about valuations, particularly in bad equity markets! Private equity managers shamelessly pretend that the value of their companies falls less when stocks are in bear territory, giving the illusion that private equity usefully counters portfolio volatility. Anyone with an operating brain cell knows that absent exceptional cases, levered equities will fall more that less heavily geared ones. So the reporting fallacy of knowing where you really stand makes this idea unappetizing to investors.
The other way to go about it would be to have an in-house team that does private equity investing. A group of Canadian public pension funds has gone this route and not surprisingly, reports markedly better results net of fees than industry norms. And this is becoming more mainstream, as Reuters reported last Friday (hat tip DO):
Some of the world’s biggest sovereign wealth funds are increasingly striking their own private equity deals rather than relying on external fund managers, in a drive to cut costs and gain more control.
With some $6.5 trillion in assets, sovereign investors already account for 19 percent of capital committed to private equity, according to data from research firm Preqin.
But mega-funds such as the Abu Dhabi Investment Authority (ADIA), Saudi Arabia’s Public Investment Fund (PIF) and Singapore’s GIC, are hiring specialists to find or vet deals – enabling them to negotiate with private equity firms from a position of strength or to go it alone.
In 2012 sovereign investors participated in just 77 direct private equity deals. By 2016, that had risen to 137, Thomson Reuters data shows. Deal value more than trebled to $45.2 billion from $14.8 billion….
This allows funds to better protect their interests when markets go south. One sovereign investor who spoke on condition of anonymity said that during the global financial crisis, some external funds behaved irrationally.
“They had different liability streams than us, so they were under pressure to sell at a time when they should have been investing more,” the source said. “Going more direct means you don’t have to worry about whether your interests are aligned with other investors’.”
In 1999, CalPERS engaged McKinsey to advise them as to whether they should bring some of their private equity activities in house. My understanding was that some board members thought this issue was worth considering; staff was not so keen (perhaps because they doubted they had the skills to do this work themselves and were put off by the idea of being upstaged by outside, better paid recruits).
In hearing this tale told many years later, I was perplexed and a bit disturbed to learn that the former managing partner of McKinsey, Ron Daniel, presented the recommendations to CalPERS of not to go this route. Only a very few directors (as in the tenured class of partner) continue at McKinsey beyond normal retirement age; one was the head of the important American Express relationship at the insistence of Amex. Daniel served as an ambassador for the firm as well as working on his former clients. Why was he dispatched to work on a one-off assignment that was clearly not important to McKinsey from a relationship standpoint, particularly in light of a large conflict of interest: that he was also the head of the Harvard Corporation, which was also a serious investor in private equity?
Although the lack of staff enthusiasm was probably a deal killer in and of itself, the McKinsey “no go” recommendation hinged on two arguments: the state regulatory obstacles (which in fact was not insurmountable; CalPERS could almost certainly get a waiver if it sought one), and the culture gap of putting a private equity unit in a public pension fund. Even though the lack of precedents at the time no doubt made this seem like a serious concern, in fact, McKinsey clients like Citibank and JP Morgan by then had figured out how to have units with very divergent business cultures (investment banking versus commercial banking) live successfully under the same roof. And even at CalPERS now, there is a large gap between the pay levels, autonomy, and status of the investment professionals versus the rank and file that handles mundane but nevertheless important tasks like keeping on top of payments from the many government entities that are part of the CalPERS system, maintaining records for and making payments to CalPERS beneficiaries, and running the back office for the investment activities that CalPERS runs internally.
Why do I wonder whether McKinsey had additional motives for sending someone as prominent as Daniel to argue forcefully (as he apparently did) that CalPERS reject the idea of doing private equity in house? Clearly, if CalPERS went down that path, then as now, the objective would be to reduce the cost of investing in private equity. And it would take funds out of the hand of private equity general partners.
The problem with that is that McKinsey had a large and apparently not disclosed conflict: private equity funds were becoming large sources of fees to the firm. By 2002, private equity firms represented more than half of total McKinsey revenues. CalPERS going into private equity would reduce the general partners’ fees, and over time, McKinsey’s.
In keeping, as we pointed out in 2014, McKinsey acknowledged that the prospects for private equity continuing to deliver outsized returns were dimming. That would seem to make for a strong argument to get private equity firms to lower their fees, and the best leverage would be to bring at least some private equity investing in house, both to reduce costs directly and to provide for more leverage in fee discussions. Yet McKinsey hand-waved unconvincinglyabout ways that limited partners could contend with the more difficult investment environment, and was discouraging about going direct despite the fact that the Canadian pension funds had done so successfully.
Better late than never. Let’s hope CalPERS pursues this long-overdue idea.