Authoritative Consultant Slams Private Equity in Journal Article: Cheap Index Funds and In House Buys Beat PE Funds

CalPERS and other public pension funds cling so doggedly to private equity despite ever-increasing evidence that the strategy doesn’t beat simple stock investing, when it needs to do a lot better than that to compensate for its much higher risk that one has to wonder why. As a wag in the Financial Times comment section put it:

There a strange but widely held assumption here that PE is operated to enrich people other than the general partners.

Another nail in the private equity hype coffin comes via a new study by CEM Benchmarking, Benchmarking the Performance of Private Equity Portfolios of the World’s Largest Institutional Investors in The Journal of investing. The article is paywalled but Chris Flood provided a detailed write-up in the Financial Times and supplied more detail about the article in the comments section.

CEM Benchmarking is an influential voice in the world of investing, particularly with public pension funds who collectively are the biggest investors in private equity. A 2015 CEM study demonstrated that investors had no clue of the total cost of investing in private equity. Since one of the core legal requirements of a fiduciary is to weigh potential returns against risks and costs, the CEM finding should have given investors powerful ammo in demanding that private equity fund managers disclose total fees and costs, including the largely hidden charges they levy to the companies they have bought with investors’ money. As we wrote then:

A major standard-setter in the private equity industry, CEM Benchmrking, has thrown down a gauntlet to investors. It said in a recent report that it is impossible for private equity investors to know how much they are paying in private equity fees and costs. Moreover, CEM also points out that most public pension funds are not complying with government accounting standards in how they report private equity fees and costs, and that based on their benchmaring efforts with the South Carolina Retirement System Investment Commission and foreign investors, most public pension funds are missing at least half of the total costs.

This report is particularly significant because CEM is an authoritative voice in the investment industry. It didn’t simply say that public pension funds are out to lunch as far as not understanding what they were investing in. It also pointed out as a result, the public pension funds have been not been reporting fees accurately are out of compliance with government reporting requirements.

That CEM study did lead to some improvement in disclosure, but given how bad the baseline was, it was perilously little relative to what ought to have occurred. Unfortunately, that result highlights the depth of intellectual capture, laziness, and at least soft corruption that pervades the world of private equity investing.

Nevertheless, this salvo by CEM will be hard for limited partners to shrug off. CEM took a simple small cap index and lagged it from three to five months as a basis of comparison.1 CEM then compared that performance to the results achieved by 330 private equity limited partners, including any co-investments, from 1996 to 2018.

The choice of time frame is damning. More and more studies have found poor performance of private equity for the last ten years or so, starting with just before or just after the financial crisis, when investors started reaching for yield. Private equity as a share of global equity more than doubled from 2004 to 2013, for instance.

Thus one explanation for private equity’s flagging performance is too much money chasing too few deals. And that hasn’t gotten any better with pension funds like CalPERS trying to throw even more dollars at private equity, much like a rat desperately hitting the lever of a machine that once dispensed treats but is now empty.

The CEM study demonstrates that private equity underperformance is far more fundamental. 1996 was during the glory years of 1995 to 1999, when private equity was coming out of a period of disfavor and was trying to distance itself from its earlier “leveraged buyout” branding, which produced a lot of terrible end of cycle deals in the late 1980s that blew up in the 1990-1991 recession. The industry story line has been that if you participated in those “vintage years,” you reaped outsized results. CEM has demonstrated you would have done even better in a simple stock index, a full 67 basis points, which over the long investing horizon of pension funds and life insurers, adds up.

Keep in mind that there are “public market replication of private equity” strategies that have been modeled, of buying the kind of public companies that private equity firms like, and selling/rebalancing quarterly using pre-set rules. That has produced even better results than a simple small cap index; it would be useful if someone could update those models and see if the outperformance continues to hold.

Doing deals in house is an even better strategy. CEM found those investors beat private equity funds by 1.44% per annum over this timeframe.

From the Financial Times:

Cheap index tracking funds beat the returns of private equity investments over the past two decades, according to a survey of pension schemes…

CEM chose a mix of small-cap indices as a test of skill for private equity managers because it provided a robust benchmark that could be recreated easily by investors.

Alex Beath, a senior analyst at CEM, said the mix of small-cap indices had comparable risk and was highly correlated, but was “hard to beat” for private equity funds.

He added private equity presented a “double edged sword” as a pension fund might earn a 20 per cent outperformance over a public market from a top performing PE portfolio or a 20 per cent loss if its bets soured.

Beath is being extraordinary charitable. As we’ve pointed out repeatedly, in every other sort of investment, pension funds and other institutional investors accept the proposition that they can’t out-invest, that the best they can reasonably expect to achieve is an index-type return, and the name of the game is therefore minimizing fees and costs. And a recent study slammed public pension funds’ investments in private equity and real estate as drags on performance. From a July post:

We are embedding an important new study by Richard Ennis, in the authoritative Journal of Portfolio Management,1 on the performance of 46 public pension funds, including CalPERS, as well as of educational endowments.

Ennis’ conclusions are damning. Both the pension funds and the endowments generated negative alpha, meaning their investment programs destroyed value compared to purely passive investing.

Educational endowments did even worse than public pension funds due to their higher commitment level to “alternative” investments like private equity and real estate. Ennis explains that these types of investments merely resulted in “overdiversification.” Since 2009, they have become so highly correlated with stock and bond markets that they have not added value to investment portfolios. From the article:

Alternative investments ceased to be diversifiers in the 2000s and have become a significant drag on institutional fund performance. Public pension funds underperformed passive investment by 1.0% a year over a recent decade.<.blockquote>

The Financial Times continued:

Investors tend to measure the performance of private equity portfolios against a wide variety of benchmarks, including public equity indices such as the S&P 500 or against custom-built benchmarks of PE funds.

Mr Beath said most of these metrics were flawed and did not provide an “apples to apples” comparison of the value added by private equity.

This again is overly polite. Oxford Professor Ludovic Phalippou has described how investors have chosen unduly flattering benchmarks precisely because they typically have performance-based bonuses. It was typical, until a few years ago, to use the S&P 500 because it was virtually assured to show lower growth by virtue of private equity investing in much smaller companies than in the S&P 500. But then the S&P 500 had a very good run, leading investors to change their hurdles.

Even as evidence keeps growing that private equity is a poor choice on a risk adjusted and even an absolute basis, investors keep sticking their heads in the sand. As the pink paper concludes:

A survey by the data provider [Preqin] also found investors expected pension plans and other large investors to further increase PE allocations…

It showed 23 per cent of respondents expected a significant increase in their PE allocations with a further 56 per cent planning a slight expansion. Just 4 per cent of the investors planned to reduce their PE allocation.

So the transfers from taxpayers to billionaires are set to increase.


1 This is a basic step most analysts consistently fail to implement. One bogus defense regularly offered for private equity is that it offers a different profile of returns than stocks. That only appears to be true thanks to bad accounting. Investors like CalPERS report private equity one quarter late (some even later) so the March 31 quarter results, which unlike stocks and bonds, are not available until later since the fund managers have to do their valuations and send the results along, are bizarrely included with the June 30 results. A more reasonable approach would be to put in an estimate as of March 31, the same way the BEA provides an initial estimate of GDP, and update it as actual data comes in.

The other reason private equity appears not to track stocks all that closely is that private equity fund managers “smooth” results, as in understate how bad things are in bear markets.

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  1. Bob

    But will a Index fund buy you a steak dinner ? Or will the Index fund help with campaign donations (bribes) ?

    1. Shtucb


      But the investments made by pension funds in PE vehicles are long term, and can’t be exited prematurely. 10 years would not be uncommon.

      During those 10 years, PE funds will use various deliberately misleading metrics to report on the the ROI, like internal rate of return.

      And as the article suggests, fund managers don’t actually do their own math after the investments close out.

  2. David in Santa Cruz

    Very interesting discussion in the comments at the FT. One of the last commenters notes that a decade-old Citibank study found, “that the principal attraction was opacity and the absence of mark-to-market volatility on pension schemes.”

    The paradigm at CalPERS is that Californians are all above-average in every way and only pick top-quartile performers in any investment category. The main appeal of Private Equity is that phony IRR numbers allow staff to cash-in their annual bonus targets and that board members get to kick the funding can down the road. Actual returns are irrelevant to them — in fact I seem to recall CalPERS board president Henry Jones stating a few years ago that he didn’t care about high fees, so long as the reported IRR hit the annual target. The actual performance of these investments is completely opaque — they never seem to be wound-up with a final cash value.

    What’s more, with “too much money chasing too few deals” we’re starting to see deals that are obviously phony — the billions that the disgraced CIO shoved into Blackstone (along with many others) have yet to be deployed. The one investment made by these Blackstone vehicles appears to be a massively leveraged buy-out of a PE-controlled company that CalPERS was already invested-in — pretty much a pyramid scheme as far as any return that the fund’s staff will report.

    CalPERS and some other large pension funds appear to have effectively given up on generating actual returns. They are chasing PE precisely because of the extreme opacity, which allows them to game their books.

  3. ewmayer

    Not in any way to defend the PE scammers, but re. index funds, wasn’t there a long-form post on NC just yesterday detailing the ever-worsening market distortions caused by the metastasization of index funds.

    Ah yes, indeed there was.

    Index-mania looks to be an even bigger market distorter than computerized trading and “Flash Boys”-style scammery. Turned everything into a giant Ponzi scheme, and the biggest problem is that, thanks to the Fed’s relentless policy of interest-rate suppression, Mom&Pop-style people – and pension funds – who traditionally could earn a decent inflation-beating RoR in safe investments have all been forced to participate in the Ponzi or watch their $ get eaten away by inflation. Resulting asset-valuation bubble now so all-consuming the Fed can’t let it pop.

    1. vlade

      If you decide, or, as in CP’s case, must invest into public markets (index-funds cover not only equity, but other assets too) – and with its size, there’s literally no way how CP could invest in private markets only – indexes are least-bad way to do it.

      Yes, there’s tons of concerns with them. But there’s tons of concerns with investing in public markets to start with, and CP has to invest into something.

      And there’s no point in crying about Fed, either. Yes, even Fed would like to normalise rates. It even tried, once, and it ended in debacle. The largest practical economic problem we have is that literally no-one knows how we could normalise the rates w/o a massive economic disruption somewhere (and arguably it’s impossible), and no-one wants to make the call who should suffer (because all options hit someone rich and powerful).

      There’s a number of econ PhDs in looking at how playing with rates doesn’t do what central banks thought it did and does what they didn’t.

  4. vlade

    I just don’t get it. I know people who run large financial advisory networks, and was moving in that environment for a while. At least for a decade, the retail-investor mantra is “fees matter!”. Subsequently, there was also a large regulatory push (at least in the EU/UK) for fee transparency (both on the investment and, in the UK also advisor side) for retail investor.

    I cannot think of a scenario where the same basics would not apply to _any_ investor (as opposed to pure speculator).

    So, to get to the topic, PE has famously the highest and the least transparent fees in all of the investment industry (even hedgies got their house a bit in order, which is something to say. And yes, it cost them investors). And, to be fair to most of the pension industry, they also noticed, and behave accordingly.

    Not so CalPERS. At best, it’s incompetence with hubris, a deadly combination if I ever saw one. At worst, it’s cynical corruption. Given what we saw from Marcie and the like, it can be both (you can ask why that combination it’s not worst – well, because incompetence + hubris may make them do essential random moves, which can, now and then, cancel the corruption effect. Cynical corruption never, under any circumstances does anything that’s not in their short term interest).

    I cannot see how this will not end up in tears for California taxpayers at least, and quite likely CP pensioners too.

  5. B Easy

    While this all may be true, the biggest issue is that it is very difficult to invest $25 billion (current asset allocation of PE) in index funds while still be diversified from the asset allocation of public equities. While PE may not be the best answer to account for diversification, people always seem to forget the amount of money that needs to be invested and the opportunity costs of holding cash.

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