Wrong Way CalPERS Increased Private Equity Allocation by Over 50% as Investors Are Dumping Holdings

CalPERS is so reliably bad at market timing that the giant fund serves as a counter indicators. Last fall, CalPERS increased its allocation to private equity from 8% of its total portfolio to 13%, which is an increase of over 50%. This is after this humble blog, regularly citing top independent experts, pointed out that the investment raison d’etre for private equity had vanished in the 2006-2008 time frame, not once, but many many times as various studies kept confirming that finding. Not only did private equity no longer earn enough to compensate for its much higher risks (leverage and illiquidity) but it was no longer beating straight up large cap equities.

Now there is a way out of this conundrum: to bring private equity in house. Private equity fees and costs are so egregious (an estimated 7% per annum) that even a bit of underperformance relative to private equity indexes will be more than offset by greatly lower fees. A simpler option would be public market replication of private equity.

But the dogged way funds like CalPERS stick to private equity points to rank corruption, of the sort that landed CalPERS former CEO Fred Buenrostro in Federal prison for four and a half years.

CalPERS’ desperation to throw more money at private equity looks even more suspect in light of the rush for the exits reported in the Financial Times yesterday. Note that this article presupposed a bit of knowledge that most investment professional would have: it’s very unusual to try to sell a holding in a private equity fund. There is a secondary market but it’s thin. Investors in private equity are supposedly making a long-term commitment and understand that they get their dough back only as the fund manager sells the companies that the fund acquired. Most of the money comes back by year 8 to 10, but there are often dogs so that the fund may remain open with a zombie investments or two well beyond the theoretical ten year time frame. But those leavings are usually small relative to the total value of the fund.

The other aspect that the pink paper may assume that its readers understand is that private equity has been the belle of the ball for over 30 years. Its only period of disfavor was after the late 1980s-early 1990s LBO crash, which was spared the press it deserved thanks to the much more attention-getting S&L crisis. So for investors to be running away, when before their big fear was whether they could get into “hot” funds, is a remarkable turn of events.

From the Financial Times, in Investors sell stakes in buyout funds at a record pace:

Investors are selling stakes in private equity and venture capital funds this year at the fastest pace on record, as the downturn in equities spreads to the private markets that boomed during the era of low interest rates.

Pension and sovereign wealth funds were among those that sold $33bn worth of stakes in private funds in the first six months of the year, up from $19bn in the same period in 2021, according to Jefferies, typically selling them below their face value.

The sell-off follows a decade of surging allocations to private markets…

Pension funds say the move to ditch stakes has been partly triggered by the steep decline in stock markets, leaving their overall portfolios too exposed to buyout funds and other private investments whose value has not been marked down in the same way.

Let’s stop here for a second. We’ve repeatedly pointed out, and have provided quotes from private equity investors that provide corroboration, that one of the perceived benefits of private equity is that the funds lie about their values in lousy markets. As levered equity, private equity values should fall further than those in public equity. But private equity fund managers maintain their marks as well above public equity levels. Everyone knows it’s a fraud on the investors. But the limited partners love it because it makes their performance in crappy markets look less bad than it is.

So what the Financial Times is saying is that the decline in public equities versus private equity pretend valuations is so marked that some look over-allocated to private equity. One way to deal with that is not allocate new money to private equity. But if the disparity is too great, it could argue for selling down private equity.

Another problem is cash flow management. Private equity funds do not take investor money at closing. Instead, investors get “capital calls” to pony up part of their commitment to the fund so the fund manager can buy a company. These capital calls require the dough to be sent as specified in the offering memorandum, usually in five to ten days. The consequences of missing a capital call are draconian. The fund manager can seize all the investments made so far and distribute them to the other limited partners.

In the financial crisis, CalPERS had too little cash on hand to meet private equity capital calls. It wound up dumping stocks at distressed prices to satisfy the private equity demands. So the risk outlined below is real. Again from the Financial Times:

At the same time, pension funds that had committed money to buyout firms have had to actually stump up the cash far more quickly than expected over the past two years because of the frenzy of dealmaking.

That has sparked fears of a funding squeeze, according to a senior executive at an endowment fund that invests in private equity, as some pension funds worry they may not have enough cash on hand to meet future capital calls from the buyout funds they have committed to.

The pink paper said the average price for the early exit of buying funds in first half 2022 was 86 cents on the dollar for buyout funds, and 71 cents for venture.

Even though this development is a harbinger, at this point the sentiment is more noteworthy than the dollar amounts being dumped. It’s refreshing, if also telling, to see the religion of private equity finally being seen for what it is, a cult. And perhaps for the biggest public pension funds like CalPERS, a political money laundering machine.

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  1. Freddie

    Don’t forget they jumped on the private credit train a year or two ago (most likely last to the party). Meanwhile credit spreads are blowing out now. If you thought they had bad fiscal year end results. Wait until the one quarter market lag hits their private asset returns. May be a big hole to dig out of after their fiscal first quarter.

  2. The Rev Kev

    Being a bit of a newshound, every now and then I see mention of how somebody is getting a job in a major financial corporation who had previously worked for CalPERS. The thought occurred to me of rats and sinking ships but at the higher echelons, perhaps something different is happening. The way that CalPERS has bolted themselves to the whole idea of private equity does make me wonder if they are doing this as a way to “burnish” their resumes so to say. That when these people move on, that they will find lucrative future employment as they have proved themselves good ‘team players’ who look out for the interests of other players. And why wouldn’t they do so? After all, it’s not their money.

    1. Freddie

      Although that is a good thought in reality slew of departures over the past few years have had nearly nobody leave the private equity team meanwhile there have been a lot of departures from the fixed income and public equity teams. Within private equity it has nearly been the opposite whereby the organization is reaching to bring in outsiders with good credentials in an effort to make the team more professional however in reality there’s still no change since they are beholden to the managers that they are invested in and they are not making direct investments themselves.

  3. PlutoniumKun

    Just a quickie – in paragraph 4 line 2 I assume you mean ‘unusual’, not ‘usual’.

  4. John Beech

    Yves’ hit the nail on the head. How long before teachers, firemen, and other state employees realize it? By then, will it be too late and the fund will be grievously wounded? Will politicians be able to act quick enough, then? And is anybody going to be on the hook for this, or will they walk away barely Scotched and utterly free as did the banksters in 2007, meaning business as usual? Lotta little people gonna get hurt. Sigh.

  5. Trustee

    There may be hope for private equity. CalPERS just dumped a bunch of it.

    On the other hand, they first increased PE, then dumped PE to buy more of it. I assume there is a logic there. (However, remember what they say about assume.)

    When CalPERS first moved into international equity it was at a market top and the fund was under water for seven years. It expanded aggressively into single family housing in 2006-07. It dumped an equity hedge just before COVID, worse it announced it would have done so even knowing what was coming.

    More proof of the “value” of market timing.

  6. Tom Stone

    There’s gotta be a place for Marcie in the Biden Administration given her track record.
    Perhaps she can replace Mayo Pete when he announces his run for the Preznidency,or maybe Becerra if things get too hot for him at HHS.
    She’s almost as well qualified as Kamala Harris so either one would be a natural fit.

    1. HotFlash

      And Fauci’s gotta retire someday, Marcy could just lie fib about having a degree like she did before. Or just skip it — she has the main job requirement, superb ability to BS without any confusing knowledge.

  7. David in Santa Cruz

    Capital Calls have to be a significant driver of CalPERS most recent underperformance versus the CalSTRS state teachers pension fund — a -6.6% loss reported at CalPERS but just a -1.3% loss reported by the teachers fund.

    Capital Calls were probably also behind the claim that CalPERS somehow “needed” to conduct a fire sale of “old” Private Equity in order to “deploy” more Private Equity — that Ed Siedle described last week in forbes under the headline CalPERS Transfers $600 Million of State Workers’ Wealth To Wall Street.

    Those “losses” were gains on someone else’s balance sheet. As always, Follow the Money

    1. Freddie

      What is more comical is the fact that the organization believes that due to its long time horizon, that benefits it from the perspective of holding investments for longer. However, given that it truly doesn’t want to hold investments for longer, makes one question the validity of that belief. If anything the organization should be looking to deploy capital in buying other LPs stakes at discounts given its long time horizon belief.

      1. David in Santa Cruz

        Marcie and her sycophants mouth platitudes like “long term investor” but it’s quite evident here that they lack even the most rudimentary understanding of investments or finance.

        Disgraced ex-CIO Meng’s hair-on-fire rush toward his friends at Blackstone resulted in a severe misalignment that ultimately proved that Marcie and her sycophants in management and on the somnolent board lack the slightest understanding of the difference between a “commitment” of funds and a “deployment” of funds, or that there can often be a harsh opportunity cost when the two are badly aligned.

  8. flora

    Asked not entirely in jest: is CalPERS used as a slush fund for other actors? They consistently place their bets wrong, even with good advice from others if they’d take it. Sheesh!

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

    1. Freddie

      Well if you are part of one of the teams there that deploys capital to outside managers, then it would stand to reason that you may benefit from directing more capital to certain managers with the hope to gain employment by said manager multiple years down the road.

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