Private Equity Becomes Roach Motel as Public Pension Funds and Other Investors Borrow As Funds Remain Tied Up

The Wall Street Journal had an important article over the weekend on how private equity has become and is set to remain a money pit, at least as long as interest rates remain high.

Public pension funds and other investors dutifully paid up, double pronto, when they received capital calls from private equity general partners; otherwise these so-called limited partners faced the liquidation of all funds they had invested so far.

But in the typical sort of “heads I win, tails you lose” private equity arrangement, private equity kingpins face no penalty for refusing to sell companies in their fund portfolios because the prices on offer would not be very good. One big reason for wanting to avoid that sort of recognition event is that it would call into question the values of many, if not all, of the other companies in their portfolio. Recall that private equity is the only investment strategy where the fund manager gets to set the value of its holdings, and then only quarterly; all others require independent valuations, typically monthly if not daily.

We’ve written before about how private equity funds sometimes do not sell their tail-end holdings and we have not gotten good explanations when the amounts are not all that large. Even if there was a big loss on the final bits, the investors have long ago moved on to newer funds and won’t mind some sort of writedown, particularly since the computation of IRR (a misleading but preferred metric) would understate the impact. For instance, out of CalPERS’ 357 funds, 19 are for vintage years 2004 or earlier.

But recall pension funds in particular have actuarially-estimated payout schedules to meet. In the stone ages, they used to buy bonds and match the maturity to expected obligations. But then the Department of Labor in 1976 changed its interpretation of what the prudent man rule meant, allowing funds to look at risk on a portfolio rather than an investment-by-investment basis. This revision was the direct result of venture capital lobbying.

And then in the early 1990s, Christine Todd Whitman set out to underfund New Jersey pensions by making unduly low contributions on a current basis. This took the growing practice of expecting Mr. Market to make up for less than full contributions to new heights.

To summarize many many posts, in the post crisis, super-low interest rate era, many pensions saw their underfunding get worse as market returns generally fell. They piled into what seemed to be the highest return option, private equity. But as academic studies increasingly showed, since 2006 if not earlier, private equity properly measured was not outperforming stocks. Yet the rule of thumb had been that private equity needed to outperform equities by at least 300 basis points (3%) to compensate for its greater risks: illiquidity and leverage. Compliant consultants helped public pension funds like CalPERS to rejigger their benchmarks, including lowering the risk premiums, to make investing in private equity look attractive.

And now illiquidity risk is biting in a big way. Pension funds are scrambling to make up for the distributions they expected to get from maturing private equity funds but are not taking place. That often includes, as the Journal describes, borrowing, as in paying interest to get cash to meet obligations. Although the article does not say so, it is a pretty sure bet that these interest costs are not being netted against private equity returns, even though private equity shortfalls are the cause of the cash need. The other main approach for dealing with the cash crunch is to sell private equity holdings at a discount.

From the Journal in Pensions Piled Into Private Equity. Now They Can’t Get Out:

Private-equity and pension funds seemed like a match made in heaven…

Now the honeymoon is over. The payouts have dried up, creating an expensive problem for investment managers overseeing the savings of workers retired from big corporations and state and city governments.

To keep benefit checks coming on time, those managers are unloading investments on the cheap or turning to borrowing—costly measures that eat into returns. California’s worker pension, the nation’s largest, will be paying more money into its private-equity portfolio than it receives from those investments for eight years in a row. The engine maker Cummins took a 4.4% loss in its U.K. pension last year, in large part because it sold private assets at a discount.

The Journal describes how public pension funds have on average 14% of their assets invested in private equity and private pensions, about 13%. A chart shows how that percentage has increased smartly since 2000.

Remarkably, the Journal points out that the fund valuations can be, erm, permissive:

But as private equity has grown, its lead over traditional stocks has narrowed. And during the decade before the investments pay out, it can be hard to trust interim estimates provided by fee-seeking managers.

The article describes private equity funds as expected to return the money after ten years. While that is technically accurate, it is a bit misleading. Prototypically, funds spend the first five years putting the money to work and then the next five selling their holdings. If they get a hot deal early, they could conceivably cash out by year 3. So on average, the investor funds are outstanding for five years.

Back to the Journal:

Nearly half of private-equity investors surveyed by the investment firm Coller Capital earlier this year said they had money tied up in so-called zombie funds—private-equity funds that didn’t pay out on the expected timetable, leaving investors in limbo.

So pension funds are selling private-equity fund stakes secondhand—often taking a financial hit in the process. Secondary-market buyers last year paid an average of 85% of the value the assets were assigned three to six months before the sale, according to Jefferies Financial Group. Secondhand sales by private-equity investors increased 7% to $60 billion last year….

Some pension funds are borrowing to access cash. Both Calpers and the $333 billion pension serving California teachers have approved plans to take out loans equivalent to 5% and 10% of fund holdings, respectively.

The Alaska Permanent Fund Corp. has received cash from a different kind of borrowing: private-equity managers making payouts that come not from investment gains but from loans they have taken out to appease cash-starved pensions and other investors. That is frustrating for the investment chief, Marcus Frampton. He estimated that his fund, which invests mineral revenue and other state money, could borrow on its own at lower cost. So far, this practice doesn’t appear to be widespread

The Journal mentions in passing that CalPERS is increasing its private equity allocation to 17%, with nary a thought as to whether it needs to rethink its benchmarks and its fealty to private equity in light of zombification.

An interesting sign of the times is the tenor of comments on this piece. In the past, articles on public pension fund misadventures in private equity would generate reader criticism of dumb overpaid public officials and reflexive cheerleading for private equity. The 303 comments on this article (a very healthy number) were overwhelmingly skeptical of the one-times masters of the universe. Some examples:

James Singer

The roach motel aspect of PE comes to the forefront.
Of course PE managers themselves are in the Denial phase as Glen Garry Glen Ross storylines play out.
The world is coming for the high profile billionaire financiers but that is for another time.

Michael Young (emphasis original)

It’s one thing for pension funds to invest in equities that provide returns and gains over time. It is quite another for pension funds to commit to invest equity in future years without even knowing what that equity will buy…and then to compound the problem by going into debt to pay for those future commitments. This is or should be called breach of fiduciary duty and the fiduciaries/trustees should be held personally liable. D&O insurance should not cover this form of breach.

Peter S

The big scam from the Leveraged Buyout Funds ( renamed Private Equity) is their self determination of returns during the interim period.
With this allowance, they make their returns look smoother
( enhancing their “Sharp ratio “ ) and even higher.
As interest rates have likely entered a very long term period of rising , similar to the period 1948-1982, these firms that rely on borrowing ( leverage ) to buyout companies will have a heavy headwind against their returns.

Robert Weinberger

Private equity has damaged more industries, especially healthcare, than ever imagined. They saddle their acquisitions with heavy debt recovering their capital yet causing bankruptcies. This is capitalism gone wild. Legislation is needed to to slam these vultures.

Roy Laferriere

I missed any discussion in the article about how these problems affect the KKRs and Blackstones of the space. My impression is they blithely continue to reap their fees, rain or shine on the investor’s situation.

Stephpen Siu

When something looks too good to be true, it’s probably too good to be true.
Privates may have juicy returns on the headline, but give up in transparency and liquidity in the fine print.

While it is good to see awareness of the considerable problems with private equity (for those not involved in the looting), in much the same way that the US and Europe suffer from a lack of political accountability, so to does the investment world. I am told big endowments don’t even do due diligence before investing in private equity funds, as if being in the club means no pointed questions. Admittedly, universities have a wee problem in that they are soliciting donations from the very same rich people who are running these investment pools. But hardly anyone even acknowledges this monster conflict of interest exists, let alone comes up with feeble attempts at fixes.

Bizarrely, powerful unions like SEIU bizarrely defend CalPERS, despite its history of corruption and incompetence. Even though the State of California backstops state pensions, and (as we have described long form), CalPERS has a defective governance structure that makes it answerable to no one, legislators are afraid to implement even the modest check of an inspector general.

So expect things to have to get a lot worse before there is any hope that they might get better.

Print Friendly, PDF & Email


  1. sporble

    Thanks, Yves, for another informative – and ominous – piece on PE.
    It appears something is missing in the last sentence before “From the Journal in…:”

    “The other main approach for dealing with the cash crunch is to sell private equity ho”

      1. mrsyk

        “The other main approach for dealing with the cash crunch is to sell private equity ho”
        I figured it was just missing an “s” at the end. PE buying its way to the top of the world’s oldest profession wouldn’t surprise me. At all.

  2. hemeantwell

    Thanks, Yves, for steadily following the destructive efforts of these creatures. Over time you’ve taken on a number of topics in a dedicated way. Would it be possible to at least roughly consolidate your PE commentary into a doc available here? Could that be a site project? I’d be happy to donate. Anything to hasten the “world is coming for them” moment that the WSJ article commenter hopes for.

    1. Winston S

      Seconded! Both your suggestion hemeantwell, and I would also be happy to donate to such a project.

      This needs to be disseminated widely. Unfortunately it’s such a complicated issue that it is near impossible to explain this easily to people not fairly well versed in finance.

      In my country (Norway), we have the CEO (Nicolai Tangen, a “self made” ex hedge fund guy himself) for (one of) the largest sovereign wealth and pension funds (NBIM) in the world, campaigning aggressively towards the public and politicians for the fund to start “investing” in PE. Because according to him and his entourage it’s money on the street, stupid not to invest in.

      Or he is, as some see it, displaying immaculate class solidarity to help out his struggling old buddies in PE.

      Every article you publish out here on this beat seems to confirm the latter, and to pick apart any “argument” these parasites think they have.

      Here’s to “Anything to hasten “the world is coming for them” moment”

    1. ChrisFromGA

      Mall-pocalypse continues apace:

      Shopping mall giant Macerich has surrendered the Santa Monica Place mall after defaulting on a $300 million mortgage tied to the sprawling outdoor retail center just down the road from the Santa Monica Pier in Los Angeles

      $300M question is who owns that mortgage? Pension funds, insurance cos, banks? When our local mall went into foreclosure, it ended up going back to Deutsche Bank.

      Bank-owned CRE … it’s what’s for breakfast!

      1. tawal

        According to First American Title, the only loan I can see is an $85MM Trust Deed/Mortgage, recorded on 10/04/2000, by Secore Financial Corporation. According to Secore Financial Corporation: “SECORE is an FHA/HUD Approved commercial real estate lender that was founded in 1987 by veteran real estate professionals who wanted to approach real estate lending from a different point of view – the borrower’s.

  3. Roquentin

    My personal opinion, as an accountant, is that after SOX a lot of the finance community decided that added level of transparency and scrutiny was a bridge too far and the long rotation from public markets to private equity funds went into overdrive to avoid the added level of scrutiny required. While this trend was already underway, the passage of SOX in 2002 really stamped on the accelerator. Not having a market with relatively objective values to reference in making fair market valuation adjustments opens the door to all kinds of shenanigans.

    Everyone knows that as soon as a rule or law is passed, many people will immediately start trying to circumvent it or game the system to their advantage. This is the perpetual dance between regulators and the organizations they regulate. If I had to pick a sector for the next big accounting scandal, I think private equity would be a pretty solid candidate. It is difficult to tell what kind of trash investments are on their books and far too many ways to mask this potential risk. Illiquid assets are exactly that, difficult to unload except at a significant discount and this vicious cycle effect if many of these firms need to unload these assets at the same time.

  4. mrsyk

    One big reason for wanting to avoid that sort of recognition event is that it would call into question the values of many, if not all, of the other companies in their portfolio. This. The financial bloodbath that would occur if there were to be a liquidation event would be epic.
    Also, a big thanks to the commenter Peter S for reminding us that PE are nothing more than rebranded leveraged buyouts funds.

    1. John Steinbach

      I think much of what is being discussed here is a consequence of the Obama administration OKing the abandonment of mark to market valuations of securities in favor of face value valuations. Malcolm X said something about “Chickens coming home to roost”…

  5. noonespecial

    Re quoted WSJ from above: “To keep benefit checks coming on time, those managers are unloading investments on the cheap or turning to borrowing…”

    Humbly posting this link from a recent Bloomberg piece because I think it reveals and adds to the maelstrom of PE’s workings, reliance on debt and ultimately the industry’s knack for employing complex bingo games to make more $$. link not original due to brickblock.

    “…funds have adopted more novel forms of borrowing against their holdings to free up cash for investors, adding to the proliferation of debt across private equity…The clients get more spare change to re-invest with the funds — and a new round of fees flow to the managers.”

    1. Yves Smith Post author

      If you read the article carefully, it concedes that the private equity firms have been borrowing on margin for over a decade. And despite the effort to depict something new happening, all I can detect is that the PE firms are making capital calls to meet the margin calls.

      1. noonespecial

        Agreed and thanks for the feedback Yves, I am a galaxy-and-a-half away from knowing much about PE. My intention was to add to an NC reader’s reading list who may have wondered about funds capitalizing on loans to itself.

  6. JOC

    Another area of PE scrutiny should be the suspected conflict of interest of the investors at public pension funds who allocate large sums to PE. A hypothesis would be that those folks’ compensation benefits from the stale marks to market in PE. One presumes that compensation structures favor stability over volatility.

  7. David is Friday Harbor

    It is not only university endowments who are soliciting funds from PE billionaires: the political class who appoint public pension boards are wholly-owned subsidiaries of Our Billionaire Overlords. CalPERS increasing its PE allocation is part of the political “skim” that overlooks how destructive the PE billionaire factory is to the overall economy. It is the driver of precarity and homelessness.

    With California’s reckless ballot initiative “direct democracy” process, SEIU is hostage to Our Billionaire Overlords using workers’ own money to run initiatives hostile to worker protections and pension funding. In a state over-run by immigrants from conservative cultures who have been brainwashed by libertarianism, hostility to liberalism and civil servants is on the rise. One simply need look at what happened in 2008, when minority voters who turned-out for Obama also overturned the GOP-controlled state supreme court’s approval of same-sex marriage.

    However, under our system of Inverted Totalitarianism the congress and state legislatures will not act to stop this looting. Handing over billions in funds held in trust to high-fee pig-in-a-poke PE funds without the slightest knowledge of where the funds will go or when they will be liquidated is a is the very definition of a violation of fiduciary duty, but it would be political suicide for any law firm to file the case.

  8. Ron Singer

    The class war is over. Mostly what you’re seeing now is just the mopping up operations.

    Land grabs are a popular method of avoiding inflation because they won’t be printing up any more land, even though the value of land in absolute terms continues to decline as overexploitation and climate change do their work. The next phase will be a repeat of European medieval history, when land barons warred against each other to see who gets to carve kingdoms out of whatever’s left that’s worth fighting over.

  9. Cato the Uncensored

    Private Equity funds are neither good nor bad, but are vehicles nibbling at the fringes of the markets to find the future stars of their markets. As they say, you have to kiss a lot frogs to find your prince. I wouldn’t say there is no place for these funds in a pension portfolio, since they are mid- to long-term vehicles that would match up with the longer term cash flow needs of a scheme, but putting more than 5% of your portfolio in them does border on breach of fiduciary responsibilities.

    BTW, the UK government is pushing pension trustees to put more money in illiquid “British” investments like the to help boost UK economic development and growth. I jokingly call it the “Fund the Friends of Tony Plan,” for the genius pushing it the loudest.

    1. Yves Smith Post author

      I must strong disagree with your claims.

      This site has written extensively about private equity since 2014 and even published a trove of limited partnership agreements, the contracts which the industry has systematically sought to hide from the public. That is unique among contracts that government entities enter into, which are all public information. When one of Bill Gates’ attorneys, who had formerly been in M&A and knew in this sort of document that every sentence counts, was excited to have the opportunity to review a limited partnership agreement. After the two days it took to get through it, he said, “People really sign these things?” That is how egregiously one-sided they are.

      Private equity does not outperform public stocks. We debunked long-form your claim that there are such things as better private equity managers and the even more striking fallacy, that investors can identify. Persistence of outperformance has ceased as of about 20 years ago and even then the idea that a limited partner could be the Warren Buffett of investing and find them. Institutional investors have long ago recognized that it is a mug’s game to try to beat the market; that’s why so many heavily employ index funds.

      See here for details:

      Private equity also does not provide diversification of returns. When its delayed reported is corrected for, private equity has extremely high correlation of returns with public equities.

      Authoritative quant analyst Richard Ennis has shown that investment in alternative assets drives down endowment and public pension returns, producing negative alpha. He attributes it to overdiversification.

      And you are ignoring the information presented in this post. Private equity returns capital unpredictably, meaning it cannot be matched with pension’s actuarially-determined cash flow needs. Here we find private equity burdening investors by tying up their money and not returning it at all!

      Finally private equity does not “find future stars”. Limited partner funds go overwhelmingly to leverage buyout type strategies. Growth-y private equity funds constitute only a comparatively small proportion of total private equity assets under management.

  10. Revenant

    Small and midmarlet private equity funds (with reference to the companies they invest in) are a smaller part of the market on a capital weighted basis than the large cap, leveraged buyout private equity funds. However, they have more chance of finding undervalued deals (who knows what a Mom & Pop engineering company is worth, there’s no public market in such thingse?). I am not familiar with the industry data (VC is my thing) and I shares Yves’s overall scepticism but I think a lot of the heads I win, tails you lose, limited partners re up on Autopilot world of private equity is the leveraged buyout sector.

  11. drive-by commenter

    In regard to pension funds, it’s tragic, but I don’t see any changes in the near future. My hunch is that union leaders lack the expertise to evaluate this. It can be intimidating to have all the suits telling you financial gibberish and saying that unless you do as they say, you will be the reason for the pensioners losing their money. In light of all the other priorities of unions (e.g., a strike), it’s easier for unions not to rock the boat and then defend their own position when criticized, doubling down. Maybe what we needed was some credit union to offer financial services consulting or asset management to unions, in line with their own values and priorities (ditto for university endowments). This could be a successful business if advertised correctly, me thinks. Esp. given how poorly PE, VC etc. perform, an S&P500 ETF gets you more money. A competitor that advertises profits even a bit lower, but in line with the values of the membership, might have a good chance of approval.

    And to defend the indefensible, probably it’s not just bribery, quid pro quos and shady insider trading schemes that make asset managers of these billions invest with the billionaires (some of that too, of course). If you’re a manager, you’re hanging out with the suits and in their echo chamber, you don’t wanna rock the boat and certainly you don’t want to be blamed for errors that always happen. It’s better to fail in imitation than to succeed in originality. I think an ethnographic study here would do wonders

  12. Trustee

    The other main approach for dealing with the cash crunch is to sell private equity holdings at a discount” is wrong. An asset is worth what a willing buyer will pay a willing seller. Assets do not sell at a discount. They sell at the market value. What “discount” sales prove is that the GP has over stated the value (and hence the returns).

    “The Journal mentions in passing that CalPERS is increasing its private equity allocation to 17%, with nary a thought as to whether it needs to rethink its benchmarks and its fealty to private equity in light of zombification.” The Board has not even discussed this. The Board only knows what it is told and staff has not pointed this out. As Sinclair Lewis said it is not easy to get someone to believe something when their livelihood depends believes on not believing.

    Trustees want the high reported returns. Note the word “reported”.

    It is unclear how any trustee can invest in an asset that everyone agrees is not worth its “reported value.”

    1. Yves Smith Post author

      I see your point but do not agree entirely. Private placements and other illiquid equity, like restricted stock, is routinely valued at a 20% or greater discount to comparable public shares. The PE marks are based on presumed liquidity events. You’d expect a discount even if the marks were accurate.

      1. Trustee

        It is not like the equity is moving from liquid to illiquid and hence a mark down.

        From illiquid equity to illiquid equity should not lead to an additional mark down just because it is moving from one pocket to another pocket.

        The GP’s mark reflects not the value of the illiquid asset but rather the amount the GP feels it can get away with to calculate assets under management.

  13. flora

    Thanks for this post. I realize what I type below is wrong, and yet it seems apt:

    PE has become a large, 2-steps-removed Ponzi scheme. (Yes, I know it’s not a classic Ponzi.)

    PE takes money in on a promised payout. Things go south. PE stops not only payouts but borrows money to make margin calls. Pension funds left in the lurch. (Do I have that right?)

    Thank’s for your continued reporting PE, CalPERS, and pensions.

Comments are closed.