Financial Times and Stanford Business School Describe How Private Equity Investors Like CalPERS Act Like the Dumb Money They Are

In a bit of synchronicity, we have two accounts that describe different aspects by which private equity limited partners, such as public pension funds like CalPERS, private pension funds, endowments, life insurers, and sovereign wealth funds are all cheerfully fleeced by private equity fund managers, which in the trade are called “general partners”. The Financial Times describes what ought to be a scam, continuation funds, which allow general partners to collect yet more fees on doggy old deals. Stanford Business sets forth the limited partners’ tender faith that general partners can generate alpha (return for investor skill) on a strategy that is leveraged equity in a very toppy stock market. Oh, and after many studies have demonstrated that to the extent private equity outperforms, the general partners harvest that through their fees and expenses, resulting in net returns to limited partners that more or less equate to stock market returns, but with higher risks.¹

First to the Financial Times, which gave the piece a headline that both signaled that these continuation funds are not new and are dodgy: Private equity firms flip assets to themselves in record numbers. That begs the question as to why investors sign up. From the story:

Private equity firms made record use of a controversial tactic to cash out their clients by selling assets to themselves in the first half of the year, as they struggle to find external buyers or list holdings.

Buyout groups used so-called continuation funds — in which a private equity group sells assets from one of the funds they manage to a fresher fund also managed by the firm — to exit $41bn of investments in the first six months of 2025, according to a report by investment bank Jefferies.

That was equal to a record 19 per cent of all sales by the industry, and 60 per cent higher than a year ago.

The increasing reliance of private equity groups on continuation funds to exit older deals comes as the industry contends with a prolonged downturn in initial public offerings and takeover activity that has squeezed the amount of cash returned to investors.

We have from time to time pointed to how CalPERS has a significant portion of its total holdings in funds that are more than ten years old. That raises serious doubts about the valuations of the presumed dogs still left in these funds. The article oddly acts as if an unfavorable IPO market is a fatal obstacle. Remember that private equity firms also sell portfolio companies to “strategic” buyers as well as other funds on a (more or less) arm’s length basis.

The article does indicate why this practice is objectionable but does so in the most anodyne and unrevealing language possible:

Continuation funds give investors the choice to roll over their investment or to cash out. For their private equity sponsors, they allow the firm to keep portfolio companies beyond the typical 10-year life of a fund, and to crystallise performance fees on the assets sold while collecting a steady stream of management fees from the new fund buying the investments.

“Crystallize performance fees”? Help me. They harvest the profit share called carry fees….by deciding to sell to themselves, and pretty much the same limited partners, at a nominal profit. If there was really a bona fide profit to be had, why was the asset not sold to an independent party?

The article also fails to unpack the issue about management fees. Management fees, which are prototypically 2% of funds under management. They are normally paid at a higher level in the first five years of the fund for the effort of finding companies to buy and then somehow magically creating value from them. The management fee then steps down because the general partners are no longer colorably managing the companies, just baby-sitting them.

Hopefully you have noticed why this is unadulterated grift. The general partners are collecting a fee for the work of nominally finding companies, doing due diligence on them, valuing them, and then hopefully improving their performance. But they’ve already owned these companies. There’s no finding or due diligence or new valuation happening (save the justification for making up the price over what clearly is market value when the new fund buys it). Nor is there any credible performance improvement to be had, otherwise it would have happened in the 10+ years of ownership.

As former CalPERS board member JJ Jelincic said:

This is news? It has been going on for years.

The GP locks in and cashes out carried interest. The LP gets to claim a profit even though they now own the same asset at a higher basis. The GP avoids “zombie” funds for which they can collect costs but not management fees.

I doubt fiduciaries would do this with their own money IF they understood what was happening. If they don’t understand they are also breaching their fiduciary duty.

The over 300 comments on the piece were overwhelmingly derisive. Some examples:

Terra_Desolata
Informed investors have been looking for the exits from PE for the last few years, which is the whole reason for this situation. Sponsors haven’t been able to dump old investments on new entrants into the PE space – the trick they were running before now – so they’ve been having to get creative to find funding for cashing out the big investors whose relationships they want to salvage.

The people getting into continuation funds are either getting a big price break on pricing or, just as likely, haven’t gotten the memo yet that the party’s over. Public investors are dodging a bullet by being kept away from this whole mess.

a.kipping
In finance, the insiders can always rewrite the rules in their favor. Yes I understand the IPO market is closed, but IPOs are but one exit strategy. More common are sales to strategic buyers or even other financial sponsors. These routes are not closed to PE managers, the issue is that PE firms need to lower their asking prices to get deals done…which will lead to lower returns on capital and trouble raising their next fund. Enter the continuation fund…where you sell to yourself at a price you determine and you never have to write-down any valuations or take a hit on reported returns. Not to mention, the LPs in the main fund and the continuation fund may be the same investors so how does one reconcile their return? Seems crazy to me that this is allowed.

By happenstance, Stanford Business School just published a new report which takes issue with wishful thinking among public pension funds about private equity, and is so bold as to depict it as herd mentality. Mind you, private equity and venture capital barons are big donors to business schools like Stanford. Even though they are fully aware of the low level of acumen among their investors, saying so in public is a tad unusual.

We’ve embedded the short article below. The key bits:

The California Public Employees’ Retirement System, which now manages more than $500 billion in retirement funds, said it planned to shift more of its portfolio away from stocks and bonds and toward private equity and private debt. Two years earlier, CalPERS acknowledged that its choice to steer clear of private equity had potentially caused it to miss out on up to $18 billion in returns over the previous decade….

The researchers say the main reason for this shift is pension managers’ belief that alternative investments can yield superior returns — so-called alpha — compared to traditional investments. “Beliefs have played a central role in this crazy, giant shift in investment portfolios toward alternative assets,” Begenau says. “This goes against what many people thought: Because public pensions are underfunded and are facing a low return investment environment, they are taking on more risks and gambling with retirement savers’ money.”…

Furthermore, these bullish beliefs stem from the powerful role of investment consultants, who advise almost all U.S. public pensions.

Studying capital market assumptions reports published by major investment consulting firms, the researchers found that advisors’ beliefs about the potential relative returns from alternative investments have consistently increased, rising by about 68 basis points since 2001. This “consultant effect” is large enough to account for the entire increase in the share of alternative investments in public pension portfolios.

Moreover, the research found a strong connection between consultants’ animal spirits and the share of alternative investments in their clients’ portfolios, even after controlling for factors like the financial health and size of the pension funds.

This is damning. Warren Buffett explained this all some time back in his parable of the Gotrocks family, which owns all US corporations. All is well until some Helpers appear and persuade some family members to try to out-do their relatives…for fees, of course. They go through more and more iterations…first by trading and incurring transaction fees, then by hiring fund managers, then hiring consultants, then adding in “hyper helpers” from private equity and hedge funds that claim they can do better by virtue of being paid even more.

The result, per Buffett:

And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.

In the same vein, the dean of quant analysis, Richard Ennis, has painstakingly and exhaustively documented in a series of studies what a loser “alternative” investments like private equity have been for public pension funds and endowments. And as for alpha? Come on! Consider this recap of one of his papers in a 2020 post: New Study Slams Public Pension Funds’ Alternative Investments as Drag on Performance, Identifies CalPERS as One of the Worst “Negative Alphas”; Shows Folly of CalPERS’ Desperate Plan to Increase Private Equity and Debt and Go Bigger Using Leverage. Some quotes in that post from Ennis’ analysis:

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…..

Note that the cost estimates are very similar to the composites’ respective margins of underperformance: 0.99% [for public pension funds] and 1.59% [for endowments] per year relative to passive investment. These closely comparable results provide support for the simple model of institutional investment cost; that is, given the two composites’ extraordinary degree of diversification, we would expect them to underperform properly constructed passive benchmarks by about the amount of costs incurred….

Diversification, per se, is not the problem… The problem is the combination of extreme diversification and high cost: a recipe for failure…

The 10 largest public pension funds in our data set reported having outperformed their custom benchmark
by an average of 0.17% per year over the study period. Those same funds underperformed their respective
equivalent-risk benchmarks by an average of 0.83% a year—which is to say, the average of custom benchmarks lagged that of equivalent-risk benchmarks by 100 bps per year. This suggests the custom benchmarks are slow rabbits in the parlance of greyhound racing. It certainly raises a question about the objectivity of self-measurement.

In other words, funds like CalPERS engage in a tremendous amount of busywork, with the biggest and best paid of all public pension fund investment offices, hiring big name consultants, all in the name of actively destroying value. But doing something sensible like running an in-house stock index (which CalPERS does do), and making a simple US/foreign stock² and US/foreign bonds and putting it on auto pilot (one compelling study I saw found that picking and sticking to an asset allocation over time and merely rebalancing gave top 1% investment returns, so actively managing asset allocation is also a bad idea).

But CalPERS board members would have so much less to do! And in particular, they could no longer justify the perk of flying to glamorous locales for investment conferences. And CalPERS also pays roughly three times the level of private equity fees, adjusted for assets under management, as its Sacramento sister CalSTRS. This looks like rank incompetence or a payoff. And that line of speculation is not unreasonable given that former CalPERS CEO Fred Buenrostro served four and a half years in Federal prison for bribery and other charges, and CalPERS later hired Matt Jacobs, a white collar criminal defense attorney, as its general counsel. Even though we have not gotten to the bottom of it, something is rotten in the state of CalPERS.

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¹ The evidence is so overwhelming that we hope you forgive us for not updating our tally from a 2020 post:

For the sake of completeness, here’s some of the extensive evidence from our archives that private equity not only doesn’t earn enough to compensate for its higher risk, but has even become merely an “on par with stocks” level investment:

Experts effectively or actually telling CalPERS that private equity does not outperform:

CalPERS Debunks Private Equity: Executive Summary

Private Equity Expert Dr. Ashby Monk Repudiates CalPERS CEO Marcie Frost’s Private Equity Scheme During and Immediately After Presentation at CalPERS

CalPERS staff trying to hide private equity underperformance

CalPERS Used Sleight of Hand, Accounting Tricks, to Make False “There is No Alternative” Claim for Private Equity

CalPERS Admits Its New Private Equity Funds Will Dilute Returns, Seeks to Change Benchmark to Hide That; Presents Other Questionable Claims as Top Investors Underperform Due to “Alternative Investments”

Analyses by non-captured parties

Why Private Equity Does Not Outperform

New Study Undermines Rationale for Investing in Private Equity and CalPERS Strategy in Particular, as Oregon CIO Demonstrates that Public Pension Funds Are Dumb Money

Even Endowments Like Harvard, Former Top Investors in Hedge and Private Equity Funds, No Longer Beat Boring Stocks and Bonds

New Study Slams Public Pension Funds’ Alternative Investments as Drag on Performance, Identifies CalPERS as One of the Worst “Negative Alphas”; Shows Folly of CalPERS’ Desperate Plan to Increase Private Equity and Debt and Go Bigger Using Leverage

Oxford Professor Phalippou: Since 2006, Private Equity Has Produced Only S&P 500 Returns While Reaping $400+ Billion in Fees

Private Equity Clearly Inferior to Public Equity: Delivers Similar Returns With Lower Liquidity

² Ennis has pointed out there is no reason to invest in real estate funds. Corporations in aggregate have substantial real estate holding, plus US indices include REITS.

There’s plenty more where that came from.

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