Yves Smith on CalPERS’ Private Equity Review: Is It Enough?

magnifying glass on a twenty dollar bill

On Thursday, Pensions & Investments broke the story that CalPERS was putting its private equity benchmarks under review.

Beginning with the end of last fiscal year, the fund’s private equity portfolio has underperformed benchmarks over one year, three-year, five-year and ten-year periods [see the chart embedded in the post below].

CalPERS staff says the benchmarks are too aggressive – in their words, the current system “creates unintended active risk for the program”.

Yves Smith of Naked Capitalism has published a post that dives deeper into the pension fund’s decision – is the review justified? And is it enough?


By Yves Smith, originally published at Naked Capitalism

The giant California pension fund roiled the investment industry earlier this year with its decision to exit hedge funds entirely. That decision looked bold, until you look at CalPERS’s confession in 2006 that its hedge funds had underperformed for three years running. Its rationale for continuing to invest was that hedge funds delivered performance that was not strongly correlated with other investments. Why was that 2006 justification lame? Because even as of then, it was widely acknowledged in the investment community that hedge funds didn’t deliver alpha, or manager performance. Hedgies nevertheless sought to justify their existence through the value of that supposedly-not-strongly-correlated performance, or “synthetic beta”. The wee problem? You can deliver synthetic beta at a vastly lower cost than the prototypical 2% annual fee and 20% upside fee that hedge funds charge. Yet it took CalPERS eight more years to buck convention and ditch the strategy. Admittedly, CalPERS did keep its investments in hedge funds modest, at a mere 2% of its portfolio, so it was not an enthusiast.

By contrast, CalPERS is the largest public pension fund investor in private equity, and generally believed to be the biggest in the world. And in the face of flagging performance, CalPERS, like Harvard, appeared to be rethinking its commitment to private equity. In the first half of the year, it cut its allocation twice, from 14% to 10%.

But is it rethinking it enough? Astonishingly, Pensions & Investments reports that CalPERS is looking into lowering its private equity benchmarks to justify its continuing commitments to private equity. Remember, CalPERS is considered to be best of breed, more savvy than its peers, and able to negotiate better fees. But look at the results it has achieved:


And the rationale for the change, aside from the perhaps too obvious one of making charts like that look prettier when they are redone? From the P&I article:

But the report says the benchmark — which is made up of the market returns of two-thirds of the FTSE U.S. Total Market index, one-third of the FTSE All World ex-U.S. Total Market index, plus 300 basis points — “creates unintended active risk for the program, as well as for the total fund.”

In effect, CalPERS is arguing that to meet the return targets, private equity managers are having to reach for more risk. Yet is there an iota of evidence that that is actually happening? If it were true, you’d see greater dispersion of returns and higher levels of bankruptcies. Yet bankruptcies are down, in part, as Eileen Appelbaum and Rosemary Batt describe in their important book Private Equity at Work, due to the general partners’ success in handling more troubled deals with “amend and extend” strategies, as in restructurings, rather than bankruptcies. So with portfolio company failures down even in a flagging economy, the claim that conventional targets are pushing managers to take too many chances doesn’t seem to be borne out by the data.

Moreover, it looks like CalPERS may also be trying to cover for being too loyal to the wrong managers. Not only did its performance lag its equity portfolio performance for its fiscal year ended June 30, which meant the gap versus its benchmarks was even greater. A Cambridge Associates report also shows that CalPERS underperformed its benchmarks by a meaningful margin. CalPERS’ PE return for the year ended June 30 was 20%. By contrast, the Cambridge US private equity benchmark for the same period was 22.4%. But the Cambridge comparisons also show that private equity fell short of major stock market indexes last year, let alone the expected stock market returns plus a PE illiquidity premium.

The astonishing part of this attempt to move the goalposts is that the 300 basis point premium versus the stock market (as defined, there is debate over how to set the stock market benchmark) is not simply widely accepted by academics as a reasonable premium for the illiquidity of private equity. Indeed, some experts and academics call for even higher premiums. Harvard, another industry leader, thinks 400 basis points is more fitting; Ludovic Philappou of Oxford pegs the needed extra compensation at 330 basis points

So if there is no analytical justification for this change, where did CalPERS get this self-serving idea? It appears to be running Blackstone’s new talking points. As we wrote earlier this month in Private Equity Titan Blackstone Admits New Normal of Lousy Returns, Proposes Changes to Preserve Its Profits:

Private equity stalwarts try to argue that recent years of underwhelming returns are a feature, not a bug, that private equity should be expected to underperform when stocks are doing well. To put that politely, that’s novel.

The reality is uglier. The private equity industry did a tsunami of deals in 2006 and 2007. Although the press has since focused on the subprime funding craze, the Financial Times in particular at the time reported extensively on the pre-crisis merger frenzy, which was in large measure driven by private equity.

The Fed, through ZIRP and QE didn’t just bail out the banks, it also bailed out the private equity industry. Experts like Josh Kosman expected a crisis of private equity portfolio company defaults in 2012 through 2014 as heavily-levered private equity companies would have trouble refinancing. Desperation for yield took care of that problem. But even so, the crisis led to bankruptcies among private equity companies, as well as restructurings. And the ones that weren’t plagued with actual distress still suffered from the generally weak economic environment and showed less than sparkling performance.

Thus, even with all that central help, it’s hard to solve for doing lots of deals at a cyclical peak. The Fed and Treasury’s success in goosing the stock market was enough to prevent a train wreck but not enough to allow private equity firms to exit their investments well. The best deals for general partners and their investors are ones where they can turn a quick, large profit. Really good deals can typically be sold by years four or five, and private equity firm have also taken to controversial strategies like leveraged dividend recapitalizations to provide high returns to investors in even shorter periods.

Since the crisis, private equity companies have therefore exited investments more slowly than in better times. The extended timetables alone depress returns. On top of that, many of the sales have been to other private equity companies, an approach called a secondary buyout. From the perspective of large investors that have decent-sized private equity portfolios, all this asset-shuffling does is result in fees being paid to the private equity firms and their various helpers….

As the Financial Times reports today, the response of industry leader Blackstone is to restructure their arrangements so as to lower return targets and lock up investor funds longer. Pray tell, why should investors relish the prospect of giving private equity funds their monies even longer when Blackstone is simultaneously telling them returns will be lower? Here is the gist of Blackstone’s cheeky proposal:

Blackstone has become the second large buyout group to consider establishing a separate private equity fund with a longer life, fewer investments and lower returns than its existing funds, echoing an initiative of London-based CVC.

The planned funds from Blackstone and CVC also promise their prime investors lower fees, said people close to Blackstone.

Traditional private equity funds give investors 8 per cent before Blackstone itself makes money on any profitable deal – a so-called hurdle rate.

Some private equity executives believe that in a zero or low interest rate world, investors get too sweet a deal because the private equity groups do not receive profits on deals until the hurdle rate is cleared.

Make no mistake about it, this makes private equity all in vastly less attractive to investors. First, even if Blackstone and CVC really do lower management fees, which are the fees charged on an annual basis, the “prime investors” caveat suggests that this concession won’t be widespread. And even if management fees are lowered, recall how private equity firms handle rebates for all the other fees they charge to portfolio companies, such as monitoring fees and transaction fees. Investors get those fees rebated against the management fee, typically 80%. So if the management fees are lower, that just limits how much of those theoretically rebated fees actually are rebated. Any amounts that exceed the now-lower management fee are retained by the general partners.

The complaint about an 8% hurdle rate being high is simply priceless. Remember that for US funds, the norm is for the 8% to be calculated on a deal by deal basis and paid out on a deal by deal basis. In theory, there’s a mechanism called a clawback that requires the general partners at the end of a fund’s life to settle up with the limited partners in case the upside fees they did on their good deals was more than offset by the dogs. As we wrote at some length, those clawbacks are never paid out in practice. But the private equity mafia nevertheless feels compelled to preserve their profits even when they are underdelivering on returns.

And the longer fund life is an astonishing demand. Recall that the investors assign a 300 to 400 basis point premium for illiquidity. That clearly need to be increased if the funds plan slower returns of capital. And recall that we’ve argued that even this 300 to 400 basis points premium is probably too low. What investors have really done is give private equity firms a very long-dated option as to when they get their money back. Long dated options are very expensive, and longer-dated ones, even more so.

The Financial Times points out the elephant in the room, the admission that private equity is admitting it does not expect to outperform much, if at all:

The trend toward funds with less lucrative deals also represents a further step in the convergence between traditional asset managers with their lower return and much lower fees and the biggest alternative investment companies such as Blackstone.

So if approaches and returns are converging, fees structures should too. Private equity firms should be lowering their fees across the board, not trying to claim they are when they are again working to extract as much of the shrinking total returns from their strategy for themselves.

Back to the present post. While the Financial Times article suggested that some investors weren’t buying this cheeky set of demands, CalPERS’ move to lower its benchmarks looks like it is capitulating in part and perhaps in toto. For an institution to accept lower returns for the same risk and not insist on a restructuing of the deal with managers in light of their inability to deliver their long-promised level of performance is appalling. But private equity industry limited partners have been remarkably passive even as the SEC has told them about widespread embezzlement and widespread compliance failure. Apparently limited partners, even the supposedly powerful CalPERS, find it easier to rationalize the one-sided deal that general partners have cut with them rather than do anything about it.


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CalPERS Puts Private Equity Benchmarks Under Review


CalPERS’ private equity portfolio underperformed its benchmark by 3.3 percent last fiscal year – but that’s only one of the reasons that the country’s largest public pension fund is putting its private equity benchmarks under review.

Reported by Pensions & Investments:

CalPERS’ $31 billion private equity portfolio has underperformed its policy benchmark over both long- and short-term periods, shows a review of the program, but pension fund officials feel part of the problem is that the benchmark seeks too aggressive a return and are seeking revisions.

The private equity staff review, to be presented to the investment committee Dec. 15, shows that as of June 30 the private equity portfolio produced an annualized 10-year return of 13.3%, compared to its custom policy benchmark of 15.4% annualized.

Over the shorter one-year period, CalPERS’ portfolio returned 20%, compared to the benchmark’s 23.3%; over three years, it returned 12.8% annualized compared to the benchmark’s 14.5%; and over five years, it returned 18.7% compared to the benchmark’s 23.2%.

But the report says the benchmark — which is made up of the market returns of two-thirds of the FTSE U.S. Total Market index, one-third of the FTSE All World ex-U.S. Total Market index, plus 300 basis points — “creates unintended active risk for the program, as well as for the total fund.”

California Public Employees’ Retirement System investment officials have said publicly at investment committee meetings that they feel the private equity benchmark they are shooting to outperform is too aggressive.

CalPERS manages $295 billion in assets, of which $31 billion is private equity.


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Fitch: Hedge Funds Will Continue “Winning and Keeping” Public Pensions Assets

Fitch Ratings

Fitch Ratings predicts that, despite several high-profile exits by pension funds this year, hedge funds will continue to count public pension funds as major investors.

The ratings agency says exits by funds like CalPERS are “not representative of broader sector trends” and says it believes hedge funds still “deliver competitive returns net of fees, while providing a degree of downside protection and uncorrelated return during periods of stress”.

From Fitch:

Recent decisions by two large US public pension plans to pull back from hedge fund investments, and the likelihood of a sixth consecutive calendar year of return averages underperforming broad equity market returns, are not expected to curb investors’ overall allocations to hedge funds, according to Fitch Ratings.

Barring an unforeseen major market decline, hedge fund assets under management (AUM) should continue on a path toward $3.0 trillion, good growth relative to 2013’s year-end level of $2.6 trillion. The rise is attributable to market appreciation and inflows outpacing redemptions. The AUM flows show significant variation by strategy, with equity-oriented funds attracting more capital in recent periods, but global macro funds falling from favor.

While hedge fund growth has certainly slowed over the past several years, the high-profile pension plan withdrawals seen over the past six weeks are not representative of broader sector trends, in our view.

The Fitch report backs its conclusions with data from several studies conducted this year:

Fitch points to analysis recently compiled by Preqin as an indicator of the progress that hedge funds have made in winning and keeping US public pension assets more broadly. The data generally shows improvements in hedge fund investment allocations by public pensions since 2010. As of June 2014, 269 public pensions in the US made allocations to hedge funds, with an average of about 8.6% of their total AUM allocated to hedge funds.


Over the past decade and a half, hedge funds have delivered steadier performance relative to the overall market during bear markets, as was seen in 2000 to 2002 and in 2008. This downside protection, however, comes at the expense of limited upside during bull markets, a trend seen in 2003, 2009 and especially 2013.

According to Hedge Fund Research, hedge fund performance averages are set to be nearer to the broad equity market measures in 2014. However, trailing 36- and 48-month annual return levels generally range around low single-digit percentages, which paint the entire sector as under delivering relative to broader equity index benchmarks.

Read the full Fitch release here.

Dan Primack: All Alternatives Are Not Created Equal

flying one hundred dollar bills

Pension funds have been receiving flak from all sides lately regarding alternative investments.

The criticisms have been varied: the high fees, opacity, underperformance and illiquidity.

But, outside of official statements from pension staff defending their investments, it’s not often we get to here from the people on the other side of the argument.

Dan Primack argues in a column this week that not all alternatives are created equal—and the fight against the asset class has been “oversimplified”.

From Fortune:

Hedge funds are considered to be “alternative investments.” So is private equity. And venture capital. And sometimes so is real estate, timber and certain types of commodities.

A number of public pension systems have increased their exposure to “alternatives” in recent years, at the same time that they either have curtailed (or threatened to curtail) payouts to pensioners. The official line is that the former is to prevent more of the latter, but many critics believe Wall Street is getting rich at the expense of modest retirees.

The complaint, however, generally boils down to this: Alternatives have underperformed the S&P 500 in recent years, even though many alternative funds charge higher fees than would a public equities index fund manager. In other words, state pensions are overpaying for underperformance.

Great bumper sticker. Lousy understanding of investment strategies.

The simple reality is that not all alternatives are created equal. Some, like private equity, are more tightly correlated to public equities than are others. Some are designed to chase public equities in bull markets without collapsing alongside them (that’s where the name “hedge” name from). Real estate is largely its own animal. Same goes for certain oil and gas partnerships.

Lumping all of them together because of fee strategies makes as much sense as arguing that a quarterback should be paid the same as an offensive lineman. After all, they both play football, right?

Primack uses New Jersey as an example:

For those who want to criticize public pensions for investing in alternatives, be specific. New Jersey, for example, reported alternative investment performance of 14.21% for the year ending June 30, 2014. That trailed the S&P 500 for the same period, which came in at 21.38% (or the S&P 1500, which came in at 16.99%). But that alternatives number is a composite of private equity (23.7%), hedge funds (10.2%), real estate (12.74%) and real assets/commodities (6.12%). The sub-asset class most tightly correlated to public equities actually outperformed the S&P 500 (net of fees).

Would New Jersey pensioners have been better off without private equity? Clearly not for that time period. Having avoided real estate or hedge funds, however, would be a different argument. But even that case is tough to prove until New Jersey’s relatively immature alternatives program experiences a bear market. For example, both hedge funds and the S&P 500 went red last month, but the S&P 500’s loss was actually a bit worse. And macro hedge fund managers actually had positive returns. Does that make up for years of the S&P 500 outperforming hedge? Likewise, should real estate performance receive an indirect bump from recent rises in venture capital performance, just because they are both “alternatives?”

Again, that’s a judgment call that should be based on voluminous data, rather than on knee-jerk anger that alternative money managers are getting paid while retiree benefits are getting cut. If alternative managers are helping to stem the severity of those cuts, then everyone wins. If not, then the state pension needs a change in policy. But, in either case, the specific alternative sub-asset classes should be analyzed on their own merits, rather than as one homogeneous bucket. Otherwise, critics may throw out the baby with the bathwater.

Read the entire column here.


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Report: Maryland Fund Lost Billions Due To Underperformance

Wilshire Trust Universe Comparison Service
Credit: Maryland Public Policy Institute report

The Maryland State and Retirement Pension System returned 14.4 percent last fiscal year – a return that the Chief Investment Officer praised as “strong” and that doubled the fund’s expected rate of return of 7.75 percent.

But a new report from the Maryland Public Policy Institute claims that the returns weren’t good enough From the Maryland Reporter:

In a report, Jeffrey Hooke and John Walters of the Maryland Public Policy Institute say the failure to match the 17.3% return on investment made by over half the public state pension funds cost the state over $1 billion. As they have in the past, they also complained about the high fees paid to outside managers of some of the funds used by the State Retirement and Pension System, which covers 244,000 active and retired state employees and teachers and their beneficiaries

“As the table shows, the underperformance trend is not only continuing but worsening as the percentage divide widens,” said Hooke and Walters. “Part of problem may be due to the fund’s large exposure to alternative investments, such as hedge funds and private equity funds, that have tended to perform worse in recent years than traditional investments such as publicly traded stocks and bonds.”

A spokesman for the Maryland pension fund offered his response to the report:

[Spokesman] Michael Golden said the institute’s report was “flawed,” “not supported by facts,” and mischaracterized the agency’s investment performance.

“These returns have resulted in greater progress toward full funding of the system that was projected last year,” Golden said. The five-year return on investment was 11.68%, while the target for the fund is 7.7%.


Golden admitted that Maryland’s investment performance is “unimpressive” compared to other state funds.

“However, the reason for this ranking is not due to active management and fees,” Golden said. “After the financial crises of 2008-2009, the board determined that the fund had too much exposure to public equities, which historically has been one of the riskiest, most volatile asset classes, and wanted a more balanced and diversified portfolio.”

See the chart at the top of this post for a comparison between the returns of Maryland’s pension fund versus the Wilshire’s Trust Universe Comparison Service (TUCS), a widely accepted benchmark for institutional assets.

Harvard Endowment Fund Under Fire For Bonuses, Other Investment Expenses


A group of Harvard alumni are voicing concern and anger over the compensation packages of investment managers who run the school’s endowment fund. From Chief Investment Officer:

Harvard Management Company (HMC), which runs the $32.7 billion fund, paid $132.8 million in salaries, bonuses, and benefits in the 12 months to June 30, 2013. This was more than double the $63.5 million it paid in 2010, according to Bloomberg.

HMC staff salaries and benefits were “increasing at a much faster rate than the endowment, which still has a long way to go before it reaches its pre-crisis peak”, they said in the letter.

A spokesperson for the Ivy League university told Bloomberg: “HMC’s unique hybrid model has saved the university more than $1.5 billion in management costs compared to what an equivalent external management strategy would have cost over the past decade.”

The nine alumni, who aired their concerns in a letter to Harvard’s president, said it’s not just the compensation packages that rub the, the wrong way. It’s also the performance. From Chief Investment Officer:

They criticized the pay hikes, which had come despite the endowment underperforming many of its peers. It has still to reach its pre-financial crisis peak of $36.9 billion in assets after losing 27% in the 12 months to June 30, 2009—although its 11.3% return for the fiscal year ending June 30, 2013 marked an outperformance of its benchmark.

According to AI-CIO, Princeton University also shoveled out the dough to its investment managers. They received $8.3 million in bonuses last year, which was a 39 percent increase over 2012.


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