I can’t recall a time where a top financial publication has taken to lobbying, hard, against an investment strategy that has boatloads of fund managers and professional hangers-on benefitting from its largesse. Yet the Financial Times has in the space of barely more than a week, published two pieces, one a very long and extremely well done FT Alphaville overview, from the early days of private equity to the present, with emphasis on how its returns have been falling, yet there are all sorts of pretenses that that isn’t happening. Then after reporting that CalPERS is planning to greatly increase its allocation to private assets, both private equity and private debt, the pink paper releases a story that says, bluntly, that this looks like a Bad Idea.
Mind you, we have been writing for over a decade about how private equity did not out-perform on a risk-adjusted basis. And there have been tacit admissions of that. Over the last decade plus, benchmarks have been made more forgiving. Since the early days of the strategy, the rule of thumb, embraced by the likes of Wilshire and other portfolio consultants, was 300 basis points (3%) over the an equity index, which was nearly always the S&P 500. The risk premium was to compensate for private equity’s higher leverage and its illiquidity. Some experts argued 300 basis points was too low. And using the S&P 500 was also a gimmie: S&P 500 members are much bigger that private equity portfolio companies, so they should have been compared to a smaller company index. But heavens, private equity might come up short!
It has now hit the point where any pretense at intellectual honesty has gone out the window. CalPERS justifies its decision to commit more bigly to private equity by saying it offers the best potential return. Not the best risk adjusted potential return, mind you. Chasing absolute return and not considering risk is a mug’s game. But then again, this is CalPERS.
There is plenty of corroborating evidence for this view. For instance, dean of the quant analysis industry, Richard Ennis, has looked in depth at so-called “alts,” as in alternative investments over a series of papers and articles. Some headlines from our posts making use of his findings:
Quelle Surprise! High Fee “Alternative Investments” Produce Serious “Negative Alpha” as in Underperformance as Managers Get RichAs CalPERS Doubles Down on Private Equity, New Analysis Finds CalPERS’ Private Equity Returns “Based on a Mirage;” Another Study Reaffirms that Private Equity Drags Down PerformanceEndowments’ Money Management Destroying Value Demonstrates Economic Drain of Asset Management BusinessQuelle Surprise! New Study Confirms that Public Pension Funds Use Flattering Benchmarks to Hide Failure to Beat Simple Indexing; CalPERS Is a Case Study
But before we go deeper into the Financial Times’ recent takedowns of private equity pretenses to having built a better investment mousetrap for their investors, as opposed to creating a ginormous fee machine for themselves and their many minions, these critiques miss another element, which is the societal costs. Public pension fund enthusiasm for private equity is a variant of the Lenin quip: Public pension funds are buying the rope which is being used to hang them.
Private equity is a major vehicle for wealth transfer upward. Private equity managers regularly cut pay, employment levels1 and benefit levels, including breaking defined benefit plans and cutting contributions to defined contribution plans. And in the not-infrequent event of bankrupting a business, the losses are bigger and wider-ranging, not just to employees but to vendors and landlords.
The effect of this asset-stripping is to stain local and state government budget by crimping real wages of ordinary workers. That in turn hurts sales and property tax receipts. CalPERS’ employers, as in the government entities that pay to maintain the CalPERS benefits to their workers, are complaining about the costs, which have been taking a larger and larger share of their budgets. And exiting CalPERS is no solution; the giant fund manager has a draconian formula for assessing an exit charge (the short version is they have to immediately pay CalPERS the total actuarially expected amounts due to be paid for the employees in the plan, with very conservative, as in low, investment return assumptions).
Let us return to the Financial Times’ private equity critiques. The first was an impressive long-form treatment in FT Alphaville, Is private equity actually worth it? by Robin Wigglesworth. This treatment was about as good as it gets in long-form article format, and I have to add that I am envious in the day it tidily covered many of the issued Naked Capitalism has explored over the last decade. The article starts from the decision of a private equity holdout, the Norwegian sovereign wealth fund, to join the private equity party.2 to the inception of private equity in the 1970s, when it was first called bootstrapping and then leveraged buyouts.
The article describes the analysis by some prominent private equity boosters, claiming private equity beats stock market returns. Wellie, private equity companies are vastly more leveraged than public companies, so if that was not happening on average, there would be something extremely wrong with that picture. Again, not a single one of these cheerleaders mentions risk-adjusted returns. The all tout absolute returns. If any of them tried that argument on an MBA or CFA exam, they’d get a failing grade.
Wigglesworth then turns to a long (but still partial!) list of academic studies questioning the notion that private outperforms, staring with the classic 2005 Private Equity Performance: Returns, Persistence and Capital Flows by Steven Kaplan and Antoinette Schoar in the prestigious Journal of Finance.
Again, due likely to length and reader patience constraints, the article includes only some of the items from the industry’s rap sheet of questionable return computation: the use of internal rates of return, and later papers that pointed out that to the extent the industry outperformed, the fund managers took it for themselves in eyepopping fees (estimated by CalPERS at 7% per annum’; the fact that no limited partner knows what they are paying is another scandal).
Other known problem with private equity returns:
The lack of independent valuations, which is acceptable no where else in fund management;
The resulting fact that private equity fund managers have been found to or even are widely acknowledged to exaggerate value: right before raising big funds (as in years 3-5 into their current fund), when equity markets are bad, and late in fund life, by carrying unsaleable dogs at their purchase price. Even though the fund managers say the lying in years 3-5 is of no matter since they have to back it out later, it goose those widely used IRRs. Similarly, lying about value in bad markets makes fund risks look way lower than they are.
Another not-widely acknowledged fact is that the appearance of superior returns comes from the very early days of leveraged buyouts, where there were many over-diversified, under-valued conglomerates that could be busted up, with the parts selling for more than the value of the former whole, and vintage years 1995 to 1999, when the returns were spectacular due to the money allocated to private equity having thinned down after the late 1980s leveraged buyout crisis (masked by the bigger and more visible S&L crisis), so that from 1990 to say as late as 1995-1996, there were plenty of companies to be bought cheaply. When those spectacuar return years rolled out of comparisons, the industry case looked weaker.
And the Norwegian state fund and now CalPERS bulking up in private equity continues the returns-depressing trend of too much money chasing too few deals.
The article also goes through some claims we have debunked, that co-investing is a magic solution (it isn’t; there is often adverse selection in the deals the general partners offer up for that) or that a big investor can extract better terms (they can’t; most investors insist on most favored nation clauses, so the way big fish get better prices is because the general partner, at fundraising time, has a pricing schedule, with larger commitments getting better prices).
Now to the even more fun Financial Times dissing of CalPERS’ plan to bulk up in private equity and private debt. To quickly dismiss the private debt part, a contact just wrote:
Of course, they [private equity fund managers] don’t engage at all the evidence that excess return in PE is gone. I want to a credit conference a few weeks ago where a professor gave the keynote arguing that there is no alpha in lending. So cross that off the list as well as an opportunity.
No alpha = no extra performance generated by managers. Investors might as well go to BlackRock and buy the cheapest comparable index.
Here is the Financial Times’ recap from Calpers to invest more than $30bn in private markets:
Calpers, the US’s biggest public pension plan, is to increase its holdings in private markets by more than $30bn and reduce its allocation to stock markets and bonds in an effort to improve returns.
A proposal to increase the $483bn fund’s positions in assets such as private equity and private credit from 33 per cent of the plan to 40 per cent was approved on Monday…
The throat-clearing comes in a related article, Calpers bets on leveraged equities
The worrisome aspect of this allocation decision jumps right off the page: it sounds like Calpers is steering the car by the rear-view mirror. … And, as Unhedged has argued before, there are at least three good reasons to think that private equity performance is going to get worse in relative terms. At least one of them, and maybe two, applies to private credit, too:
The fast growth of the private equity industry has led to greater competition for assets, and therefore higher purchase valuations. This results in lower returns relative to public equity. This may explain the compression in private equity’s outperformance that is already evident; see the chart below from Bain & Company’s Global Private Equity report (while remembering that internal rates of return are not the same as distributions). It is would not be surprising if private credit returns followed the same pattern relative to high-yield bonds.
A crucial component of private equity’s high historical returns, very inexpensive debt, may not be available in years to come…
If you believe that a private equity portfolio is a near equivalent to a leveraged public equity portfolio — as Unhedged does — then underlying returns on US public equities are a critical component of private equity return (depending on your global equity weightings). But US equities returns are very likely to be lower in the next 10 years than the last 10, for the simple reason that they were extraordinarily high in the past decade, at 12 per cent annually for the S&P 1500 broad index. Long-term equity returns revert pretty reliably to 7 per cent or so.
It may be that the Calpers investment office does have a theory about why private equity should continue to be the best asset class in the next 10 years. But I don’t know what that theory is, and it’s not in the slide decks from the office’s recent asset allocation review or its 2023 trust level review.
There is a LOT more where that came from.
The article also criticized CalPERS’ barmily low correlation assumptions (as in its claim as to how much private equity will reduce portfolio risk by not moving up and down in synch with other assets), which is something we have assailed before. The pretense that it happens (and the claims are typically way more modest than the CalPERS assumption), it’s due to bad accounting, namely not correcting for the one-quarter reporting lag for private equity, and fibbing about losses in bad markets.
But so many are so dazzled by what is now increasingly recognized as sham superior returns that the hopium keeps growing. If someone out there is making more money, or thinks he is, others will follow the herd.
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1See Eileen Applelbaum and Rosemary Batt in Private Equity at Work, for example. They looked carefully at one seen as reputable study that found the reverse, and found a fundamental misdirection in the sample construction that when corrected, led to the opposite findings, that PE-bought companies cut pay and headcount more than carefully-matched peer companies.
2 This fund had previously sought the advice of Oxford professor Ludovic Phalippou, who in a very detailed analysis of industry returns, showed why private equity didn’t earn enough to compensate for its additional risk. He did advise the fund to invest in private equity…but only in market downdrafts when they could buy secondary interests on the cheap.