Wednesday, December 17, 2014

CalPERS Mulls New PE Benchmark?

Michael B. Marois of Bloomberg reports, California Pension Fund May Change Benchmark for Private Equity:
The California Public Employees’ Retirement System, the biggest U.S. pension, may change the benchmark it uses to measure private equity performance as $31.3 billion in investments underperform.

The $294 billion pension, known as Calpers, currently uses a custom benchmark its staff designed based on global and U.S public equity plus 300 basis points. That benchmark is imprecise in measuring private equity performance and encourages riskier investments to meet the goal, officials said.

Calpers’ current staff-designed benchmark creates “unintended active risk for the program, as well as for the whole fund,” Réal Desrochers, the system’s senior investment officer in charge of private equity, said in a report today to the fund’s governing board. Calpers’ 10-year return on private equity of 13.3 percent as of June 30 fell short of its own benchmark by 2.1 percentage points, according to the pension system’s data. The performance also missed in one-, three- and five-year periods.

Calpers has been working to reduce risk in its portfolio after the global financial crisis wiped out more than a third of its wealth, forcing it to increase contributions from taxpayers to cover losses.

As public pension funds have poured money into private equity in search of higher returns, they have sometimes struggled to set accurate benchmarks to determine the holdings’ value. Some benchmarks are devised by firms such as Prequin Ltd. and State Street Corp. One, called AARM-FOIA Global PE Benchmark, uses data on private equity performance reported by pension funds such as Calpers, the California State Teachers’ Retirement System, or Calstrs, and those in Florida, New York and Wisconsin.
Internal Benchmark

Calstrs, the second biggest with $190 billion, in August switched from an internal benchmark to the GX Private Equity Index offered by State Street, which services institutional investors and manages financial assets worldwide.

“After seeking a better private equity benchmark for years, we have decided that State Street’s Private Equity benchmark has achieved enough mass and history to replace our own internal index,” Calstrs Chief Investment Officer Christopher Ailman said in a statement at the time.

Private-equity firms use borrowed money to buy companies, improve profits and resell them. The top 25 percent of private-equity funds delivered better returns than the Standard & Poor’s 500 stock index by 37 percent over the life of the fund, according to a 2011 study that looked at 450 buyout funds from 1984 to 2010.
Peer Group

Pension funds typically use peer group and public benchmarks of private equity performance, according to a study by Kellogg School of Management at Northwestern University. Public market benchmarks are based on time-weighted returns of private equity funds and public market equivalent indexes or an index plus a premium, such as the one now used by Calpers. Because private equity lags public markets, a lagged benchmark may be preferable, according to the report.

Calpers announced in September that it was divesting from hedge funds, saying they are to complex and too expensive while contributing too little to returns.

The Calpers board is scheduled to review all its benchmarks in 2015.
State Legislation

Calpers board members today were also urged to seek state legislation allowing the fund to bypass competitive bidding rules when it hires some types of investment services.

Current state law requires that agencies seek competitive bids when seeking to buy most goods and services. The pension fund needs an exemption so it can be more nimble and timely when considering potential investment opportunities, Danny Brown, the fund’s chief of legislative affairs, told the pension’s investment committee.

“It just doesn’t make sense” for the fund to require a request for proposals to rehire top-performing money managers or to pay for an RFP process that can take as long as nine months, Brown said.

California seeks bids for everything from building roads and schools to buying portable toilets and fire extinguishers. The process is used to ensure that the state pays a fair price for goods and services.

Calpers paid Wall Street firms almost $1.2 billion to manage investments in the fiscal year that ended June 30, 2013.

California grants a blanket exemption from bidding requirements for the state’s Health Benefits Exchange and the California Housing Finance Agency. Calpers already has exemptions for health, vision, and long term care benefits and services.
FINalternatives also reports, CalPERS Mulls New P.E. benchmark:
Having dealt with its hedge-fund investments by abandoning them, the nation’s largest public pension fund is turning its eye to its private-equity portfolio.

The California Public Employees Retirement System isn’t considering an end to its p.e. program. In fact, it’s considering lowering the bar for its managers by abandoning its custom benchmark for those investments.

That benchmark is based on the stock market plus 300 basis points. CalPERS, which is seeking to reduce risk across its $294 billion portfolio, believes that such a high hurdle creates “unintended active risk for the program” by encouraging riskier investments to meet the level. The pension is set to review all of its benchmarks next year.

CalPERS’ review follows the California State Teachers Retirement System’s substitution of a State Street private-equity index for its own.

Earlier this year, CalPERS said it would redeem its entire hedge-fund portfolio, saying it is too large and its hedge-fund allocation too small to make an impact.
Whenever CalPERS does anything, it's big news. For example, when it dropped a hedge fund bomb back in September, everyone had an opinion. I defended this decision based on their reasons and based on my personal knowledge that CalPERS never dedicated sufficient resources to their hedge fund investments to justify keeping that program alive.

Other large pension funds, like Ontario Teachers and the Caisse are still investing in hedge funds and couldn't care less about what CalPERS is doing in that space. They've been investing in hedge funds for a long time, have dedicated important resources to these investments and see it as another way to generate alpha and gain timely market insights from the best alpha managers across the globe (ie. knowledge leverage).

Of course, high fees and low performance is a huge concern for all limited partners investing in hedge funds and I think many institutional investors should follow CalPERS and exit these investments altogether while they still can. Too many of them simply don't understand the risks and complexities of these investments and they typically rely on useless investment consultants placing them in the hottest "brand name funds" which end up underperforming on an absolute and relative basis.

I would also ignore big billionaire hedge fund gurus like Elliott Management's Paul Singer who criticized CalPERS decision to axe hedge funds stating: "We are certainly not in a position to be opining on the 'asset class' of hedge funds, or on any of the specific funds that were held or rejected by CalPERS, but we think the decision to abandon hedge funds altogether is off-base." Singer doesn't have a clue of what he's talking about in this regard and he should worry more about his hedge fund and his ongoing dispute with Argentina.

Enough about hedge funds. Let me get back to the topic of this comment and discuss why CalPERS is reviewing its private equity benchmarks. I was contacted in January 2013 by Réal Desrochers, their head of private equity who I know well, to discuss this issue. Réal wanted to hire me as an external consultant to review their benchmark relative to their peer group and industry best practices.

Unfortunately, I am not a registered investment advisor with the SEC which made it impossible for CalPERS to hire me. I did however provide my thoughts to Réal along with some perspectives on PE benchmarks and told him unequivocally that CalPERS current benchmark is very high, especially relative to its peers, making it almost impossible to beat without taking serious risks.

Almost two years later, we now find out that CalPERS is looking to change its private equity benchmark to better reflect the risks of the underlying portfolio. Yves Smith of Naked Capitalism, aka Susan Webber, came out swinging (again!) stating CalPERS is lowering its private equity benchmark to justify its crappy performance:
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 (click on image to enlarge):


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.
I stopped reading this comment right after that last paragraph. There are things I agree with but her lengthy and often vitriolic ramblings just annoy the hell out of me. She didn't bother to mention how Réal Desrochers inherited a mess in private equity and still has to revamp that portfolio.

More importantly, she never invested a dime in private equity and quite frankly is far from being an authority on PE benchmarks. Moreover, she is completely biased against CalPERS and allows this to cloud her objectivity. Also, her dispersion argument is flimsy at best.

Let me be fully transparent and state that neither Réal Desrochers nor CalPERS ever paid me a dime for my blog even though I asked them to contribute. I am actually quite disappointed with Réal who seems to only contact me when it suits his needs but I am still able to maintain my objectivity.

I remember having a conversation with Leo de Bever, CEO at AIMCo, on this topic a while ago. We discussed the opportunity cost of investing in private markets is investing in public markets. So the correct benchmark should reflect this, along with a premium for illiquidity risk and leverage. Leo even told me "while you will underperform over any given year, you should outperform over the long-run."

I agreed with his views and yet AIMCo uses a simple benchmark of MSCI All Country World Net Total Return Index as their private equity benchmark (page 33 of AIMCo's Annual Report). When I confronted Leo about this, he shrugged it off saying "over the long-run it works out fine." Grant Marsden, AIMCo's former head of risk who is now head of risk at ADIA, had other thoughts but it shows you that even smart people don't always get private market benchmarks right.

And AIMCo is one of the better ones. At least they publish all their private market benchmarks and I can tell you the benchmarks they use for their inflation-sensitive investments are better than what most of their peers use.

Now, my biggest beef with CalPERS changing their private equity benchmark is timing. If we are about to head into a period of low returns for public equities, then you should have some premium over public market investments. The exact level of that premium is left open for debate and I don't rely on academic studies for setting it. But there needs to be some illiquidity premium attached to private equity, real estate and other private market investments.

Finally, I note the Caisse's private equity also underperformed its benchmark in 2013 but handily outperformed it over the last four years. In its 2013 Annual Report, the Caisse states the private equity portfolio underperformed last year because "50% of its benchmark is based on an equity index that recorded strong gains in 2013" (page 39) but it fails to provide what exactly this benchmark is on page 42.

Also, in my comment going over PSP's FY 2014 results, I noted the following:
Over last four fiscal years, the bulk of the value added that PSP generated over its (benchmark) Policy Portfolio has come from two asset classes: private equity and real estate. The former gained 16.9% vs 13.7% benchmark return while the latter gained 12.6% vs 5.9% benchmark over the last four fiscal years. That last point is critically important because it explains the excess return over the Policy Portfolio from active management on page 16 during the last ten and four fiscal years (click on image):



But you might ask what are the benchmarks for these Private Market asset classes? The answer is provided on page 18 (click on image):


What troubles me is that it has been over six years since I wrote my comment on alternative investments and bogus benchmarks, exposing their ridiculously low benchmark for real estate (CPI + 500 basis points). André Collin, PSP's former head of real estate, implemented this silly benchmark, took all sorts of risk in opportunistic real estate, made millions in compensation and then joined Lone Star, a private real estate fund that he invested billions with while at the Caisse and PSP and is now the president of that fund.

And yet the Auditor General of Canada turned a blind eye to all this shady activity and worse still, PSP's board of directors has failed to fix the benchmarks in all Private Market asset classes to reflect the real risks of their underlying portfolio.
All this to say that private equity, real estate, infrastructure and timberland benchmarks are all over the map at the biggest best known pension funds across the world. There are specific reasons for this but it's incredibly annoying and frustrating for supervisors and stakeholders trying to make sense of which is the appropriate benchmark to use for private market investments, one that truly reflects the risks of the underlying investments (you will get all sorts of "expert opinions" on this subject).

Below, Joseph Baratta, global head of private equity at Blackstone Group LP, talks about oil prices, financial markets and the firm's investment strategy. Baratta speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "Market Makers" stating Blackstone sees opportunity amid slumping oil prices.

I wish Blackstone good luck with these energy investments and totally disagree with his views on the plunge in oil being a "supply-side issue" but listen carefully to their approach.

No comments:

Post a Comment