CalPERS's Private Equity Disaster?
We’ve said for the last couple of years that private equity has not been earning enough to compensate for its extra risks, that of high leverage and lack of liquidity.Yves Smith, aka Susan Webber of Aurora Advisors, is back at it again, going after CalPERS' private equity program, enlisting "academic experts" like this professor at Oxford who sounds credible but the problem is like so many academics, he doesn't have a clue of what he's talking about, and neither does Yves Smith, unfortunately.
One of the core tenets of finance is that extra risk-taking should be rewarded with higher returns over time. But for more than the last decade, typical investor portfolios of private equity funds haven’t delivered the additional returns, typically guesstimated at 300 basis points over a public equity benchmark like the S&P 500.
We’ve pointed out that even that widespread benchmark is too flattering. Private equity firms invest in companies that are much smaller than the members of the S&P 500, which means they are capable of growing at a faster rate over extended periods of time. The 300 basis point (3%) premium is a convention with no solid analytical foundation. Some former chief investment officers, like Andrew Silton, have argued that a much higher premium, more like 500 to 800 basis points (5% to 8%) is more appropriate. And that’s before you get to other widespread problems with measuring private equity returns, such as the fact that they are routinely exaggerated at certain times, namely right before a new fund is being raised by the same general partner, late in a fund’s life, and during bear markets, all of which goose overall results.
And that’s before you get to the fact that some investors use even more flattering benchmarks. As Oxford professor Ludovic Phalippou pointed out by e-mail, in the last two years, more and more investors have switched from using the already-generous S&P 500 to the MSCI World Index as their benchmark. Why? Per Phalippou: “Because the S&P 500 has been doing very well over the last three years, unlike the MSCI World Index.”
So why hasn’t private equity been producing enough over the past decade to justify the hefty fees? The short answer is too much money chasing deals. Private equity’s share of global equity more than doubled from 2005 to 2014.
And you can see how this looks in CalPERS’ latest private equity performance update, from its Investment Committee meeting last week (from page 14 of this report). In fairness, CalPERS does have a more strict private equity benchmark than many of its peers (click on image):
Since that chart is still mighty hard to read (by design?), let’s go through the sea of read ink.
The only period in which CalPERS beat its benchmark was for the month before the measurement date of December 31, 2016, and that by a whopping 3 basis points. In all other measurement periods, the shortfall was hundreds of basis points:
3 months (219)
Fiscal YTD (283)
1 year (994)
3 years (132)
5 years (479)
10 years (286)
To its credit, CalPERS has been cutting its private equity allocation. CalPERS had a private equity target of 14% in 2012 and 2013; it announced last December it was reducing it from 10% to 8%. Like so many of its peers, CalPERS hoped that private equity would rescue it from its underfunding, which came about both due to the decision to cut funding during the dot com era, when CalPERS was overfunded, and to the damage it incurred during the crisis. At least CalPERS is finally smelling the coffee.
However, even with these appalling results, CalPERS does have another avenue: it could pursue private equity on its own, which would virtually eliminate the estimated 700 basis points (7%) it is paying to private equity fund managers. CalPERS confirmed this estimate by Ludovic Phalippou in its November 2015 private equity workshop. Since at that point it had gathered private equity carry fee data, that means the full fees and costs are at least that high; it would presumably have reported a lower number or flagged the figure as an high plug figure. Getting rid of the fee drag would mean much more return to CalPERS and its retirees, and would make private equity more viable.
CalPERS has two ways it could go. One would be a public markets replication strategy, which would target the sort of companies private equity firms buy. Academics have modeled various implementations of this idea, and they show solid 12-14% returns. However, as we’ve discussed at length, and some pubic pension funds have even admitted, one of the big attractions of private equity is…drumroll…the very way the mangers lie about valuations, particularly in bad equity markets! Private equity managers shamelessly pretend that the value of their companies falls less when stocks are in bear territory, giving the illusion that private equity usefully counters portfolio volatility. Anyone with an operating brain cell knows that absent exceptional cases, levered equities will fall more that less heavily geared ones. So the reporting fallacy of knowing where you really stand makes this idea unappetizing to investors.
The other way to go about it would be to have an in-house team that does private equity investing. A group of Canadian public pension funds has gone this route and not surprisingly, reports markedly better results net of fees than industry norms. And this is becoming more mainstream, as Reuters reported last Friday (hat tip DO):
Some of the world’s biggest sovereign wealth funds are increasingly striking their own private equity deals rather than relying on external fund managers, in a drive to cut costs and gain more control.And to its credit CalPERS is considering joining this trend…after having been deterred from leading it. From a 2016 post:
With some $6.5 trillion in assets, sovereign investors already account for 19 percent of capital committed to private equity, according to data from research firm Preqin.
But mega-funds such as the Abu Dhabi Investment Authority (ADIA), Saudi Arabia’s Public Investment Fund (PIF) and Singapore’s GIC, are hiring specialists to find or vet deals – enabling them to negotiate with private equity firms from a position of strength or to go it alone.
In 2012 sovereign investors participated in just 77 direct private equity deals. By 2016, that had risen to 137, Thomson Reuters data shows. Deal value more than trebled to $45.2 billion from $14.8 billion….
This allows funds to better protect their interests when markets go south. One sovereign investor who spoke on condition of anonymity said that during the global financial crisis, some external funds behaved irrationally.
“They had different liability streams than us, so they were under pressure to sell at a time when they should have been investing more,” the source said. “Going more direct means you don’t have to worry about whether your interests are aligned with other investors’.”
In 1999, CalPERS engaged McKinsey to advise them as to whether they should bring some of their private equity activities in house. My understanding was that some board members thought this issue was worth considering; staff was not so keen (perhaps because they doubted they had the skills to do this work themselves and were put off by the idea of being upstaged by outside, better paid recruits).Better late than never. Let’s hope CalPERS pursues this long-overdue idea.
In hearing this tale told many years later, I was perplexed and a bit disturbed to learn that the former managing partner of McKinsey, Ron Daniel, presented the recommendations to CalPERS of not to go this route. Only a very few directors (as in the tenured class of partner) continue at McKinsey beyond normal retirement age; one was the head of the important American Express relationship at the insistence of Amex. Daniel served as an ambassador for the firm as well as working on his former clients. Why was he dispatched to work on a one-off assignment that was clearly not important to McKinsey from a relationship standpoint, particularly in light of a large conflict of interest: that he was also the head of the Harvard Corporation, which was also a serious investor in private equity?
Although the lack of staff enthusiasm was probably a deal killer in and of itself, the McKinsey “no go” recommendation hinged on two arguments: the state regulatory obstacles (which in fact was not insurmountable; CalPERS could almost certainly get a waiver if it sought one), and the culture gap of putting a private equity unit in a public pension fund. Even though the lack of precedents at the time no doubt made this seem like a serious concern, in fact, McKinsey clients like Citibank and JP Morgan by then had figured out how to have units with very divergent business cultures (investment banking versus commercial banking) live successfully under the same roof. And even at CalPERS now, there is a large gap between the pay levels, autonomy, and status of the investment professionals versus the rank and file that handles mundane but nevertheless important tasks like keeping on top of payments from the many government entities that are part of the CalPERS system, maintaining records for and making payments to CalPERS beneficiaries, and running the back office for the investment activities that CalPERS runs internally.
Why do I wonder whether McKinsey had additional motives for sending someone as prominent as Daniel to argue forcefully (as he apparently did) that CalPERS reject the idea of doing private equity in house? Clearly, if CalPERS went down that path, then as now, the objective would be to reduce the cost of investing in private equity. And it would take funds out of the hand of private equity general partners.
The problem with that is that McKinsey had a large and apparently not disclosed conflict: private equity funds were becoming large sources of fees to the firm. By 2002, private equity firms represented more than half of total McKinsey revenues. CalPERS going into private equity would reduce the general partners’ fees, and over time, McKinsey’s.
In keeping, as we pointed out in 2014, McKinsey acknowledged that the prospects for private equity continuing to deliver outsized returns were dimming. That would seem to make for a strong argument to get private equity firms to lower their fees, and the best leverage would be to bring at least some private equity investing in house, both to reduce costs directly and to provide for more leverage in fee discussions. Yet McKinsey hand-waved unconvincinglyabout ways that limited partners could contend with the more difficult investment environment, and was discouraging about going direct despite the fact that the Canadian pension funds had done so successfully.
Before Ludovic Phalippou, there was a blogger who warned the world of bogus benchmarks in illiquid asset classes and keeps hammering the point that it's all about benchmarks stupid! This blogger even did a short stint on Yves' blog, Naked Capitalism, before leaving to write for another popular blog for a brief while, Zero Hedge (I now post my comments only on my blog and I'm much happier. My advice to bloggers is not to routinely post anywhere else even if they are popular blogs.).
My views on benchmarking illiquid assets have evolved because I realize how hard it is to benchmark these assets properly (never mind what Yves and Phalippou think), but that doesn't mean we shouldn't pay attention to these benchmarks (we most certainly should).
Ok, let me be fair here, Yves' comment above is not ALL nonsense, but there are so many gaps here and the way the information is presented is so blatantly and foolishly biased that a relatively informed reader might read this comment and think CalPERS should just nuke its multi-billion PE program just like it nuked its hedge fund program a couple of years ago.
Knowing what was going on at CalPERS's hedge fund program, I actually agreed with that decision. CalPERS never staffed that team appropriately, they didn't know what they were doing and the program produced very disappointing returns, year in, year out, net of billions in fees they were doling out to their lousy external hedge fund managers.
Private equity at CalPERS was also one HUGE mess prior to the arrival of Réal Desrochers in May 2011 to head that group. Basically, up until then, CalPERS was everyone's private equity cash cow, giving everyone and their mothers an allocation. Their program became one giant PE benchmark for the entire industry.
The problem with that approach is it simply doesn't work, especially in private equity where there is a huge dispersion of returns between top funds and bottom funds and there is evidence of performance persistence (although the evidence is somewhat mixed pre and post-2000).
When Réal Desrochers took over CalPERS PE program, he did what he did at CalSTRS, namely, clean it up, getting rid of underperformers and focusing on having a concentrated portfolio of a few top-performing funds. In others words, allocate more money in fewer and fewer funds, and watch them like a hawk to see if it's worth reinvesting in new funds they raise.
It's fair to say Réal Desrochers and his team inherited one huge private equity mess because they're still cleaning up that portfolio, years after he got in power (that is something Yves neglects to mention).
Still, private equity is an important asset class, one that has delivered excellent returns for CalPERS over the last 20 years, net of fees (click on image):
As far as its benchmark, CalPERS started mulling over a new PE benchmark two years ago and I reviewed the latest publicly available annual PE program review (November, 2015) which states the current policy benchmark of 2/3 FTSE US = 1/3 FTSE ROW (rest of world) + 300 basis points "creates unintended active risk for the Program, as well as for the Total Fund." (click on image):
Now, instead of reading nonsense on Naked Capitalism, take the time to read this attachment on private equity that CalPERS put out in November 2015, it's excellent and discusses performance persistence and the problems benchmarking private equity.
I have long argued that the benchmark should be the S&P 500 + 300 basis points but the truth is the deals are increasingly outside the US and that 300 basis points spread to capture illiquidty and leverage is a bit high and this benchmark does expose the program and the Total Fund to active risk (ie. risk it underperforms its benchmark by a considerable amount) on any given year (not over the long run).
Having said this, when I went over CalPERS fiscal 2016 results back in July, I said they weren't good and that they were smearing lipstick on a pig:
Lastly, and most importantly, let's go over CalPERS's news release, CalPERS Reports Preliminary 2015-16 Fiscal Year Investment Returns:CalPERS latest annual report for 2015-2016 is now available here. I stand by remarks that CalPERS Private Equity program is delivering paltry returns, but the truth is these are treacherous times for private equity and there is gross misalignment of interests going on.
The California Public Employees' Retirement System (CalPERS) today reported a preliminary 0.61 percent net return on investments for the 12-month period that ended June 30, 2016. CalPERS assets at the end of the fiscal year stood at more than $295 billion and today stands at $302 billion.You can read more articles on CalPERS's fiscal 2015-2016 results here. CalPERS's comprehensive annual report for the fiscal year ending June 30, 2015 is not yet available but you can view last year's fiscal year annual report here.
CalPERS achieved the positive net return despite volatile financial markets and challenging global economic conditions. Key to the return was the diversification of the Fund's portfolio, especially CalPERS' fixed income and infrastructure investments.
Fixed Income earned a 9.29 percent return, nearly matching its benchmark. Infrastructure delivered an 8.98 percent return, outperforming its benchmark by 4.02 percentage points, or 402 basis points. A basis point is one one-hundredth of a percentage point.
The CalPERS Private Equity program also bested its benchmark by 253 basis points, earning 1.70 percent.
"Positive performance in a year of turbulent financial markets is an accomplishment that we are proud of," said Ted Eliopoulos, CalPERS Chief Investment Officer. "Over half of our portfolio is in equities, so returns are largely driven by stock markets. But more than anything, the returns show the value of diversification and the importance of sticking to your long-term investment plan, despite outside circumstances."
"This is a challenging time to invest, but we'll continue to focus on our mission of managing the CalPERS investment portfolio in a cost-effective, transparent, and risk-aware manner in order to generate returns for our members and employers," Eliopoulos continued.
For the second year in a row, international markets dampened CalPERS' Global Equity returns. However, the program still managed to outperform its benchmark by 58 basis points, earning negative 3.38 percent. The Real Estate program generated a 7.06 percent return, underperforming its benchmark by 557 basis points. The primary drivers of relative underperformance were the non-core programs, including realized losses on the final disposition of legacy assets in the Opportunistic program.
"It's important to remember that CalPERS is a long-term investor, and our focus is the success and sustainability of our system over multiple generations," said Henry Jones, Chair of CalPERS Investment Committee. "We will continue to examine the portfolio and our asset allocation, and will use the next Asset Liability Management process, starting in early 2017, to ensure that we are best positioned for the future market climate."
Today's announcement includes asset class performance as follows (click on image):
Returns for real estate, private equity and some components of the inflation assets reflect market values through March 31, 2016.
CalPERS 2015-16 Fiscal Year investment performance will be calculated based on audited figures and will be reflected in contribution levels for the State of California and school districts in Fiscal Year 2017-18, and for contracting cities, counties, and special districts in Fiscal Year 2018-19.
The ending value of the CalPERS fund is based on several factors and not investment performance alone. Contributions made to CalPERS from employers and employees, monthly payments made to retirees, and the performance of its investments, among other factors, all influence the ending total value of the Fund.
The Board has taken many steps to sustain the Fund as part of CalPERS' Asset Liability Management Review Cycle (PDF) that takes a holistic and integrated view of our assets and liabilities.
I must admit I don't track US public pension funds as closely as Canadian ones but let me provide you with my insights on CalPERS's fiscal year results:
In a nutshell, those are my thoughts on CalPERS fiscal 2015-16 results. Is CalPERS smearing lipstick on a pig? No, the market gives them and everyone else what the market gives and unless they're willing to take huge risks, they need to prepare for lower returns ahead.
- First, the results aren't that bad given that CalPERS's fiscal year ends at the end of June and global equity markets have been very volatile and weak. Ted Eliopoulos, CalPERS's CIO, is absolutely right: "When 52 percent of your portfolio is achieving a negative 3.4 percent return, that certainly sets the main driver for the overall performance of the fund." In my last comment covering why bcIMC posted slightly negative returns during its fiscal 2016, I said the same thing, when 50% of the portfolio is in global equities which are getting clobbered during the fiscal year, it's impossible to post solid gains (however, stocks did bounce back in Q2).
- Eliopoulos is also right, CalPERS and the entire pension community better prepare for lower returns and a lot more volatility ahead. I've been warning about deflation and how it will roil pensions for a very long time.
- As far as investment assumptions, all US public pensions are delusional. Period. CalPERS and everyone else needs to lower them to a much more realistic level. Forget 8% or 7%, in a deflationary world, you'll be lucky to deliver 5% or 6% annualized gains over the next ten years. CalPERS, the government of California and public sector unions need to all sit down and get real on investment assumptions or face the wrath of a brutal market which will force them to cut their investment assumptions or face insolvency. They should also introduce risk-sharing in their plans so that all stakeholders share the risks of the plan equally and spare California taxpayers the need to bail them out.
- What about hedge funds? Did CalPERS make a huge mistake nuking its hedge fund program two years ago? Absolutely not. That program wasn't run properly and the fees they were doling out for mediocre returns were insane. Besides, the party in hedge funds is over. Most pensions are rightly shifting their attention to infrastructure in order to meet their long dated liabilities.
- As far as portfolio returns, good old bonds and infrastructure saved them, both returning 9% during the fiscal year ending June 30, 2016. In a deflationary world, you better have enough bonds to absorb the shocks along the way. And I will tell you something else, I expect the Healthcare of Ontario Pension Plan and the Ontario Teachers' Pension Plan to deliver solid returns this year because they both understand liability driven investments extremely well and allocate a good chunk into fixed income (HOOPP more than OTPP).
- I wasn't impressed with the returns in CalPERS's Real Estate portfolio or Private Equity portfolio (Note: Returns in these asset classes are as of end of March and will end up being a bit better as equities bounced back in Q2). The former generated a 7.06 percent return, underperforming its benchmark by 557 basis points and suffered relative underperformance in the non-core programs, including realized losses on the final disposition of legacy assets in the Opportunistic program. CalPERS Private Equity program bested its benchmark by 253 basis points, earning 1.70 percent, but that tells me returns in this asset class are very weak and the benchmark they use to evaluate their PE program isn't good (they keep changing it to make it easier to beat it). So I'm a little surprised that CalPERS new CEO Marcie Frost is eyeing to boost private equity.
But CalPERS and its stakeholders also need to get real in terms of investment projections going forward and they better have this conversation sooner rather than later or risk facing the wrath of the bond market (remember, CalPERS is a mature plan with negative cash flows and as interest rates decline, their liabilities skyrocket).
Even Canada's mighty PE investors aren't returning what they used to in this asset class despite having developed much better capabilities to co-invest with their general partners (GPs) in larger transactions to lower overall fees.
Here is something else Yves and her academic friend don't understand about what exactly is going on at Canada's large pensions and large sovereign wealth funds in terms of direct investments in private equity. The bulk of direct investing at Canada's large pensions is in the form of co-investments after they invested billions in comingled funds where they pay 2 & 20 in fees, not in the form of purely direct (independent) private equity investments where they source their deals on their own, invest in a private company and fix up its operations.
I explained the key points on private equity at large Canadian pensions in this comment:
- Private equity is an important asset class, making up on average 12% of the total assets at Canada's large public pensions.
- All of Canada's large public pensions invest in private equity primarily through external funds which they pay big fees to and are then able to gain access to co-investment opportunities where they pay no fees. In order to gain access to these co-investments, Canada's large pensions need to hire professionals with the right skill set to analyze these deals in detail and have quick turnaround time when they are presented with opportunities to co-invest.
- Some of Canada's large public pensions, like Ontario Teachers and OMERS, engage in purely direct (independent) private equity deals where they actually source deals on their own and then try to improve the operational efficiency of that private company. Apart from paying no fees, the added advantage of this approach is that unlike PE funds who try to realize gains in three or four years, pensions have a much longer investment horizon on these investments (ten++ years) and can wait a long time before these companies turn around.
- However, the performance of these type of purely direct (independent) deals is mixed with some successes and plenty of failures. Also, we simply don't have independently verifiable information on how much is truly allocated in independent direct deals versus fund investments and co-investments, and how well these independent direct deals have done over the long run relative to fund investments and co-investments.
- The reality is that despite their long investment horizon, Canada's large public pensions will never be able to compete effectively with the large private equity titans who are way more plugged into the best deals all around the world.
- This is why CPPIB, Canada's largest pension, focuses purely on fund investments and co-investments all around the world in their private equity portfolio. They will never engage in independent direct deals like they do in infrastructure. Their philosophy, and I totally agree with them, is that they simply cannot compete on direct deals with premiere private equity funds and it's not in the best interests of their beneficiaries.
- Under the new leadership of André Bourbonnais, PSP Investments is also moving in this direction, as Guthrie Stewart's private equity team sells any independent direct stakes to focus its attention solely on fund investments and co-investments to reduce overall fees (again, I agree with this approach in private equity).
- CPPIB and PSP will be the world's top private equity investors for a very long time as they both have a lot of money coming in and they will be increasingly allocating to top credit (private debt) and private equity funds that can make profitable long-term private investments all over the world.
- Ontario Teachers, the Caisse, bcIMC, OMERS and other large Canadian pensions will also continue to figure prominently on this list of top global private equity investors for a long time but they will lag CPPIB and PSP because they are more mature pensions with less money coming in. Still, private equity will continue to be an important asset class at these pensions for a long time.
- Real estate is an important asset class to "protect against inflation and it generates solid cash flows" but "cap rates are at historic lows and valuations are very stretched." In this environment, PSP is selling some of their real estate assets (see below, my discussion with Neil Cunningham) but keeping their "trophy assets for the long run because if you sell those, it's highly unlikely you will be able to buy them back."
- Same thing in private equity, they are very disciplined, see more downside risks with private companies so they work closely with top private equity funds (partners) who know how to add operational value, not just financial engineering (loading a company up with debt to then sell assets).
- PSP is increasingly focused on private debt as an asset class, "playing catch-up" to other large Canadian pension funds (like CPPIB where he worked for ten years prior to coming to PSP). André said there will be "a lot of volatility in this space" but he thinks PSP is well positioned to capitalize on it going forward. He gave an example of a $1 billion deal with Apollo to buy home security company ADT last February, a deal that was spearheaded by David Scudellari, Senior Vice President, Principal Debt and Credit Investments at PSP Investments and a key manager based in New York City (see a previous comment of mine on PSP's global expansion). This deal has led to other deals and since then, they have deployed $3.5 billion in private debt already (very quick ramp-up).
- PSP also recently seeded a European credit platform, David Allen‘s AlbaCore Capital, which is just ramping up now. I am glad Miville asked André about these "platforms" in private debt and other asset classes because it was confusing to me. Basically, hiring a bunch of people to travel the world to find deals is "operationally heavy" and not wise. With these platforms, they are not exactly seeding a hedge fund or private equity fund in the traditional sense, they own 100% of the assets in these platforms, negotiate better fees but pump a lot of money in them, allowing these external investment managers to focus 100% of their time on investment performance, not marketing (the more I think about, this is a very smart approach).
- Still, in private equity, PSP invests with top funds and pays hefty fees ("2 and 20 is very costly so you need to choose your partners well"), however, they also do a lot of co-investments (where they pay no fees or marginal fees), lowering the overall fees they pay. André said "private equity is very labor intensive" which is why he's not comfortable with purely direct investments, owning 100% of a company (said "it's too many headaches") and prefers investing in top funds where they also co-invest alongside them on larger transactions to lower overall fees (I totally agree with this approach in private equity for all of Canada's mighty PE investors). But he said to do a lot of co-investments to lower overall fees, you need to hire the right people who monitor external PE funds and can analyze co-investment deals quickly to see if they are worth investing in (sometimes they're not). He gave the example of a $300 million investment with BC Partners which led to $700 million in co-investments, lowering the overall fees (that is fantastic and exactly the right approach).
But there is no question that PSP and other large Canadian pensions still invest a huge chunk of their private equity assets with top funds where they pay big fees in comingled funds to gain access to larger co-investment opportunities.
In fact, at the end of the lunch, Neil Cunningham, PSP's Senior Vice President, Global Head of Real Estate Investments, shared his with me:
On private equity fees, he agreed with André Bourbonnais, PSP doesn't have negotiating power with top PE funds because "let's say they raise a $14 billion fund and we take a $500 million slice and negotiate a 10 basis reduction on fees, that's not 10 basis points on $500 million, that's 10 basis points on $14 billion because everyone has a most favored nation (MFN) clause, so top private equity funds don't negotiate lower fees with any pension or sovereign wealth fund. They can just go to the next fund on their list."Whether you like it or not, in order to invest properly in private equity, and make big returns over any public market benchmark over the long run, you need to pay big fees to the private equity kingpins.
But if you're smart like Canada's large pensions, you will tell them "Ok boys, we're going to invest a lot of money in your PE funds, pay the big fees like everyone else, but you'd better give us great co-investment opportunities to lower our overall fees."
Sounds easy but in order for CalPERS and other large US pensions to pursue this long-overdue idea, they need to get the governance and compensation right at their shops to attract qualified people to analyze co-investment opportunities quickly and diligently. And that isn't easy.
Below, Maria Bartiromo interviews CalPERS CIO Ted Eliopoulos on Fox Business Network's Mornings with Maria. Listen carefully to what he says about what they can and cannot bring in-house.
Comments
Post a Comment