Pension Funds Taking Aim at Private Equity?

Heather Perlberg, Sabrina Willmer, and John Gittelsohn of Bloomberg report, Buyout Firms’ Profit-Goosing Scheme Spurs Backlash From Clients:
Pension funds are taking aim at private equity firms for exploiting a financial sleight of hand that can make even mediocre investments look brilliant.

Discontent has been simmering for a couple of years, but now the California Public Employees’ Retirement System and others are more forcefully pressing their case. The dispute centers on a common -- and legal -- practice: To make an investment, private equity funds are increasingly borrowing against clients’ commitments, then asking for the cash later.

This strategy packs a powerful, if obscure, punch: goosing the reported return on investment. How? It shortens the time that a customer’s actual money is deployed. That changes the math that private equity firms use to calculate their results. Consultant Cambridge Associates figures the approach can inflate a fund’s return by as much as 3 percentage points a year.

Private equity firms say the retirement pools benefit from holding onto their cash longer. They are “pursuing this in droves, like a Black Friday shopping mob,” Andrea Auerbach, head of global private investments research at Cambridge Associates, wrote in a blog post last month.

Earlier: Buyout Firms Are Magically -- and Legally -- Pumping Up Returns

In contracts over the last year, Calpers, the largest U.S. public pension fund, has tried, so far without success, to eliminate these kinds of loans, known as subscription credit lines, according to people briefed on its concerns who requested anonymity to discuss private conversations. At Calpers, private equity funds reported an average 12.1 percent annual return over the past five years, the most of any major asset class in the fund, which manages about $350 billion on behalf of 1.9 million public employees, retirees and their families.

APG Group NV, which manages 469 billion euros ($548 billion) on behalf of government and education employees in the Netherlands, is opposed to the growing and what it considers excessive use of the loans by private equity firms, according to people with knowledge of its concerns. Low interest rates are encouraging more private equity firms to borrow aggressively and extend the terms of the loans, these people said.

Some of the biggest private-equity firms, including Apollo Global Management LLC, Ares Management LP, Carlyle Group LP and KKR & Co., have disclosed in securities filings that they use these credit lines, without indicating their precise impact on investment performance. Ares and KKR said their reported returns would generally have been lower without the loans, though they didn’t say by how much.

“KKR provides very specific and detailed information on the use of credit facilities and what the IRR is -- both with and without them -- in our quarterly transparency reports to fund investors,” said spokeswoman Kristi Huller.

Apollo and Carlyle declined to comment, and others either didn’t respond or referred to their filings.

TPG, co-founded by billionaires David Bonderman and Jim Coulter, appears to have been among the most transparent. By using a credit line, TPG was able to boost the “net internal rate of return” on its 2015 buyout fund to 22 percent from 15 percent, as of the end of last year, according to a March fund document viewed by Bloomberg News. TPG declined to comment.

Tough Comparisons

Juicing returns with borrowed money makes it harder for pension funds and other institutions to compare the actual investment skills of private equity funds, according to Oliver Gottschalg, an associate professor at French business school HEC Paris.

“You can have a situation where even after 10 years, a fund is reporting an overstated level of returns,” Gottschalg said. “In more than 15 percent of cases, this could put them into a different performance quartile.”

For their part, private equity groups say such borrowing is merely a short-term tool that helps firms invest money between so-called “capital calls,’’ when institutional investors are required to follow up their commitments with cash. By using credit lines, firms can react quickly and invest in new deals, providing a “win-win” for both institutional investors and the private equity firms, says Jason Mulvihill, general counsel of the American Investment Council, a Washington group that represents private equity firms.

Some customers, such as Karl Polen, chief investment officer of Arizona State Retirement System, agree. He calls the loans an efficient way to manage cash, as long as they’re repaid every three to six months and aren’t used simply to increase returns. The Wyoming Retirement System sees the credit lines as mostly beneficial as well, and appreciates the way they can minimize multiple calls for capital, said a person familiar with the pension.

‘Bad Rap’

“They are getting a bit of a bad rap,” said Zachary Barnett, a partner at law firm Mayer Brown who represents banks that make loans to private equity funds. “Investors are only on the hook for the money they already promised the fund, which would be the case with or without a credit facility.”

Representatives from Wyoming and APG declined to comment. Calpers spokeswoman Megan White declined to comment beyond saying the pension giant backs guidelines from the Institutional Limited Partners Association, which represents private equity fund customers, that call for limited use of borrowing and enhanced disclosure.

Still, even some within the private equity world acknowledge their own risk in investing with borrowed money. What happens if the customer can’t actually come up with the cash later? Oaktree Capital Group LLC, one of the largest alternative asset managers, is developing guidelines it expects to help mitigate those risks, which could arise during a financial crisis.

Hidden Risk

“It’s mostly during crises that weaknesses are exposed,” Howard Marks, co-chairman of Oaktree, wrote last year in a memo to clients.

For now, it’s unclear whether the pension funds will be able to change this practice. Private equity firms, which took in a record $453 billion last year, are being flooded with money and can basically dictate their terms. Customers are then forced to make decisions with incomplete information on a fund’s performance, said Jennifer Choi, managing director of industry affairs for the private-equity customer group.

Private equity funds “are telling you what the terms of trade are to participate,” Ashby Monk, a researcher on pension and sovereign wealth fund design at Stanford University’s Global Projects Center, told the Calpers board in Sacramento last month. “They are using scarcity. They’re using side letters. They’re using more tricks than I could probably fit into a 20-minute conversation.”
Private equity funds have many tricks to juice their returns, and some of them aren't very kosher. Go back to read one of my most popular comments, Private equity's misalignment of interests, where an industry insider discussed some of these tricks which also cause a misalignment of interests.

In this case, however, using credit lines doesn't just benefit private equity funds. Indeed, pensions pay fees on committed not called capital, so they're subjected to a drag from fees in the early stages of a fund, ie. the so-called J-curve effect.

So, there is an argument to be made that pensions benefit from holding on to their cash longer hopefully earning returns somewhere in liquid stocks or bonds.

Something nobody seems to understand is one of the biggest reasons pensions invest in private equity is leverage. Hence the name leveraged buyout firms. Private equity firms load up portfolio companies with debt and then extract a pound of flesh from them. It’s all part of PE's asset stripping boom.

Here, they're adding another layer of leverage, using low rates to borrow to invest in companies, allowing them to tie less capital up.

But unlike traditional buyout leverage, here they're doing exactly what Canada's mighty pensions are doing, cranking up the leverage to goose up their returns.

It all works well until there is a crisis, at which point leverage works against you. This is what Howard Marks warns of above.

But if done properly and not abused, this is a great way to juice up returns in a low-rate environment.

And the returns are spectacular. TPG added 700 basis points to its net IRR in its 2015 buyout fund using these credit lines. So why not? They benefit, their clients benefit, everyone goes home happy.

One thing, however, when evaluating the performance of any investment fund, you need to take leverage into account and adjust the spread in the benchmark used to evaluate private equity returns.

CalPERS argued to lower its PE benchmark but if all its private equity funds are using this trick to juice returns, it makes the case for adjusting the PE benchmark lower much harder (but I still think they need to adjust it lower).

Below, as a follow up to my recent comment on CalPERS gearing up CalPERS direct,  watch part 1, 2 and 3 of the June Investment Committee. Take the time to watch these clips, very interesting.