On November 24, CalPERS, the California public employee pension fund, released the long awaited figures on the amounts it has paid private equity firms in performance fees — so-called carried interest. For years, the pension fund failed to ask for or report these fees. This changed recently under pressure from unions, media and the tax-paying public which were highly critical of CalPERS claim that it could not track and did not know how much these fees cost it. As widely anticipated, the number is ginormous. Over the 25 years since 1990, CalPERS has paid $3.4 billion in carried interest to the PE firms in whose funds it has invested. In the last year, CalPERS paid $700 million in these performance fees. At this rate, it will pay private equity $17.5 billion in performance fees over the next 25 years, more than 5 times what it paid in the last 25.
As Dan Primack notes, the carried interest CalPERS reported is only for active funds. Most of the funds in which CalPERS invested more than 10 years ago have come to the end of their life span and been liquidated. Carried interest paid to private equity firms on investments in these funds is not included in the just released numbers. PE firms typically do not collect performance fees until they have repaid the principal to investors in their funds. In the early years of recent funds, this will artificially reduce the amount of carry that will ultimately be paid. Thus, the numbers released by CalPERS are an understatement of the true amounts of carried interest the pension fund paid.
$3.4 billion in carried interest paid out of tax-payer funded retiree savings is a very large number that needs to be evaluated in terms of the performance of CalPERS private equity investments. The question is whether CalPERS private equity returns justify such large performance fees. The answer, unfortunately, is no; and CalPERS staff chose not to include in the report on carried interest the data showing the mediocre performance of the pension fund’s PE investments over the last decade.
CalPERS November board meeting focused on the performance of its PE investments. In its presentation, the CalPERS staff noted the importance, in the case of risky and challenging investments, of a benchmark against which to judge performance. As the CalPERS staff materials pointed out at this meeting, it’s important to determine the appropriate benchmark. According to the staff materials, "PE should generate a premium over long term equity returns to compensate for the challenges. Public market index plus a spread reflects the opportunity cost over the long term."
The benchmark CalPERS has selected is comprised of:
2/3rds of the FTSE U.S. Total Market Index +
1/3rd of the FTSE All World Total Market Index (ex US) +
300 basis points (outperformance of 3% a year)
CalPERS private equity investments have failed to beat this benchmark in 3-year, 5-year, and 10-year time frames (see figure).
In the 10-year time frame, PE investments underperformed the bench mark by about 3 percent. This means that CalPERS could have gotten the same return over the past 10 years by investing in a stock market portfolio that mimicked the stocks in its benchmark indexes without the illiquidity or challenges of investing in private equity funds. Performance returns in shorter time periods are quite volatile, but appear to be mediocre.
CalPERS did beat its benchmark over a 20-year time frame, but that is largely due to the performance of private equity funds in the 1996 to 2005 decade. The median PE fund beat the stock market in that time period. But the median PE fund launched in every year since 2005 has failed to beat the market.
CalPERS staff failed to include this information on PE fund performance in their release of the performance fees the pension fund paid, but they do report numbers that make their PE investments look good. CalPERS reports the absolute returns of its PE investments and then compares this to its target return for the pension fund and to its returns on other asset classes in which it is invested. These numbers are largely irrelevant as measures of private equity performance. Absolute returns make no adjustment for risk and are not appropriate for measuring the performance of risky investments. As we noted, CalPERS staff itself has pointed out the importance of having a benchmark.
That the absolute returns for private equity investments are higher than the target return for the fund is to be expected. Private equity is a high risk asset class and should yield a higher absolute return than the target for the overall fund which includes investments in fixed income assets (e.g., Treasury and corporate bonds) and liquid assets (e.g., money market funds), both of which provide greater safety for the pension fund but lower returns. Comparing the absolute return on its private equity investments with the return on its own portfolio of stock market investments is also misleading; CalPERS own stock portfolio underperformed the broad stock market. It appears that CalPERS may have overinvested in large cap and foreign stocks. CalPERS would have had higher returns if its stock market portfolio had mimicked the stock market indexes in its private equity benchmark.
Speaking at the November board meeting, Harvard professor and private equity guru Josh Lerner told the board that unless CalPERS invested in top quartile funds (funds whose performance placed them in the top 25% of PE funds), it probably wasn’t worth investing in PE. Top quartile funds do beat the stock market by the 3 to 4 percent that makes these investments worth tying up funds for 10 years. The problem for CalPERS is that fund performance is a crap shoot. Since 2000, a PE firm with a top performing fund has a nearly 50 percent probability that its next fund will perform below the median and only a 22 percent chance that its next fund will be a top performer. A PE firm with a fund in the bottom quartile has a 21 percent chance that its next fund will be top quartile. A PE firm’s track record, which prior to 2000 could be used to predict the performance of follow-on funds, no longer tells you which new funds are likely to be top performers.
Reporting by the CalPERS staff obscures the performance of the pension fund’s investments in private equity and does not inspire confidence in the staff’s ability to manage this challenging asset class. High and rising performance fees paid to PE firms for mediocre private equity performance suggest that, as was the case with CalPERS hedge fund investments, private equity is not an asset class in which the pension fund should be investing the retirement savings of California’s public sector workers.