December 09, 2015
Guest Blog
by Eileen Appelbaum and Rosemary Batt
Co-authors of Private Equity at Work: When Wall Street Manages Main Street
The usually perceptive Deal Professor, Steven Davidoff Solomon has swallowed CalPERS’ staff’s spin on the more than $3.4 billion the California public employees’ pension fund has paid to private equity firms in performance fees (so-called carried interest) hook, line, and sinker. In Private Equity Fees Are Sky-High, Yes, but Look at Those Returns, Davidoff Solomon accepts uncritically CalPERS report of its return on its risky PE investments — a report that the industry publication, Private Equity International in its November 27 Friday Letter, labeled a private equity public relations coup. Those high fees are worth it in Davidoff Solomon’s view because of CalPERS stellar private equity returns. If only!
Davidoff Solomon failed to note that CalPERS’ staff did not provide information in this report on the risk-adjusted return to its risky private equity investments. The staff provided misleading information because its risk-adjusted PE returns were awful: CalPERS investments in private equity have underperformed its risk-adjusted benchmark over the last 10 years and in 3-year and 5-year sub-periods. The staff no doubt expected to pull the wool over the eyes of public sector workers and taxpayers in California, but has surely succeeded beyond its wildest dreams with this endorsement in The New York Times by someone who should know better. Indeed, over the last 10 years, the pension fund’s PE investments underperformed it stock market benchmark by about 300 basis points. In layman’s language, this means CalPERS would have had exactly the same return over this period if it had invested in the stock market index it uses in its benchmark. Actually, CalPERS would have had a much higher return from investing in this stock market index because it could have invested the $3.4 billion of its members’ retirement savings that it paid PE firms in performance fees. It’s amazing that these ginormous performance bonuses were paid to PE firms for delivering results that did not beat the stock market over 10 years and certainly did not provide a return high enough to compensate the pension fund for the greater risk and lack of liquidity present in PE investments.
This brings us to the second place where Davidoff Solomon is taken in by the CalPERS staff. In the report the CalPERS staff compares the pension fund’s private equity returns with the dismal returns from its own stock market investments. Here’s the rub: CalPERS would have done much better and had much higher stock market returns by investing in the stock market index it uses in its benchmark. That the poor performance of its own stock market investments makes its investments in private equity look good should not fool anyone.
As University of Chicago professor Steven Kaplan and colleagues show in a recent paper, private equity returns are declining. Unable to beat its PE benchmark for the past 10 years, CalPERS’ staff now proposes to do away with the benchmark all together and no longer risk-adjust its private equity returns. It will ask the CalPERS board to vote on that proposal this Monday, December 14. That may be good news for the PE firms that will continue to collect performance bonuses while providing returns that are not high enough to justify the risk involved in such investments. But it’s bad news for California taxpayers and California workers and retirees that depend on CalPERS to invest their retirement savings wisely.
Addendum (back to Dean)
In response to the questions raised by ltr, here are the absolute returns and the returns relative to the CalPERS benchmark.
Net Return (Absolute Return)
|
Private Equity |
FYTD |
3-YR |
5-YR |
10-YR |
20-YR |
|
As of 6-30-15 |
8.9% |
14.1% |
14.4% |
11.9% |
12.3% |
|
As of 8-31-15 |
3.1% |
15.2% |
14.9% |
12.0% |
12.5% |
Return relative to benchmark
|
Private Equity |
FYTD |
3-YR |
5-YR |
10-YR |
20-YR |
|
As of 6-30-15 |
-2.21% |
-2.64% |
-0.61% |
-3.00% |
0.93% |
|
As of 8-31-15 |
0.04% |
-6.13% |
-2.08% |
-2.80% |
1.20% |
The benchmark is an index that is weighted by 2/3rds for the total U.S. stock index and 1/3rd a total world stock index, plus 3.0 percentage points. As I understand the second table, the -6.13 percent in the bottom means CalPERS PE funds have underperformed the benchmark stock indexes by an average 3.13 percentage points over the last three years, before any risk adjustment. For the last ten years they have on average slightly out-performed these indexes (a difference of 0.2 percentage points) before any risk adjustment.
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