Standard Operating Procedure: CalPERS and Private Equity
The private equity portfolio at CalPERS has underperformed its benchmark for just about every reporting period. As expected, their PE portfolio has beaten publicly traded equities by a considerable margin. However, that’s insufficient compensation given the risks of private equity. For example, over the past ten years, CalPERS PE portfolio has returned 13.3% versus 7.6% for a global portfolio of public stocks. However, private equity should have returned 15.4% according to CALPER’s current benchmark. Even the 13.3% figure has to be taken with a grain of salt, because something like half of that return is based on estimates made by the managers of the value of private companies that have yet to be sold.
What’s CalPERS going to do about their poor relative performance? Rather than ask the hard questions about what it might take to drive superior returns from a $31 billion portfolio, they’ve decided to follow the standard institutional recipe. First, they’ve decided to change the benchmark. This action is the equivalent of moving in the fences at a baseball stadium because a team isn’t hitting enough home runs.
Second, they are going to cut down the number of managers in their program in order to be able to do a better job on due diligence monitoring. It’s hard to argue with this statement, except that it isn’t going to do anything to improve performance. CalPERS has 106 direct managers and 306 more through various fund-of-find programs. However, only 20 managers already manage two-thirds of the PE assets. Reducing the number of managers is going to have more of an effect on the managers than CalPERS private equity program. The largest managers who have the capacity to handle large allocations will get even more capital from the California pension. Conversely, small and mid-size PE firms are going to find that CalPERS is less interested in investing in their next offering. At CalPERS huge scale, increased selectivity isn’t going to do anything for performance.
Third, CalPERS has announced that it will be more aggressive about negotiating fees. They claim that management fees have come down in the past year from $476 to $441 million, but this claim isn’t credible. CalPERS doesn’t disclose carried interest payment or other fund expenses, so we’re only seeing a fraction of the PE program’s costs. We also don’t know the amount of fees CalPERS’s managers are charging the underlying portfolio companies. Some of the charges levied against portfolio companies (e.g., monitoring fees) may partially offset management fees, allowing CalPERS to claim that its fees have decreased. However, CalPERS expenses haven’t really fallen; they’re just less transparent. In short, CalPERS will continue to chisel away at fees. However, they don’t seem committed to a wholesale attack on private equity fee practices.
By changing the benchmark, reducing the managers, and talking about fees, CalPERS has deflected attention from the central question: given the risks and illiquidity of private equity, can the asset class meet or exceed a well-constructed benchmark? It will be another 5 to 7 years before CalPERS will have an answer to that question. If they’re still underperforming the newly established benchmark, they’ll simply change the benchmark yet again. Meanwhile, private equity firms will continue to earn hundreds of millions of dollars in fees.