Monday, September 28, 2015

Another Private Equity Blunder in Sacramento: CalSTRS and its Consultant

Another Private Equity Blunder in Sacramento: CalSTRS and its Consultant

After thirty-five years in and around the money management business, I thought I’d seen every possible response to poor investment performance.  Managers and consultants have blamed market conditions, a bit of bad timing, and particular benchmarks.  Naked Capitalism has come through again with a disturbing piece of video showing a well-known consultant advising the second largest public pension plan to ignore its private equity benchmark altogether.[1]  I’ve never seen anyone advise an institutional investor to eliminate a benchmark as a response to poor relative performance.

I’m referring to PCA, a PE consultant, and the California State Teachers’ Retirement System (CalSTRS), which has $184 billion in total assets and $18 billion in private equity exposure.  In the most recent investment meeting at CalSTRS, Mike Moy, the consultant, stated that the pension plan had underperformed its PE benchmark for most reporting periods (see exhibit 1) and then suggested that the asset class shouldn’t be measured against any benchmark.  In the video, he suggests that CalSTRS should only judge private equity’s performance on an absolute return basis.  In other works, Mr. Moy is suggesting that the trustees accept the performance from their PE portfolio so long as they are satisfied that it is helping them meet their financial objective.  Naked Capitalism has meticulously exposed the absurdity of the consultant’s position. 

Exhibit 1

Private equity is a major, mainstream asset class in most institutional portfolios.  Moreover, as the name implies it is simply the ownership of common stock in companies that are not publicly traded.  As a result, the benchmark is straightforward.  Pick a major stock index like the S&P 500 and add a hefty premium (5% to 8%) to reflect the additional risk and illiquidity of PE.  In other words, if large public stocks return 8%, you should expect PE to return 13% to 16% net of all fees over the long term. 

There’s no doubt that the performance of a PE portfolio will vary from the returns of the public markets over short time periods, given the nature of PE accounting and the internal rate of return calculation used to calculate performance.  However, if an institutional investor isn’t getting a big premium over the S&P 500 from its PE portfolio over ten year periods, it’s a sign that something is wrong, and the problem isn’t the benchmark.  Ironically, the problem at CalSTRS is even more dire because their benchmark doesn’t have a big enough premium.  They only require their PE portfolio to exceed the S&P 500 by 3% to 4%.  It’s an expectation that you might be appropriate for small cap public stocks, but not private equity.

I’m not privy to the details of the CalSTRS private equity program, so I can’t tell you why it failed to beat its benchmark.  However, the board ought to be considering one or more of the following causes rather than eliminating the benchmark:

  •       The fees and expenses charged by CalSTRS’s PE managers have consumed too big a portion of the returns.  As best I can tell, CalSTRS’s fee disclosure for PE is among the worst in the country.  The pension’s annual report doesn’t even disclose management fees, let alone carried interest.[2]

  •       CalSTRS picked the wrong group of PE managers.

  •       CalSTRS didn’t properly pace its PE investments and has too big an exposure to certain periods of time when PE performed poorly.  According to CalSTRS’s latest quarterly report on PE, this is certainly part of the story.  CalSTRS invested far too heavily in 2005-2008 (see Exhibit 2).

  •       Its consultant has poorly advised CalSTRS.

Exhibit 2

Taxpayers and beneficiaries ought to be concerned about this state of affairs because CalSTRS has $9.5 billion in additional capital (see Exhibit 3[3]) to invest during a period when PE deals are grossly overpriced (see Exhibit 4).  Not only is CalSTRS likely to underperform its benchmark, it is also likely to produce anemic results based on PCA’s ill-advised absolute return standard.

Exhibit 3
Exhibit 4

A few weeks ago I wrote about CalPERS’s PE program.   Now we have evidence that the operation and performance of CalSTRS’s PE program is also problematic.  America’s two largest public pensions share PCA as their PE consultant.   Both plans ought to be taking a critical look at their PE programs.  Before that can happen they need to find a new private equity consultant.

[3] The unfunded commitment is the difference between the two figures shown in Exhibit 3

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