Maybe CalPERS should have stuck to public equities

The California Public Employees’ Retirement System reports in its latest annual performance review that its private equity portfolio has lagged its public-equities-based benchmark over the last 10 years. An analysis of the portfolio by data provider Bison using a proprietary calculation provides clues as to why.

In its annual review, due to be presented at its Dec. 15 board meeting, CalPERS puts its one-year net return for its $31.5 billion program at 20.0 percent, three-year net return at 12.8 percent, five-year return at 18.7 percent and 10-year return at 13.3 percent. All four returns beat the pension fund’s 9 percent return expectations for the asset class built into its asset liability management model, a model used to ensure CalPERS meets its pension liabilities. That in itself is a nice achievement.

Nevertheless, all four returns fall short of the pension fund’s public-equities-based “policy benchmark” for the asset class. The pension fund’s 10-year private equity return falls short of the benchmark by 2.1 percentage points. The benchmark, which CalPERS has raised concerns about and plans to review in 2015, is based on a global index of public equities plus 300 bps, with a one-quarter lag. Over the 20-year period the portfolio narrowly beats the policy benchmark.

And that raises a hard question for the roughly $300 billion pension fund. Is it being adequately compensated for the additional risk of investing in the private equity market? Among the many risk factors: the illiquidity of interests in limited partnerships, the enormous dispersion in manager returns, the heavy use of leverage by buyout shops, the high percentage of failures experienced by venture-backed startups.

Mike Nugent, co-founder and CEO of Bison, a Boston company that made a splash earlier this year by introducing a series of benchmarking tools, this month presented an analysis of the CalPERS private equity portfolio at the Buyouts Texas conference hosted by the publisher of Buyouts. Consistent with the pension’s own review Bison found that the CalPERS private equity portfolio barely beat the public equity markets over a significant period of time. It also went beyond that top-line result to find that, while CalPERS often picks funds that outperform their peers, the pension fund has much more trouble picking funds that outperform their public equity equivalents.

A CalPERS spokesman declined to comment specifically on the Bison findings. But he pointed out that the portfolio remains in the midst of a restructuring and rebalancing designed in part to reduce the number of managers. The annual review similarly notes that the private equity staff will have a “continued emphasis on reducing costs and complexity,” in part through a focus on co-investments.

All told, Bison looked at the performance of 241 buyout, venture capital and related funds backed by CalPERS and spanning vintage years 2000-2012, with data current as of year-end 2013. (It did not look at 90 funds that had either been sold or fully realized.) To compare the performance of a private equity fund or group of funds to the Russell 2000 stock index, Bison used its own “public market equivalent” method to convert the Russell 2000 into a comparable internal rate of return. The method builds off the Kaplan Schoar PME method developed in 2005 by Steven Kaplan, professor at the University of Chicago Booth School of Business, and Antoinette Schoar, professor at the MIT Sloan School of Management. Below are highlights of the Bison analysis:

• CalPERS’ private equity portfolio is one of the largest in the world. The portion of the portfolio analyzed consists of $53.50 billion in commitments, $46.24 billion in draw-downs, $35.26 billion in distributions, $33.03 billion in remaining NAV and a total value created of $68.30 billion.
• The portfolio narrowly beat the Russell 2000 equivalent. The above numbers translate into an IRR of 11.30 percent and investment multiple of 1.48x; the Russell 2000 PMEs are 10.53 percent (using the Bison PME) and 1.47x (using the Kaplan Schoar PME).
• CalPERS does a good job of picking funds. Nearly two-thirds (63 percent) of the funds it backed, by number, fall into the top quartile or second quartile of peers, based on a comparison with the appropriate Bison private equity benchmark. The percentage is the same when analyzed by amount of capital committed to those funds. The pension has had particular success picking credit funds; more than half of the capital CalPERS committed to the strategy went to first-quartile funds.
• More than half of funds backed by CalPERS underperform the Russell 2000. Using the Bison PME, the firm determined that 124 of the funds analyzed underperform the Russell 2000 while just 117 outperform the index. At the same time, 57 percent of the capital committed to those funds underperformed the index. Grouped by vintage year, seven vintage-year fund batches backed by CalPERS underperform the Russell 2000 while six outperform; five of the six outperforming years come before 2006. By investment strategy, buyout funds were the only sub-asset-class where more than half of the money committed by CalPERS went to funds that outperformed the market.
• The Carlyle Group is a fairly representative performer for CalPERS. Of the Carlyle Group-sponsored funds analyzed,10 land in the top quartile based on the appropriate Bison private equity benchmark. That lifted CalPERS’ performance as a fund picker. At the same time, just 14 Carlyle Group funds outperformed their public market equivalent, while 13 underperformed. A source close to Carlyle Group responded by pointing to the firm’s “strong long-term track record” of generating a 26 percent gross IRR (19 percent net IRR) on its “corporate private equity investments” through September 30. The source also pointed to CalPERS’ return data showing that 15 of 23 Carlyle Group funds backed generated a net IRR of at least 10 percent as of March 31, while nine generated a net IRR of at least 15 percent.

CalPERS made headlines earlier this year when it announced plans to shutter its hedge fund portfolio. The Bison analysis raises the question of whether the private equity portfolio will eventually share the same fate.

(Correction: Nine of 23 Carlyle Group funds highlighted in CalPERS return data generated a net IRR of at least 15 percent. The original version of this article said eight.)