The long-standing myth of super-duper private equity returns is meeting the cold ugly reality of unfinessable lousy returns. That’s what happens when an industry dependent on long term falling interest rates and then protracted near zero policy rates regime meets up with central banks increasing interest rates and inclined to normalize them well above their former “almost free money” levels.
And a very bad and very consequential hangover has started. David Sirota gives a fine overview. I strongly urge you to read his piece in full. Here is the money section:
As public officials across America prepare to funnel even more of government workers’ savings to private equity moguls, an alarm just sounded for anyone bothering to listen. It is a warning that Wall Street executives want you to ignore as they skim fees off retirement nest-eggs – but the longer the warning goes unheeded, the bigger the financial time bomb may be for workers, retirees, and the governments that pay them.
Earlier this month, Pitchbook — the premiere news outlet for the private equity industry — declared that “private equity returns are a major threat to pension plans’ ability to pay retirees in 2023.”…
Signs of a doomsday scenario are already evident: Some of the world’s largest private equity firms have been reporting big declines in earnings, and federal regulators are reportedly intensifying their scrutiny of the industry’s writedowns of asset valuations. Meanwhile, one investment bank reported that in its 2021 transactions, private equity assets sold for just 86 percent of their stated value last year.
Let’s stop there. That is a stunning development given that private equity, on average, accounts for 11% of public pension fund investments. But it is even worse since public pension funds and the hired guns that are supposed to steer them to make prudent decisions have been all in for private equity when it has long been known that it’s not what it’s cracked to be.
Your humble blogger, relying on the work of independent academics and experts like Eileen Appelbaum, Rosemary Batt, Ludovic Phalippou, and Richard Ennis, has been reporting for nearly a decade that private equity wasn’t generating enough in returns to justify its extra risks. In more recent years, the data showed private equity wasn’t even outperforming the stock market. That is because, to the extent private equity did outperform on a gross basis, the fund managers hoovered that out via fees and expenses that add up to a staggering 7% or so per year.
Private equity barons were warning, starting in 2016, that returns in the future would be lower than in past. They were accordingly trying to find new chumps, as in retail investors, the money kept pouring in from investors who were desperate for high returns. The most desperate have also been the most clueless, namely public pension funds. They have long believed that private equity would rescue them from the underfunding resulting from not being willing to put enough aside to cover retirement obligations on a current basis.
So why has the private equity fandom persisted? First is it takes a long time, often over a decade, to know how much a fund delivered, but by then, bizarrely, no one is much interested. The focus is on the early returns. Second, private equity bribes public pension and other investor staff by holding lavish annual meetings at tony destinations with great food and wine and routinely, top drawer entertainment. Oh, except those expenses are paid by the fund, not the fund manager….meaning the public pensioners.
Third, private equity funds generate a lot of analytical busywork which is highly profitable for various consultants. How much could advisers charge for telling public pension funds like CalPERS to invest in five Vanguard funds (or CalPERS in-house analogues) and be done? Yet a five-fund approach outperforms 90% of all public pension funds.
So back to the looming train wreck. Sirota focuses on one element, discussed in Pitchbook, of losses from 2022, which are reported on a lagged basis, showing up in 20231, as well as a second that we have discussed for many years: valuation chicanery. Private equity funds get to do their own valuations, with the justification being it would be too costly to have independent parties do it. Ahem, so if it’s too expensive to give investors proper accounting for returns, why is it considered to be prudent for fiduciaries to invest in private equity?
In fact, it’s widely acknowledged that private equity firms engage in various forms of valuation chicanery, yet it’s somehow waved away by private equity investors and their enablers in academia because private equity supposedly can’t get away with all that much, since the companies in the portfolio do get sold.
But this is hogwash. No where else in investment land is admitted falsification of valuations seen as acceptable. For instance, a 2014 study found that private equity firms inflate their valuations right before launching new funds, typically 4 years after they had their last major fundraising. The rationalization is that this fudging is harmless because the fund managers back out the air in their “marks” later.
But this practice is harmful. Goosed up returns early in a fund’s life have a disproportionate impact on then reported returns. This impact is magnified by the widespread use of a misleading return metric, internal rate of return. So investors think they are doing better than they are, which leads them among other thing to allocate more to private equity than is warranted.
It also leads them to allocate money to not necessarily deserving funds. One former private equity manager said that one of his firm’s flagship funds reported a 77% return at year 4 because they sold one deal for a monster profit. That fund’s final return was 11%. Even more disconcerting, this executive said no investor noticed.
But a second reason for public pension fund woes, not mentioned in the Sirota article, is the actual cash flows. As has been discussed at CalPERS and presumably other public pension funds, private equity had been producing more “cash out” (sales and special dividends) than “cash in” (capital calls). That reversed at CalPERS, if I recall correctly, in 2020 or 2021. CalPERS is so large that it is effectively a private equity indexer, so it’s likely that the same pattern is holding at many other private equity stalwarts.
In general, the lack of liquidity is a huge wart for private equity that is seldom acknowledged. As we wrote in 2014:
Readers might wonder why private equity relies so heavily upon the deep pockets of state entities for its funding. The reason is basic: governments are among the very few investors that can accept the uncertainty about both when a fund may demand capital contributions or when they will give back the money.
Private equity funds are highly distinctive in their design. First, they are almost always “blind pools”, which means that at the time when you commit as an investor, you have no idea what the fund will end up owning.
Second, when a given round of fund raising has been completed (in industry parlance, at the “closing”), you generally do not hand over the full amount of money that was agreed upon. Instead, you make a contractual “commitment” to send in portions of that amount whenever the PE fund “calls” for it.
Third, the investment manager will give your money back (together with your share of the profits, if any) when it suits him – there is no specified schedule. While the PE investors typically start to receive meaningful “distributions” of capital starting around year four or five, and most of the money will typically be given back within eight or nine years after the investor commitment was made, it’s not at all uncommon for some distributions to be made a dozen years or more after the closing…
In addition, the PE funds need to be sure that investors will be good for the money when they call for it. That restricts which investors the funds will welcome. For the fund, the best possible investors are extremely credit-worthy, supremely liquid institutions – and so governments often fit the bill.
Public pension funds have long been the biggest single source of private equity funds, at about 30% of the total. That meant they were playing the mugs’ game described by Lenin, of buying the rope that would be used to hang them. Private equity firms engage in large scale cost cutting and headcount reduction, to the degree that they often bankrupt companies. Those wage reductions lower state and local government tax receipts, putting pressure of budgets and making government pensions seem like a costly, unjustifiable luxury, particularly when public pensions are the last bastion of “defined benefit” pensions, as in ones that pay a fixed dollar amount to retirees every year.
So the actions of private equity firms are damaging the communities that fund public employees salaries and their pensions. The worsening of job security and employment terms is increasing resentment towards government workers, whose bet on what looked like lower upside but lower risk positions paid off. Private equity firms often engage in union busting and oppose pro-union laws. So if and when public pensions funds get in trouble, don’t expect a lot of sympathy from voters who will be asked to bail them out.
Yet Sirota also describes how the considerable majority of government investors in private equity remain enthusiastic, and are on the whole increasing their investments. However, in a possible harbinger of things to come, a few are breaking ranks. For instance:
And following a pension corruption scandal in Pennsylvania — whose state government oversees nearly $100 billion in pension money — there’s a potential financial earthquake: During his first week in office, Gov. Josh Shapiro (D) promised to reprise his move as a county executive and push to shift pensioners’ money out of the hands of Wall Street firms, which raked in more than $1.7 billion in fees in a single year from one of the state’s pension funds.
In perhaps the harshest language ever uttered on the topic by any governor, Shapiro told his state’s largest newspaper: “We need to get rid of these risky investments. We need to move away from relying on Wall Street money managers.”
Shapiro could face opposition not only from private equity moguls and their lobbyists — but also from the pension boards’ union-affiliated trustees. As the Philadelphia Inquirer reported: “Union members [on the boards] have mostly favored the old strategy of private investments, even when challenged by governors’ reps and the last couple of state treasurers.”
When investment returns were somewhat better, that unholy alliance between some unions and Wall Street firms flew under the radar, even as pension funds were ravaged by fees. Same thing for pension funds’ overall investment strategy that has been sending more and more retiree’ savings to private equity firms.
At CalPERS, we’ve chronicled how unions went into overdrive, first with JJ Jelincic, later with Margaret Brown, to prevent their re-elections to the CalPERS board. They spent what is a staggering amount of money for these private elections, over $400,000, to prevent one board member out of thirteen asking basic questions about private equity. The desperation to preserve a united front is telling. One prominent CalPERS retiree, based on the huge differential in fees paid by CalPERS compared to its nearly as large California sister CalSTRS, that some of the private equity money is a laundromat for political donations. While no one has produced a smoking gun, this idea would explain a lot of otherwise destructive behavior.
1 This lagged reporting is one of many practices that no finance professional should tolerate, yet is pervasive in public pension land. To illustrate: public pension returns as of June 30, 2022 will show marked to market values of liquid assets….but March 31, 2022 private equity valuations. Rather than use an estimate and update in when the final results are ready, false precision is prized over substance. This bogus approach has produced another unwarranted bennie for private equity, namely the appearance that private equity helped provide diversification because its returns allegedly did not correlate strongly with public equity. But when you correct for the lag, the correlation is actually tight.