Wrong Way CalPERS Increased Private Equity Allocation by Over 50% as Investors Are Dumping Holdings

Wrong Way CalPERS Increased Private Equity Allocation by Over 50% as Investors Are Dumping Holdings 1

CalPERS is so reliably bad at market timing that the giant fund serves as a counter indicators. Last fall, CalPERS increased its allocation to private equity from 8% of its total portfolio to 13%, which is an increase of over 50%. This is after this humble blog, regularly citing top independent experts, pointed out that the investment raison d’etre for private equity had vanished in the 2006-2008 time frame, not once, but many many times as various studies kept confirming that finding. Not only did private equity no longer earn enough to compensate for its much higher risks (leverage and illiquidity) but it was no longer beating straight up large cap equities.

Now there is a way out of this conundrum: to bring private equity in house. Private equity fees and costs are so egregious (an estimated 7% per annum) that even a bit of underperformance relative to private equity indexes will be more than offset by greatly lower fees. A simpler option would be public market replication of private equity.

But the dogged way funds like CalPERS stick to private equity points to rank corruption, of the sort that landed CalPERS former CEO Fred Buenrostro in Federal prison for four and a half years.

CalPERS’ desperation to throw more money at private equity looks even more suspect in light of the rush for the exits reported in the Financial Times yesterday. Note that this article presupposed a bit of knowledge that most investment professional would have: it’s very usual to try to sell a holding in a private equity fund. There is a secondary market but it’s thin. Investors in private equity are supposedly making a long-term commitment and understand that they get their dough back only as the fund manager sells the companies that the fund acquired. Most of the money comes back by year 8 to 10, but there are often dogs so that the fund may remain open with a zombie investments or two well beyond the theoretical ten year time frame. But those leavings are usually small relative to the total value of the fund.

The other aspect that the pink paper may assume that its readers understand is that private equity has been the belle of the ball for over 30 years. Its only period of disfavor was after the late 1980s-early 1990s LBO crash, which was spared the press it deserved thanks to the much more attention-getting S&L crisis. So for investors to be running away, when before their big fear was whether they could get into “hot” funds, is a remarkable turn of events.

From the Financial Times, in Investors sell stakes in buyout funds at a record pace:

Investors are selling stakes in private equity and venture capital funds this year at the fastest pace on record, as the downturn in equities spreads to the private markets that boomed during the era of low interest rates.

Pension and sovereign wealth funds were among those that sold $33bn worth of stakes in private funds in the first six months of the year, up from $19bn in the same period in 2021, according to Jefferies, typically selling them below their face value.

The sell-off follows a decade of surging allocations to private markets…

Pension funds say the move to ditch stakes has been partly triggered by the steep decline in stock markets, leaving their overall portfolios too exposed to buyout funds and other private investments whose value has not been marked down in the same way.

Let’s stop here for a second. We’ve repeatedly pointed out, and have provided quotes from private equity investors that provide corroboration, that one of the perceived benefits of private equity is that the funds lie about their values in lousy markets. As levered equity, private equity values should fall further than those in public equity. But private equity fund managers maintain their marks as well above public equity levels. Everyone knows it’s a fraud on the investors. But the limited partners love it because it makes their performance in crappy markets look less bad than it is.

So what the Financial Times is saying is that the decline in public equities versus private equity pretend valuations is so marked that some look over-allocated to private equity. One way to deal with that is not allocate new money to private equity. But if the disparity is too great, it could argue for selling down private equity.

Another problem is cash flow management. Private equity funds do not take investor money at closing. Instead, investors get “capital calls” to pony up part of their commitment to the fund so the fund manager can buy a company. These capital calls require the dough to be sent as specified in the offering memorandum, usually in five to ten days. The consequences of missing a capital call are draconian. The fund manager can seize all the investments made so far and distribute them to the other limited partners.

In the financial crisis, CalPERS had too little cash on hand to meet private equity capital calls. It wound up dumping stocks at distressed prices to satisfy the private equity demands. So the risk outlined below is real. Again from the Financial Times:

At the same time, pension funds that had committed money to buyout firms have had to actually stump up the cash far more quickly than expected over the past two years because of the frenzy of dealmaking.

That has sparked fears of a funding squeeze, according to a senior executive at an endowment fund that invests in private equity, as some pension funds worry they may not have enough cash on hand to meet future capital calls from the buyout funds they have committed to.

The pink paper said the average price for the early exit of buying funds in first half 2022 was 86 cents on the dollar for buyout funds, and 71 cents for venture.

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