The Wall Street Journal had an important article over the weekend on how private equity has become and is set to remain a money pit, at least as long as interest rates remain high.
Government pension funds and other investors have rightly paid, double pronto, when they receive large calls from private equity partners; otherwise these so-called limited partners face the liquidation of all the funds they have invested so far.
But in a typical “I win heads, you lose tails” private equity arrangement, private equity owners face penalties for refusing to sell companies in their fund portfolios because the offer prices won’t be very good. One major reason for wanting to avoid that type of recognition event is that it would question the values of many, if not all, of the other companies in their portfolio. Remember that private equity is the only investment strategy where the fund manager can set the value of his assets, and then every quarter; all others require independent measurements, usually monthly if not daily.
We’ve written before about how private equity funds sometimes don’t sell their tail funds and we haven’t found good explanations when the prices aren’t that great. Even if there was a big loss in the last bits, investors have long moved on to new funds and will not worry about some form of underwriting, especially since the calculation of IRR (a misleading but popular metric) will reduce the impact. For example, of CalPERS’ 357 funds, 19 are from 2004 harvest years or earlier.
But recall pension funds in particular have limited payment plans to meet. In the stone ages, they used to buy bonds and match maturities with expected obligations. However, the Department of Labor in 1976 changed its definition of what the prudent man rule meant, allowing funds to look at risk in a portfolio instead of investing in investments. This review was a direct result of corporate fundraising.
Then in the early 1990s, Christine Todd Whitman began undercutting New Jersey’s pension fund by making unreasonably low current contributions. This took the growing trend of expecting Mr. Market made a less than full contribution to the high areas.
To summarize many gaps, in a crisis, a period of very low interest rates, many pensions saw their funding deteriorate as market returns generally fell. They are piling into what appears to be the highest return option, private equity. But as academic studies increasingly show, since 2006 if not before, limited private equity was not the best performing stock. However the rule of thumb was that private equity needed to exceed equity by 300 basis points (3%) to compensate for its biggest risk: illiquidity and leverage. Compliance advisors have helped public pension funds like CalPERS change their benchmarks, including lowering risk premiums, to make investing in private stocks look more attractive.
And now the risk of illiquidity bites in a big way. Pension funds are scrambling to prepare for the distributions they were expected to receive from maturing private equity funds but they are not happening. That often includes, as the Journal explains, borrowing, such as paying interest to get cash to meet obligations. Although the article doesn’t say so, it’s a safe bet that these interest costs aren’t earned relative to private equity returns, even though the lack of private equity is the cause of the need for capital. Another key way to deal with cash shortages is to sell private equity
From the Journal of Accumulated Pensions in Private Equity. Now They Can’t Get Out:
Private equity and pension funds seem like a match made in heaven…
Now the honeymoon is over. The payments have dried up, creating a costly problem for investment managers who oversee the savings of retired workers at large corporations and state and city governments.
To keep the paychecks coming in on time, those managers are pulling out of cheap investments or turning to borrowing—expensive moves that eat into returns. California Public Works Pension, the nation’s largest, will pay out more in its private equity portfolio than it earns in those investments for the eighth consecutive year. Engine maker Cummins lost 4.4% in UK earnings last year, in large part because it was selling private equity at a discount.
The journal explains that public pension funds have on average 14% of their assets invested in private equity and private pensions, about 13%. The chart shows how that percentage has grown exponentially since 2000.
Notably, the Journal points out that financial moderation can, erm, allow:
But as private equity has grown, its lead over traditional stocks has narrowed. And during the decade before the investment pays off, it can be difficult to trust the short-term estimates given by managers looking for money.
The article describes private equity funds as expected to return money after ten years. While that is technically correct, it is slightly misleading. Typically, funds spend the first five years investing and the next five selling their assets. If they get a hot deal early, they are likely to cash out in year 3. So, on average, investors’ funds are left for five years.
Back to Journal:
About half of private investors surveyed by investment firm Coller Capital earlier this year said they had money tied up in so-called zombie funds—private funds that didn’t pay out when expected, leaving investors confused.
So, pension funds sell second-hand private equity funds—often with good financial results. Buyers of the secondary market last year paid an average of 85% of the value of the goods allocated three to six months before the sale, according to Jefferies Financial Group. Hand sales by private investors rose 7% to $60 billion last year….
Some pension funds borrow to get cash. Both Calpers and the $333 billion pension that serves California teachers have approved plans to take out loans equal to 5% and 10% of their holdings, respectively.
Alaska Permanent Fund Corp. got cash from a different kind of borrowing: private equity managers who make payments not from investment profits but from debt they’ve taken on to appease cash-starved pensioners and other investors. That worries chief investment officer Marcus Frampton. He estimated that his fund, which invests in minerals and other sovereign wealth funds, could borrow on its own at low cost. So far, this practice does not seem to be widespread
The Journal mentions in passing that CalPERS is increasing its private equity allocation to 17%, with little thought as to whether it needs to rethink its valuations and its commitment to private equity due to zombification.
An interesting sign of the times is the tenor of the comments in this piece. In the past, articles about the government pension fund’s misadventures in private equity would have prompted criticism from readers of dumb overpaid government officials and reflexive cheerleading for private equity. 303 comments on this article (a very healthy number) had serious doubts about the one-time masters of the universe. Some examples:
James Singer
The roach motel aspect of PE comes to the fore.
Yes, PE management is in denial as the Glen Garry Glen Ross stories play out.
The world is coming to billionaires but that is for another time.Michael Young (emphasis original)
It is one thing for pension funds to invest in stocks that provide returns and benefits over time. It’s one thing for pension funds to commit to investing in equity for years to come without knowing what those shares will buy…then compounding the problem by going into debt to pay for those future commitments. This is called or should be called breach of fiduciary duty and fiduciaries/trustees should be held personally liable. D&O insurance should not cover this type of breach.
Peter S
The biggest scam from Leveraged Buyout Funds (renamed Private Equity) is their determination of returns over a short period of time.
With this allowance, they make their return look smoother
( improving the “Sharp ratio”) and even higher.
As interest rates are likely to enter a very long period of increase, similar to the period of 1948-1982, these companies that depend on borrowing (profit) from buying companies will have a severe headwind against their profits.Robert Weinberger
Private equity has hurt more industries, especially health care, than ever before. They carry their debts with a large loan that returns their money but causes bankruptcy. This capitalism has gone sloppy. A law is needed to kill these vultures.
Roy Laferriere
I missed any discussion in the article about how these issues affect the KKR and Blackstones space. What I see is that they continue to harvest their money, rain or shine on the investor’s situation.
Stephen Siu
If something seems too good to be true, it probably is too good to be true.
Freelancers may have a nice return on a title, but give up the visibility and lack of money in good writing.
Although it is good to see awareness of the big problems with private equity (for those not involved in looting), in the same way that the US and Europe suffer from a lack of political accountability, so does the investment world. I’m told that the big endowments don’t even do due diligence before investing in private equity, as if being in the club means no direct inquiries. Granted, universities have a big problem with asking for donations from the wealthy who run these investment sites. But no one admits that this conflict of interest exists, let alone comes up with weak efforts to fix it.
Ironically, powerful unions like SEIU are fiercely protective of CalPERS, despite its history of corruption and incompetence. Even if the State of California rolls back state pensions, and (as we have explained the long way), CalPERS has a flawed management structure that makes it unaccountable to anyone, legislators are afraid to do even a small inspection of the inspector general.
So expect things to get worse before there is any hope that they might get better.
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