The Wall Street Journal ran a major article over the weekend about how private equity has become a money pit and will continue to be that way, at least as long as interest rates remain high.
Public pension funds and other investors dutifully and immediately doubled down on capital calls from private equity general partners, or else these so-called limited partners would face liquidation of all the money they had ever invested.
But in a typical “heads-I-win-tails-you-lose” private equity deal, private equity leaders aren’t penalized for refusing to sell a company in their fund portfolio because the asking price isn’t good enough. One big reason you want to avoid this kind of recognition event is because it calls into question the value of many, if not all, of the other companies in your portfolio. Keep in mind that private equity is the only investment strategy where fund managers can set a value for their holdings, and then only on a quarterly basis; all other investment strategies require independent valuations, usually monthly rather than daily.
I’ve written before about how private equity funds sometimes don’t sell their end-shareholdings, but when the amounts aren’t that big, I haven’t found a good explanation. Even if there were big losses in end-shareholdings, investors would have long ago moved on to new funds and wouldn’t care about any impairments, especially since the IRR (a misleading but beloved metric) calculations would underestimate the impact. For example, of CalPERS’ 357 funds, 1Nine are vintages from 2004 or earlier.
But remember that pension funds, in particular, must adhere to actuarially estimated payment schedules. In the Stone Age, pension funds bought bonds and aligned their maturity dates with their expected liabilities. But in 1976, the Department of Labor changed its interpretation of the meaning of the prudential man rule to allow funds to consider risk on a portfolio-wide basis, rather than on an investment-by-investment basis. This revision was a direct result of venture capital lobbying.
Then in the early 1990s, Christine Todd Whitman hatched a scheme to underfund New Jersey pension funds by setting current contributions unfairly low, taking the practice of hoping the market would make up any shortfall in full contributions to a new level.
To summarize the numerous posts, during the ultra-low interest rate era following the financial crisis, many pension funds were underfunded as market returns generally declined. They rushed into private equity, which seemed the most profitable option. But as academic research has increasingly made clear, properly measured private equity had not outperformed equity since 2006, or at least not before. But the rule of thumb was that private equity needed to outperform equity by at least 300 basis points (3%) to compensate for its greater risks: illiquidity and leverage. Obedient consultants helped public pension funds such as CalPERS recalibrate their benchmarks, lowering risk premiums to make private equity investments look attractive.
Now the risk of a liquidity shortage hits hard. Pension funds are scrambling to make up for distributions they were supposed to receive from maturing private equity funds that they never received. As the Journal notes, this often involves borrowing at interest to get cash to meet obligations. Although the article doesn’t say so, these interest costs are almost certainly not being offset by private equity earnings, even though a private equity shortfall is the cause of the cash shortage. The other main way to deal with a cash shortage is to sell private equity to make up for it.
From the journal Pensions pile into private equity. Now there’s no way out.:
Private equity and pension funds seemed like a match made in heaven…
Now the honeymoon is over, as benefits dry up and create costly problems for investment managers who manage the savings of retired workers from big companies and state and city governments.
To get pension payments on time, these managers are liquidating investments cheaply or turning to borrowing, a costly measure that eats into returns. The largest U.S. pension fund, California’s workers’ pension fund, will pay out more to its private-equity portfolio than it receives from its investments for the eighth year in a row. Engine maker Cummins Inc. lost 4.4 percent on its UK pension last year, mainly as it sold private assets at discount prices.
The Journal notes that public pension funds, on average, invest 14% of their assets in private equity and private annuities, or about 13%. The chart shows how that percentage has skyrocketed since 2000.
Surprisingly, the Journal notes that fund valuations can be, hmm, generous.
But as private equity has grown, its lead over traditional equities has narrowed, and it can be hard to trust mid-term forecasts provided by fee-hungry managers for the decade it takes for investments to generate profits.
The article explains that private equity funds are expected to get their money back after 10 years. This is technically accurate, but a bit misleading. Typically, the fund invests the money for the first five years and sells its holdings for the next five years. If it gets an attractive deal early on, it might be able to cash out by the third year. So, on average, an investor’s money remains outstanding for five years.
Back to the journal:
Nearly half of private-equity investors surveyed by investment firm Coller Capital earlier this year said they had money in so-called zombie funds – private-equity funds that haven’t paid dividends as scheduled, leaving investors in limbo.
So pension funds are reselling their shares in private equity funds, often taking a financial hit in the process. Secondary market buyers last year paid an average of 85% of the value they assigned to the assets three to six months before the sale, according to Jefferies Financial Group. Resales by private equity investors rose 7% last year to $60 billion…
Some pension funds are borrowing to raise cash. Calpers and the $333 billion fund that provides pensions to California’s teachers have approved plans to take out loans equal to 5% and 10% of their holdings, respectively.
The Alaska Permanent Fund Corp. gets its cash from a different kind of borrowing: private-equity managers paying out of loans they take out to satisfy cash-strapped pension funds and other investors, not from investment gains. That’s frustrating for investment chief Marcus Frampton, who estimates the fund, which invests mineral revenues and other state money, could borrow on its own at a lower cost. So far, the practice doesn’t seem widespread.
The Wall Street Journal briefly mentions that CalPERS is increasing its private equity allocation to 17%, but gives little consideration to whether zombification should prompt a rethinking of benchmarks or allegiance to private equity.
The tenor of the comments on this article is an interesting sign of the times. In the past, articles about public pension fund failures with private equity have elicited reader criticism of foolish, overpaid civil servants and knee-jerk cheers for private equity. The 303 comments on this article (a very healthy number) were overwhelmingly skeptical of the people who once ruled the world. A few examples:
James Singer
The cockroach motel aspect of PE comes to the fore.
Of course, PE managers themselves are in the denial stage as the Glen Garry Glen Ross saga unfolds.
The world is gunning for big-time billionaire financiers, but that’s a story for another time.Michael Young (emphasis in original)
It’s one thing for a pension fund to invest in stocks that will provide benefits and profits over the long term. But it’s quite another for a pension fund to promise itself future stock investments, and then compound the problem by borrowing to pay for those future promises, without even knowing what those stocks will buy. Breach of fiduciary duty Trustees/trustees should be held personally liable and D&O insurance should not cover this type of breach.
Peter S
The big scam of leveraged buyout funds (rebranded private equity) is that they determine their own returns during interim periods.
This deduction allows them to make their earnings look smoother.
(Improved Sharpe Ratio) and even higher.
Because interest rates are entering a very long period of rising interest rates, perhaps similar to the period from 1948 to 1982, these companies that rely on borrowing (leverage) to buy companies are going to face significant headwinds to their earnings.Robert Weinberger
Private equity has done more damage to many industries than you would think, especially healthcare. They load the companies they buy with huge debts, causing them to go bankrupt while they recoup their capital. This is capitalism run wild. We need laws to crack down on these vultures.
Roy Laferrière
There is no discussion in the article about how these issues affect fellow firms KKR and Blackstone, whose impression is that they continue to make their fees regardless of the situation of their investors.
Stephen Siu
If something seems too good to be true, it probably isn’t.
Private companies may have attractive profits in the headlines, but they lack transparency and liquidity in the details.
It’s good that private equity’s serious problems (for those not involved in the plundering) are being recognized, but in much the same way that the US and Europe suffer from a lack of political accountability, so does the investment world. We hear that large endowments don’t even do due diligence before investing in private equity funds, as if they’re exempt from pointed questions because they belong to a club. Sure, universities have a bit of a problem in that they solicit donations from the very same wealthy individuals who run these investment pools. But almost no one acknowledges that this huge conflict of interest exists, much less comes up with a feeble attempt to resolve it.
Oddly, powerful unions like SEIU defend CalPERS despite its history of corruption and incompetence, the state of California props up state pensions, and (as I explained in the long form) CalPERS has a flawed governance structure that makes it unaccountable to anyone, yet lawmakers are afraid to even implement a modest check by an inspector general.
So be prepared that things will have to get a lot worse before there is any hope that things might improve.
