Finance

Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

Decent returns aren't coming easily for U.S. pension funds, so maybe it's time to shake things up.

I've written previously that they should be taking a lesson from their Canadian counterparts, who have been pioneers as private equity investors. Funds including the Ontario Teachers' Pension Plan and Canada Pension Plan Investment Board (CPPIB) have saved on fees and bolstered returns by putting billions of dollars to work directly betting on companies and real assets such as toll roads, either alone or alongside various private equity firms in which they invest.

Where Are They?
Large U.S. pension funds are nowhere to be seen among private equity fund investors that participate directly in deals, a strategy used to amplify their returns
Source: Pitchbook
*2006 through 12/05/2016

What's holding U.S. funds back? On an earnings call Wednesday, Carlyle Group LP co-founder and co-CEO David Rubenstein zeroed in on what he thinks is keeping them from replicating the Canadian model. It has to do with pay:

"The Canadian model is somewhat unique because the Canadians are willing to pay their officials in these funds as much as $5 million to $6 million a year, which is very unlikely to happen in U.S. public pension funds. And to recruit and retain people with these skills, you often have to pay a lot more than U.S. public pension funds are willing to pay."

The largest U.S. pension funds certainly have the bandwidth to pay for performance. For instance, the California Public Employees' Retirement System paid its chief investment officer Ted Eliopoulos roughly $800,00 last year if you include a bonus. Not bad, right?

But consider that it had about $26 billion invested in private equity funds last year. While management fees aren't being charged on that entire $26 billion, it's feasible that Calpers is paying the generally imposed 2 percent on at least 80 percent of this figure, which works out to more than $400 million a year. That makes the CIO's pay look like a rounding error by comparison.

They're In
Global investors including pension funds intend to allocate varied sums to private equity in the next 12 months. Some of the largest U.S. ones should consider a revamp
Source: Preqin

The reality is, Calpers could obtain large savings and lift returns by both paying its CIO more and hiring a handful of experienced bankers or former private equity executives to build out a team focused on spending at larger chunk of of their capital directly on deals. 

I'm not saying the largest pension funds need to go to the same lengths as CPPIB, which had a whopping $16.6 billion, or almost a third, of its $54 billion total private equity investment program tied up in direct investments. But coming close should definitely improve returns.

For Rubenstein to weigh in on this is interesting. On the one hand, firms like Carlyle have an increasing level of dependence on more sophisticated pension fund and sovereign wealth fund investors, which mostly herald from Canada, the Middle East and Asia. Without them, they wouldn't be able to complete larger deals or vie for megabuyouts of companies such as Citrix Systems Inc. Nor would they have willing buyers for stakes in their larger portfolio companies, as seen in a deal last week that saw Carlyle and a partner sell a portion of their holdings in Pharmaceutical Product Development to Singapore's GIC and the Abu Dhabi Investment Authority. 

Let's Be Direct
Co-investments have mostly delivered private equity investors returns above what they would have otherwise earned
Source: Preqin, per September 2015 survey

But Carlyle also counts on investors like Calpers to commit to its various funds. It's in the process right now of trying to raise $100 billion by the end of 2019. 

For now, the robust fundraising environment looks safe. There isn't a bevy of investors increasingly setting aside pools of capital for direct deals that would have otherwise been channeled into new funds overseen by Carlyle and its ilk. But this could quickly change, especially when U.S. pension funds realize the potential savings and enhanced performance that's well within reach. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Gillian Tan in New York at gtan129@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net