Calpers Can't Eliminate Risk by Ignoring It
What would you think if a pension fund responsible for 1.7 million beneficiaries said it was going to stop considering the the riskiness of one of its biggest investments?
Incredibly, that's what the board of the California Public Employees' Retirement System, America's biggest public pension fund, might do on Dec. 14. One item on its meeting agenda would eliminate the strategic objective to "maximize risk-adjusted rates of return" on private equity, which involves using large amounts of debt to buy out companies with the aim of reselling them at a profit. This is a major policy change, engineered by the people who manage Calpers's private equity investments.
Calpers has come under increasing scrutiny for its poor performance in private equity. Management has sought an annualized return three percentage points higher than a mix of stock indices selected to resemble the companies that private equity firms target. But over the last 10 years it has consistently fallen short of this benchmark, and at times has not even achieved the returns of the stock indices.
The new investment objective -- which would require only that private equity "enhance" the fund's return -- suggests that Calpers's staff wants to solve the problem by changing the benchmark. This would be a monumental shift, because investors have long measured performance by seeking a return three to four percentage points above stocks. The premium is intended to compensate for the idiosyncratic risks of private equity -- specifically, the way it locks up investors' money for years and the amount of leverage, or borrowed money, it employs.
In other words, the revision would allow one of the world's largest investment institutions -- one that sets trends in the industry -- to ignore a fundamental concept of finance, that of the trade-off between risk and return.
The private-equity team at Calpers has ample reason to be concerned about its ability to deliver good risk-adjusted returns. Even the lackluster results to date include unrealized gains on companies that private equity firms have yet to sell. The values of those companies have been determined by the firms themselves -- unlike with hedge funds, there is no independent valuation.
Judging from disclosures of the carry fees Calpers pays to the general partners of private-equity firms (essentially their share of the profits), such unrealized gains appear to account for a full third of returns. This is troubling at a time when the prices paid for companies are at historically high levels. Given the cyclical nature of private equity, the actual gains might prove to be lower, bringing down even the lackluster returns Calpers has posted over the past decade.
Calpers is acting like a person who decides to throw out the scale rather than deal with a weight problem. It is doubling down on private equity even as the investment case becomes increasingly questionable. Recent academic studies have found that public-market strategies can deliver returns comparable to those of private equity. The logical conclusion is that pension funds could live without the illiquidity, high fees and "trust me" valuations.
Calpers is still widely seen as the best-run public pension fund in the country. If the board wants to maintain that reputation, it should not allow the staff to play on its ignorance and complacency. It should reject the change in strategic objective, exposing private equity as the poor investment that it is.
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