There’s something nasty about hammering US public pension funds — some of the most conservative investors — for trailing just one of their benchmarks. But we’re going to do it anyway.
In the US, large public pension plans that invest in private equity mostly measure these investments against a public equity performance yardstick. Given how well megacap stocks have performed in recent years, this has made explaining the relative performance of their private equity holdings . . . challenging.
Investment consultants Aon recently reported that 62 per cent of the top 50 US public pension plans benchmark their private equity portfolios against listed equity benchmarks. This approach makes some sense. The schemes see the returns from listed shares as their opportunity cost, their natural “other choice”, for their riskier positions in private equity.
Measuring private equity performance has its own issues, which Ludovic Phalippou at Oxford has written about before here, here and here. He focuses on the problems of using internal rates of return. As Phalippou makes clear, up until about the time of the pandemic, IRRs were super high, too many people in the industry accepted the figures as gospel, and they are frequently confused (perhaps understandably) with rates of return.
The debate over how to measure PE returns has run for a while. Cambridge Associates wrote about this subject back in 2014. Apart from questionable IRRs there are also time-weighted returns, which adjust for various inflows and outflows, as well as two ratios: the distribution to paid-in capital and the total value to paid-in capital. Investors seem to use all of these, as well as a public market equivalent, which tries to bridge the gaps between illiquid and liquid equity investments.
And as an illustration of how these measures vary, take a look at this chart of reported IRRs, DPIs and TVPIs for each constituent in Calpers’ private equity portfolio. Toggle between the different measures to see how the picture varies.
Nevertheless, comparing the returns of a bunch of small- and medium-cap private companies, mostly in the US, with global stock indices presents problems. Partly, this is because stock index returns get swung around by the trading fortunes of a few megacaps. And partly it’s just that PE valuations are made and issued out of sync with the rest of regular quarterly reporting.
Reporting lags can distort the size and volatility of investment returns recorded by pension funds. But there are tricks to deal with this.
“I really do think public equity is the right benchmark, but funds I think made this mistake of benchmarking themselves against large-cap stock,” Alex Beath, an independent pensions consultant, told Alphaville. He prefers using a lagged public index when possible, preferably a small-cap one.
But even using such lags, pension funds must be concerned. Because private equity performance numbers look frankly appalling against their chosen public yardsticks.
One of the biggest US public pension schemes is the Washington State Investment Board (WSIB), which had over $53bn of private equity as of March. Its returns trail its benchmark by an enormous 13 per cent. That’s 13 per cent per year over the past three years. But WSIB uses the MSCI ACWI Investable plus 300 basis points, lagged one quarter — which looks like a pretty high bar. Over ten years their PE performance deficit looks less yawning, but we’re still talking minus 1.3 per cent per annum.
Another chronic underperformer in private equity, the State of Michigan Investment Board, uses the S&P 500 plus 3 per cent as a target. As you can imagine, their relative performance over three and ten years looks even worse.
Here’s a chart of the median public pension fund’s PE performance against typical public market comparators 😬:
Karen Rode, senior partner for private investments at Aon, told us that the private equity benchmark issue is a problem for pension funds everywhere. She believes that changing the benchmark is a momentous decision and requires deep discussion. And this view was echoed by Rashay Jethalal, CEO of data analytics firm CEM Benchmarking.
Our bet is that pension fund trustees sought a fair way to create an investable, appropriate and unambiguous benchmark against which their private equity portfolios could be measured. Index plus two-to-five per cent per annum? Sounds legit.
After all, why even invest in private equity — with all its illiquidity, complexity, leverage, opacity and cost — if it can’t deliver better returns than a public index-tracker? Or maybe trustees just listened to the sky-high performance promises for which PE salesmen are known and haircut them.
Indeed, Andrea Auerbach, head of private investments at Cambridge Associates, told Alphaville that she would prefer to see these added benchmark hurdles taken “off the table” when selecting benchmarks for private equity.
Not many of the largest public pension funds we looked at use private equity benchmarks, though a number are available. And not many funds used (perhaps more appropriate) small-cap indices, such as the MSCI ACWI Small Cap index or even the US-focused Russell 2000, with or without the lag Beath suggests.
Through June, investment returns from global stocks have averaged 13.3 per cent over ten years; over three years the number’s now 20.2 per cent.
Barring a massive collapse in share prices soonish, pension funds’ private equity portfolios will have to post some big numbers to catch up.
Further reading:
— The delusion of private equity IRRs (FTAV)
— Here’s a new angle on private equity’s volatility laundering (FTAV)
