Swedroe: CalPers’ Private Equity Problem

January 27, 2014

Returns of private equity fund sure don’t appear to be worth the risk, Swedroe says.

In an effort to achieve returns that exceed those of the publicly available stock and bond markets, many large pension plans turn to alternative investments such as private equity. California’s CalPers, one of the nation’s largest public pension plans, while using equity index funds for more than one-third of its investments, is increasing its exposure to alternatives.

As of September 2013, alternatives represented 11 percent of the fund’s $272 billion in assets under management. Because of the incremental risks, CalPers has set a hurdle of 3 percentage points above the return of the market.

Perhaps that 3 percent hurdle rate was based on the results of 2012 study “Private Equity Performance: What Do We Know?” Using detailed cash-flow data covering the period 1984 through March 2011, the authors compared buyout and venture capital returns to the returns produced by public markets.

They found that the median outperformance relative to the S&P 500 Index was 3 percentage points a year, better than was previously documented (due perhaps to some problems with the data). However, that leaves the question of whether the 3-percentage-point difference is sufficient to compensate investors for the incremental risks.

Private equity is clearly much riskier than an investment in a publicly traded S&P 500 Index fund, so some premium is justified:

  • Companies in the S&P 500 are typically among the largest and strongest companies, while venture capital typically invests in smaller and early-stage companies with far less financial strength.
  • Investors in private equity forgo the benefits of liquidity, transparency, broad diversification and daily pricing—and, for individuals, the ability to harvest losses for tax purposes.
  • The median return of private equity is much lower than the mean return, which is to say to the arithmetic average. Their relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. In effect, private equity investments are like options or, perhaps more fittingly, like lottery tickets. They provide a small chance of a huge payout, but a much larger chance of a below-average return. While CalPers can diversify this risk—it had almost 400 private equity managers as of September 2013—it’s difficult for individual investors to diversify this risk.
  • The standard deviation of private equity is in excess of 100 percent. Compare that with the standard deviations of about 20 percent for the S&P 500 and about 35 percent for small value stocks.



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