Swedroe: CalPers’ Private Equity Problem

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.

While private equity/venture capital investing is high risk/high expected return, returns investors have actually realized don’t appear to have compensated them fully for the incremental risks.

For example, the returns should reflect, at least to a significant degree, a premium for the extreme illiquidity of private equity investments. Highlighting the lack of liquidity is the finding from one paper—“The Cash Flow, Risk and Return Characteristics of Private Equity”—that the internal rate of return for the average venture capital fund did not turn positive until the eighth year.

Given the above evidence, it seems appropriate that the hurdle for private equity should be a premium that isn’t just above the return of the S&P 500 Index, but above that of more similarly risky, publicly available small value stocks. From 1926 through November 2103, the Fama-French index of U.S. small value stocks (excluding utilities) had outperformed the S&P by 3.8 percentage points a year (13.9 percent versus 10.1 percent).

And since private equity is clearly riskier than publicly traded small value stocks, given the higher standard deviation of returns, the high skewness in returns and the lack of transparency and liquidity), there should be a significant premium of private equity over that of small value stocks.

If we simply added the current hurdle that CalPers is using to the 3.8 percentage points a year outperformance of small value stocks, it would require a premium above the S&P of 6.8 percentage points (3.8 + 3), not 3 percentage points.

What conclusions can we draw? The first is that investors in private equity have, on average, underperformed the performance of publicly available and more similarly risky small value stocks.

The second is that the 3-percentage-point hurdle that CalPers is requiring seems far too low to justify investment in private equity.

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.