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Eileen AppelbaumCenter for Economic

& Policy Researchand

University of Leicester

Rosemary BattILR School

Cornell University

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Prologue: Performance of CalPERS Private Equity Investments

• Investments in private equity are riskier than investments in public equities (the stock market)– They should have higher returns than stocks (beat the market) –

not just high absolute returns

• Median PE fund beat stock market 1995-2005 but not in last decade

• CalPERS PE investments haven’t beaten its stock market benchmark in YTD, 3-year, 5-year and 10-year windows– Despite high absolute returns, CalPERS would have done better in

the last decade by investing in stock market index fund

Overview of Presentation

• Private equity performance– Measurement– Persistence– CalPERS performance

• PE Fees: Why the house never loses•

Measuring Pension Fund Performance• Internal Rate of Return (IRR) is a flawed measure

• Academic researchers and many financial firms (e.g., Goldman Sachs) use Public Market Equivalent (PME)

• PME compares an investment in a PE fund to an equivalently timed investment in the relevant public equity market (e.g., S&P500, Russell 3000)

• A PME of 1.20 implies that at the end of the fund’s life, investors will earn 20% more than if they had invested in the stock market– If fund has 10-year life span, outperformance is less than 2%/year

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Pension Fund PerformanceHarris, Jenkinson & Kaplan (2014)

• PME compared to S&P 500

• PME compared to S&P 500, Russell 3000, Russell 2000

Buyout Funds PMEs

Vintage Average Median Wtd. Average

2000-08 average 1.27 1.25 1.29

Sample average 1.22 1.16 1.27

Buyout Funds PMEs

Vintage S&P 500 Russell 3000 Russell 2000

2000-08 average 1.27 1.25 1.28

Sample average 1.20 1.18 1.11

Sample median 1.11 1.09 1.02

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Pension Fund PerformanceHarris, Jenkinson & Kaplan (2014)

• Things to note:– Data are from only LPs that use Burgiss system to track performance– In the 2000 – 08 vintages, a large majority of investments by the

median fund had not been realized at time of analysis– Difference between average and median in sample average driven

by top performers

• PME shows performance over the life of the fund– If funds have 10 year life span, PME of 1.27 is outperformance of

2.4% a year– PME of 1.11% is outperformance of just over 1% a year

• If Russell 2000 is right benchmark, investors in half the funds in sample would have done better in stock market

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Performance of Fully Liquidated FundsSource: Robinson and Sensoy (2011, 2013), Tables 2, A-2*

* Data: 368 pre-vintage year 2006 funds, liquidated by 6/302010** “Tailored PME”: Fama-French size tercile index according to whether the fund is self-described a small-cap, mid-cap, or large-cap buyout fund

S&P PME Tailored PME**

Mean 1.18 1.10Median 1.09 1.0025th %ile 0.82 0.7775% %ile 1.46 1.37

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Persistence of Performance• Likelihood that next funds are in same performance bracket• Kaplan and Schoar (2005): pre-2000

• Harris, Jenkinson, Kaplan, Stucke (2014): post-2000

Bottom Middle Top

Bottom Tercile 49% 31% 20%

Middle Tercile 30% 38% 32%

Top Tercile 21% 31% 48%

4 3 2 1

Bottom Quartile 32% 32% 14% 21%

Third Quartile 18% 39% 28% 15%

Second Quartile 21% 32% 23% 24%

Top Quartile 19% 30% 29% 22%

PE Hasn’t Beaten Stock Market Since 2005(PitchBook 3Q2015 Benchmarking Report)

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CalPERS Monthly Update Performance & Risk

Net Return (Absolute Return)

Private Equity FYTD 3-YR 5-YR 10-YR 20-YR

As of 6-30-15 8.9% 14.1% 14.4% 11.9% 12.3%

As of 8-31-15 3.1% 15.2% 14.9% 12.0% 12.5%

Sources

https://www.calpers.ca.gov/docs/board-agendas/201508/invest/item04c-03.pdf

https://www.calpers.ca.gov/docs/board-agendas/201510/invest/item04c-01.pdf

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Absolute Returns – Wrong Measure for PE• Absolute return strategy not appropriate for risky investments

– No benchmark– No adjustment for risk

• LPs continue to invest in PE based on absolute return measures– U.S. stock market has been at or near record highs PE can sell

portfolio companies at high prices– PE distributions to LPs are high now, but may not beat their benchmark – LPs are looking at absolute returns and re-investing in PE

• CalPERS staff focused on absolute returns at a recent board meeting

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CalPERS Stock Market Benchmark

• The CalPERS benchmark comprised of – 2/3rds of the FTSE U.S. Total Market Index +– 1/3rd of the FTSE All World Total Market Index (ex US) +– 300 basis points (outperformance of 3% a year)

• CalPERS staff are now questioning this benchmark

CalPERS Monthly Update Performance & Risk

CalPERS Performance Returns vs. Benchmark

Private Equity FYTD 3-YR 5-YR 10-YR 20-year

As of 6-30-15 -2.21% -2.64% -0.61% -3.00% 0.93%

As of 8-31-15 +0.04% -6.13% -2.08% -2.80% 1.20%

Sources

https://www.calpers.ca.gov/docs/board-agendas/201508/invest/item04c-03.pdf

https://www.calpers.ca.gov/docs/board-agendas/201510/invest/item04c-01.pdf

Why the ‘House’ Never Loses: Management Fees• PE collects management fees from LPs & charges expenses

to LPs that should be covered by the fees– KKR and Capstone– Failed transactions– Indemnification clauses: settlements with SEC paid out of fund

profits, costly but invisible to LPs

• Management fee waivers– GP waives management fees from LPs in exchange for priority

claim on profits – taken off the top– So LPs still paying; money comes out of right pocket instead of left– Taxed as capital gains rate – benefits GP, but taxpayers’ are losers– Fee waivers circumvent tax code

Why the ‘House’ Never Loses: ‘Advisory Fees’

• PE charges advisory and monitoring fees to portfolio companies– Reduces: Resources for growth, price at exit, & LP returns– Uses accelerated fees, evergreen fees

• Illegal use of monitoring fees if services not specified– Monitoring fee contract must specify services to be provided– Fees must be commensurate with services provided– Otherwise, dividends disguised as monitoring fees– Fees reduce portfolio company’s tax liabilities, dividends don’t

PE Returns Net of Fees

• Carried interest is a share of the fund’s profit paid to the GP based on fund performance -- > performance or incentive fee

• Most GPs report returns to LPs ‘net of performance and management fees’ – lack of transparency

• Without full disclosure of these fees, LPs can’t evaluate what GPs are charging for their services or the effect on returns

• CalPERS estimates that the combined fees [performance fee + management fees] = 7% of pension fund investments in PE

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Thank You