The Breakdown

Explaining Southern California's economy

CalPERS strikes fear in the hearts of private equity firms

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38358 full

Yesterday, CalPERS, the huge California public employees pension fund, announced some good news: the $248 billion colossus made a 13.26 percent return on its investments in calendar year 2012. They're dancing with their spread sheets in Sacramento, because that's a vast improvement over the 2012 fiscal year performance, which ended on June 30.

How bad was the fiscal year performance? One percent.

Yep, one percent. It was bad.

CalPERS has targeted a rate of return for its investments of 7.5 percent — a target that it reduced from 7.75 percent last year. So that 13.26 percent return, if it holds up through the fiscal year, will go a long way toward helping CalPERS make up what it lost last year.

However, as CalPERS Chief Investment Officer John Dear pointed out and Pensions & Investments reported, that 13.26 percent wasn't as thrilling as it sounds. It was "117 basis points below the retirement system's custom benchmark for the calendar year."

Translation: CalPERS expected 14.43 percent (a basis point is 1/100th of a percent, so the math is 1326 + 117). The problem child was private equity:

Mr. Dear attributed the below-benchmark results to disappointing returns in the private equity portfolio, which had a 12.24% return in the period, compared with the custom benchmark's 28.4% return.

That's a pretty hefty expectation on CalPERS' part, and it highlights a challenge facing big pension funds. The 2012 annual return on the S&P 500 was about 13 percent, so money passively invested in that index would have beaten CalPERS private equity portfolio by...76 basis points! (0.76 percent). 

Obviously, it's an uncomfortable situation to be a pension fund manager and see that putting state workers' retirement money into an index that runs on autopilot is a better strategy than investing in sexier, riskier alternatives.

But CalPERS can't take its chances with more passive investments, because the bond and equity markets are going to have down years. In order to achieve that (reduced) 7.5 percent benchmark return — which it's only beating, barely, on a ten year basis, according to Dear — CalPERS had to construct a portfolio of alternative investments, incuding private equity, which can meet a benchmark annual return of nearly 30 percent.

It currently has $45 billion locked up in private equity, and in many cases, those funds are truly locked up — invested for long time frames.

What CalPERS calls "private equity" is actually an amalgam of "sub-asset classes," in the system's language. Of these, venture capital and "buyout" are two of the most familiar, because we hear so much about venture capitalists and their high-tech investments, as well as buyout shops, a good example of which was Mitt Romney's old firm, Bain Capital.

CalPERS, as I wrote last year, has been reviewing its venture capital allocation, in light of the meager returns that VC has generated. That looked like good news for buyout firms:

If CalPERS does greatly reduce its VC investments — and the writing is on the wall that it will — it will have to redeploy those funds in its private-equity portfolio. CalPERS calls everything that isn't "typical" in the portfolio "private equity," combining leveraged buyouts, VC, and other alternatives into one group. What most people now think of as private equity — leveraged buyouts of companies, the kind of thing Mitt Romney did when he was at Bain Capital — has been performing much better than VC. 

So while CalPERS' change in investment philosophy may strike fear in the hearts of VCs, it will likely bring a smile to faces of private-equity players. And that could be good for Los Angeles, where private-equity is more entrenched and VC is just beginning to be competitive with Silicon Valley. 

But CalPERS' big miss for 2012 on the entire private equity portfolio means that buyout firms, which represent the biggest chunk of investments, aren't doing so well, either. The Economist's Free Exchange blog tackled this problem last year, pointing out that private equity firms invested in by pension funds haven't lived up to outsized expectations. 

I reached out to CalPERS for comment — specifically, whether they've broken out returns for VC versus buyout in the private equity portfolio. But according to a spokeswoman, CalPERS hasn't generated that breakdown yet.

A number of state pension funds are starting to seriously question their commitment to alternative assets in their portfolios. CalPERS isn't totally there yet — so far, it's only had major issues with VC. But if private equity continues to miss its marks, there could soon be a day of reckoning in Sacramento.

Follow Matthew DeBord and the DeBord Report on Twitter. And ask Matt questions at Quora.

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