Calpers bets on leveraged equities

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Calpers

From the Financial Times’ intrepid pensions guru, Josephine Cumbo, yesterday:

Calpers, the US’s biggest public pension plan, is to increase its holdings in private markets . . . A proposal to increase the $483bn fund’s positions in assets such as private equity and private credit from 33 per cent of the plan to 40 per cent was approved on Monday . . . 

The formal approval comes two years after Calpers admitted that a decision to put its private equity programme on hold for 10 years had cost it up to $18bn in returns. 

However, a review of its investment policy found that, despite the gains it had already missed, private equity was still the asset class with the highest expected long-term total return.

In its announcement of the change, Calpers said that 

Private equity will increase from a target of 13 per cent of the fund to 17 per cent while private debt will increase from 5 per cent to 8 per cent . . . 

The target allocations for public equity and fixed income will decrease under the new policy. Calpers’ allocation for [public] equity will go to 37 per cent of the fund and fixed income will be reduced to 28 per cent. 

The worrisome aspect of this allocation decision jumps right off the page: it sounds like Calpers is steering the car by the rear-view mirror. The superior returns of private markets over the past decade are going to be a poor guide to its returns in the next decade, unless accompanied by a good theory of where that outperformance came from and why it should persist. 

And, as Unhedged has argued before, there are at least three good reasons to think that private equity performance is going to get worse in relative terms. At least one of them, and maybe two, applies to private credit, too: 

1. The fast growth of the private equity industry has led to greater competition for assets, and therefore higher purchase valuations. This results in lower returns relative to public equity. This may explain the compression in private equity’s outperformance that is already evident; see the chart below from Bain & Company’s Global Private Equity report (while remembering that internal rates of return are not the same as distributions). It is would not be surprising if private credit returns followed the same pattern relative to high-yield bonds. 

   

2. A crucial component of private equity’s high historical returns, very inexpensive debt, may not be available in years to come. Of course it is possible that, once inflation abates, rock-bottom pre-pandemic interest rates might return. But there are reasons to doubt it, from shifts in the balance of savings and investment to higher levels of government debt. And remember, while higher rates helps private credit funds through higher payments from borrowers, those funds also carry debt of their own, to amplify returns.

3. If you believe that a private equity portfolio is a near equivalent to a leveraged public equity portfolio — as Unhedged does — then underlying returns on US public equities are a critical component of private equity return (depending on your global equity weightings). But US equities returns are very likely to be lower in the next 10 years than the last 10, for the simple reason that they were extraordinarily high in the past decade, at 12 per cent annually for the S&P 1500 broad index. Long-term equity returns revert pretty reliably to 7 per cent or so. 

It may be that the Calpers investment office does have a theory about why private equity should continue to be the best asset class in the next 10 years. But I don’t know what that theory is, and it’s not in the slide decks from the office’s recent asset allocation review or its 2023 trust level review. What those slides do show is, first, the fund’s historical returns by asset class, with private equity leading the pack at 11.4 per cent over 10 years, and private debt with the second-best one-year return. Apologies to those reading on a phone, who will have to squint:

Calpers also provides the asset volatilities and correlations (though it is not clear to me whether these are historical numbers or assumptions about the future):

And finally here are the prospective return assumptions for each asset class, drawn from a survey of the fund’s money managers. Private equity is at left:

It is good to see, in that last chart, that the expectations for private equity returns do not call for a repeat of the last decade. Instead, the average expectation (the blue dot) is for an 8 per cent annual return, just a percentage point or two better than the hope for public equities. The distance between the blue and orange dots shows that the expectations have been trimmed since the previous analysis, in 2021. This looks like sanity. But the key question still applies: where is the expectation of higher returns for private equity vs public equity coming from?

I suspect that it comes from leverage. Private equities are more leveraged than public ones — in terms of debt, they are something like an equity index bought with 30 per cent borrowed money. Equities usually go up over the long run, so leveraged equities should usually go up more. The bet investors make, then, is that the extra return from the leverage will outweigh the private equity funds’ fees. If this is the reason for Calpers’ higher long-term return expectation, it makes sense and is another sign of sanity that the long-term volatility Calpers assigns to private equity is well higher than for public equities, at 25 per cent versus 17 per cent (the second slide, top left corner). A more leveraged asset is more volatile than a less leveraged one, whether it is marked to market, like public equity, or not, like private equity and private credit. If the high long-term volatility number is a recognition of that, good for Calpers. 

What does not make sense, if private equity is leveraged equity, is that the correlation between public and private equity should be just 0.6. More puzzlingly, the correlation of private debt to high yield is an inexplicable 0.3! A global private equity or debt portfolio should be very closely correlated with a global public equity or debt portfolio. They own a lot of the same underlying stuff, though industry or country exposure may differ a bit. The absence of mark to market on the privates, as well as full corporate control, may make it easier to ride out ugly patches in markets. There is value in this. But if we are entering a truly bad decade for equities, the private funds’ leverage will make it all worse, and marks won’t help. 

One good read

Let’s eat snakes! (Hat tip to Marginal Revolution).

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