Can Private Equity Win Where Others Lose?

Dear Reader,

The Mamas & the Papas had a massive hit single of the 1960s…‘California Dreamin’’.

The lyrics were written by John Phillips and Michelle Phillips (one half of The Mamas & the Papas).

Their inspiration came from spending a bleak winter’s day in New York and longing for some LA warmth.

California Dreamin’ on such a winter’s day.

On Monday, an article in the Financial Times had me instantly humming the song.

The Rum Rebellion

Source: FT

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The top US pension fund is California Public Employees’ Retirement Scheme (CalPERS).

As reported (emphasis added)…

Calpers is to move deeper into private equity and private debt by adopting a bold leverage strategy that the $395bn Californian public sector pension fund believes will help it achieve its ambitious 7 per cent rate of return.

In a presentation to the Calpers board, Ben Meng, chief investment officer, said the giant fund would take on additional leverage via borrowings and financial instruments such as equity futures. Leverage could be as high as 20 per cent of the value of the fund, or nearly $80bn based on current assets. The aim is to juice up returns to help the scheme, the largest public pension in the US, achieve its growth target.

Given the current low-yield and low-growth environment, there are only a few asset classes with a long-term expected return clearing the 7 per cent hurdle. Private assets clearly stand out,” Mr Meng said. “Leverage will increase the volatility of returns but Calpers’ long-term horizon should enable us to tolerate this.”

Calpers’ assets represent just 71 per cent of what it needs to pay future benefits to the 1.9m police officers, firefighters and other public workers who are members of the scheme.

Deeper into private equity.

Deeper into debt.

Bold leverage strategy.

Chasing ambitious returns in a low yield and low-growth environment.

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California Dreamin’

With this sort of ‘wing and a prayer’ strategy, the future looks as bleak as a New York winter’s day for the 1.9 million CalPERS’ members.

The health (or rather, ill-health) of the US pension system has been of interest to me for some time.

Tens of millions of boomers have planned futures based on retirement income promises being kept.

The problem is, the pension funds (public sector and corporate) do not have sufficient money in the kitty to honour these promises…and this situation exists after a decade-long bull market.

There are significant economic, political and market related consequences lying in wait in these funds.

In my recent book How to Arrange Your Wealth Now for a Post-COVID-19 World, I wrote…

Some of the more troubled US private and public sector funds have suspended annual indexation and/or reduced payments or in more dire cases, temporarily ceased payments.

The breaking of pension promises has so far been largely contained to smaller municipal funds and company schemes.

In the pension ocean, these plans are the plankton, but what about the whales?

And in terms of states, they don’t come any bigger than California.

‘“If California were its own nation, it would be the fifth largest economy in the world. With a GDP of $US2.9 trillion, California would slot between Germany and the United Kingdom in the world’s top economies.”

‘Business Insider

CalPERS (California Public Employees’ Retirement System) is the fund that manages the pension and health benefits for California’s public sector employees.

The following graphic is from “CalPERS – Comprehensive Annual Financial Report Fiscal Year Ended June 30, 2019”:

The Rum Rebellion

‘Source: CalPERS

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A few things to note here…

The figure of…70.2%…funded. Or to put it another way, CalPERS is 30% UNDERfunded. CalPERS lacks sufficient capital to meet its obligations.

How do the administrators plan to fix this rather serious problem?

With a two-pronged approach…

Assume the fund will deliver a 7% rate of return…each year.

The fund’s performance of 6.7% was just shy of the forecast return…so all good…except, these are the very best of times for markets.

What awaits when the cycle turns and markets head south?

And, the second prong?

Tap the taxpayers.

Well, the US market did turn south in March and has staged a recovery…of sorts.

Even if this recovery holds ground (which is highly doubtful), the road ahead is one of low yield and low growth.

The constant pressure to generate 7% per annum (just to stand a chance of honouring its obligations) is forcing CalPERS to roll-the-dice on a high risk strategy…leveraging into private equity funds that (at times) participate in leveraged buy-outs (LBOs).

Gearing on gearing…hmmm, not sure that’s an appropriate strategy for a pension fund with fixed (and indexed) obligations to its 1.9 million members.

But that just goes to show how desperate things are getting out there.

Long gone are the traditional pension portfolios that were heavily weighted in safe and secure government bonds.

Now, they’re going further and further out on the risk curve. Trying desperately to not slip further down into UNDERfunded territory.

This has all the look and feel of a gambling addict who keeps upping the ante to win back lost dollars.

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But can Private Equity win where others lose?

On 24 February 2020, Bain & Company published a report titled Public vs. Private Equity Returns: Is PE Losing Its Advantage?’.

This chart from the report compares the performance of US Buyout Funds (PE) — red bar — with the Public Market Equivalent (listed) funds.

Over the past decade, there’s a split hair between the performance of unlisted PE and listed PME.

Over a longer term — 15–30 years — Private Equity is a clear outperformer. However, was that outperformance due to a lot of low hanging fruit in the earlier years?

The Rum Rebellion

Source: Bain & Co

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As the Bain & Co report states (emphasis added)…

While a 15% average annual return net of fees is impressive even by private equity’s own high standard, parity with public markets is not what PE investors are paying for.

The institutions that allocate increasing portions of their portfolios to buyout funds have good reason to expect a premium.

They lock up their money for a period of years with the presumption that professional managers will generate alpha through innovative value-creation strategies and leverage. All things being equal, public equities offer more liquidity at less cost.

To a large degree, this [merging in performance] is a function of maturity.

As private equity’s relative outperformance attracts increasing amounts of capital from investors, competition for a limited number of high-quality assets increases, driving up average purchase price multiples. Buying at premium prices makes it ever more challenging to create value during ownership and exit with an acceptable return.

In this low yield and low growth environment everyone will be trawling over the same ground looking for the hidden gems…sparking bidding wars for those high quality assets that have the potential to defy the trend.

Can PE justify its exorbitant fees in this highly competitive and reversion-to-the-mean environment?

For the sake of those 1.9 million CalPERS’ members I sincerely hope so.

But I’m doubtful.

If the last decade was all sunshine for markets, the coming decade is the contrasting winter.

Leverage upon leverage is going to leave CalPERS facing a bleak future.

Perhaps the CalPERS’ members can borrow the famous tune for their own ballad of lament…

All the values are down
And the outlook is grey
I think we need to talk
About the coming day
When your pension is cut
Because CalPERS cannot pay.

California dreamin’
On such a bleak day.


Vern Gowdie,
Editor, The Rum Rebellion

Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.

The Rum Rebellion