CalPERS: Poster Child of Private Equity Cargo Cultism

CalPERS, once highly regarded for its acumen, is increasingly the willing victim of investment fads past their sell-by date. For hedge funds, CalPERS admitted they weren’t delivering adequate returns in 2006, but didn’t announce its intent to end the strategy until 2014. But even with that delay in taking action, CalPERS was willing to look at what its data said and acknowledged publicly that hedge funds were underperforming.

But in board meetings and in presentations to the press, the latest being to the New York Times, CalPERS continues to insist that private equity is its big hope for reducing its underfunding, in the face of overwhelming evidence that private equity is failing to beat public stocks.

And remember that private equity ought to deliver a markedly higher return, with experts using a rule of thumb of 300 basis points (3%) to compensate for its additional risks and costs. Yet CalPERS has taken to cooking its benchmarks to make private equity performance look better than it is, both by reducing the required risk premium by half, to 150 basis points, and by choosing more flattering equity indices as the basis for comparison.

In the New York Times article by Mary Walsh, the giant fund insists its yet-to-be-hired Chief Investment Officer will be required to implement a mandate of “more private equity”. Oddly, the article ignores the substantial and growing literature documenting private equity’s failure to outperform, statements by top industry executives forecasting that future performance will be lower than in the past, and CalPERS’ most recent fiscal year results, where private equity delivered -5.1%, worse than public equity at 0.6%. What enabled CalPERS to deliver a lower-than-target but better-than-most-other-public-pension-funds return of 4.7% was fixed income, thanks to the Fed lowering rates to combat Covid-19 fallout and CalPERS having a higher fixed income allocation than most of its peers.

New York Times insiders have told us over the years, on a contemporaneous basis, how the business section has gone ever more in the direction of toadying to big corporate interests. So it isn’t clear whether this piece coming out as artfully-packaged dictation-taking was Walsh’s doing or the result of editorial intervention.

The Times account legitimates CalPERS’ eagerness to throw more money at private equity by highlighting how municipalities are cutting spending in key areas like schools to meet their pension commitments. She never acknowledges that CalPERS underfunding hole is so deep that the system can’t earn its way out, particularly given the near-certainty that the Fed will keep interest rates super low for the foreseeable future.

The article never once questions CalPERS’ outdated belief that it can consistently beat stocks with private equity.¹ She repeats the canard that stocks are more volatile than private equity, which is true only due to private equity almost never valuing its holdings and to widely acknowledged bogus accounting (“smoothing,” as in not recognizing losses in bad markets). In other words, the advantage of stocks, its greater liquidity, is depicted as a negative!

Nor does the Times’ piece question the blather from CalPERS, perhaps directly from CEO Marcie Frost who spoke to the Grey Lady. The article depicts CalPERS as not happy with private equity but still eagerly seeking to commit more. Worse, it parrots the incredible claim that it’s the board’s fault that CalPERS’ isn’t more invested in private equity:

CalPERS has sometimes moved slowly on private equity partly because of its trustees’ qualms.

Oh, come on. The staff has plenty of authority. The Board has delegated to the CIO the ability to make an unlimited number of ONE BILLION DOLLAR ($1,000,000,000) fund commitments and an unlimited number of ONE BILLION NINE HUNDRED MILLION DOLLAR ($1,900,000,000) commitments to separate accounts.

When has staff not run roughshod over the board? Only after Ben Meng’s abrupt exit, the result of a conflicted one billion dollar commitment to Blackstone, has the board flexed badly atrophied oversight muscles. Even then, staff has been working overtime to thwart that effort.

The Times cites Theresa Taylor hand-wringing over CalPERS having invested in Toys’R’Us, whose bankruptcy was the focus of numerous stories and even a major topic at Congressional hearings last year, and Margaret Brown questioning the current private equity benchmark. Pray tell, what do either of these have to do with CalPERS pulling the trigger on investments, when staff has substantial delegated authority plus a track record of thumbing its nose at the board?

And it’s easy to find plenty of examples of union representatives and employees of companies bankrupted by CalPERS private equity investments, like Caesars, speaking in public comments only to be met by stony stares from the board.

If we accept that CalPERS being underinvested in private equity is a Bad Thing, its staff has only itself to blame. The reasons are:

Former private equity chief Real Desrochers being seen in the industry as difficult to work with, resulting in CalPERS often being called late in fundraising

CalPERS reconfirming the impression in the industry that it was a hot mess (and therefore undesirable) by taking forever to hire a new Managing Investment Director to replace Desrochers

CalPERS telling the world it didn’t want to invest in funds any more via its eighteen-month “private equity new business model” exercise. Why should CalPERS’ private equity staff break a sweat when management’s widely broadcast plan was that their jobs were on track to be eliminated?

And the price of CalPERS’ new-found overeagerness under Frost is a $400 million vintage year 2019 commitment to Vista, a fund manager that CalPERS had steered clear of due to its sales pitch being obviously not credible. Vista’s founder Robert Smith has admitted to tax fraud that provided the $1 billion sole investment in his first fund, as well as later abuses extending over a decade and a half. Smith is paying a fine of roughly $140 million. Industry observers believe that more dirty linen will come to light.

But let’s return to the central issue, which is CalPERS’, the public pension industry’s, and the press’ failure to question the mythology surrounding private equity performance. It’s classic cargo cultism. From Wikipedia, for those who may not have heard of the phenomenon:

The most widely known period of cargo cult activity occurred among the Melanesian islanders in the years during and after World War II….

The vast amounts of military equipment and supplies that both sides airdropped (or airlifted to airstrips) to troops on these islands meant drastic changes to the lifestyle of the islanders, many of whom had never seen outsiders before. Manufactured clothing, medicine, canned food, tents, weapons and other goods arrived in vast quantities for the soldiers, who often shared some of it with the islanders who were their guides and hosts. This was true of the Japanese Army as well, at least initially before relations deteriorated in most regions.

The John Frum cult, one of the most widely reported and longest-lived, formed on the island of Tanna, Vanuatu…. Cult members worshiped certain unspecified Americans having the name “John Frum” or “Tom Navy” whom they claimed had brought cargo to their island during World War II and who they identified as being the spiritual entity who would provide cargo to them in the future.

With the end of the war, the military abandoned the airbases and stopped dropping cargo. ….In attempts to get cargo to fall by parachute or land in planes or ships again, islanders imitated the same practices they had seen the military personnel use. Cult behaviors usually involved mimicking the day-to-day activities and dress styles of US soldiers, such as performing parade ground drills with wooden or salvaged rifles. The islanders carved headphones from wood and wore them while sitting in fabricated control towers. They waved the landing signals while standing on the runways. They lit signal fires and torches to light up runways and lighthouses…

The cult members thought that the foreigners had some special connection to the deities and ancestors of the natives, who were the only beings powerful enough to produce such riches.

Investors like CalPERS are acting as if they can repeat the rituals of the past and get the “once upon a time” returns of the glory years, which allowed private equity general partners to foist one-sided agreements upon their investors. The media is also helping to preserve the legend that private equity is somehow special….beyond its success in creating billionaires at the expense of those not in their entourage. The victims include governmental employers, who haven’t woken up to the fact that private equity job cutting and tax gaming drains states and municipalities of tax revenues. For public fund beneficiaries, this is a direct and deliberate attack on their sponsoring employers.

There are other parallels between cargo cults and investors’ unflagging loyalty to private equity. Again from Wikipedia:

Cargo cults were typically created by individual leaders, or big men in the Melanesian culture, and it is not at all clear if these leaders were sincere, or were simply running scams on gullible populations. The leaders typically held cult rituals well away from established towns and colonial authorities, thus making reliable information about these practices very difficult to acquire.

So secrecy, including hiding from official scrutiny, are common elements.

For the sake of completeness, here’s some of the extensive evidence from our archives that private equity not only doesn’t earn enough to compensate for its higher risk, but has even become merely an “on par with stocks” level investment:

Experts effectively or actually telling CalPERS that private equity does not outperform:

CalPERS Debunks Private Equity: Executive Summary

Private Equity Expert Dr. Ashby Monk Repudiates CalPERS CEO Marcie Frost’s Private Equity Scheme During and Immediately After Presentation at CalPERS

CalPERS staff trying to hide private equity underperformance

CalPERS Used Sleight of Hand, Accounting Tricks, to Make False “There is No Alternative” Claim for Private Equity

CalPERS Admits Its New Private Equity Funds Will Dilute Returns, Seeks to Change Benchmark to Hide That; Presents Other Questionable Claims as Top Investors Underperform Due to “Alternative Investments”

Analyses by non-captured parties

Why Private Equity Does Not Outperform

New Study Undermines Rationale for Investing in Private Equity and CalPERS Strategy in Particular, as Oregon CIO Demonstrates that Public Pension Funds Are Dumb Money

Even Endowments Like Harvard, Former Top Investors in Hedge and Private Equity Funds, No Longer Beat Boring Stocks and Bonds

New Study Slams Public Pension Funds’ Alternative Investments as Drag on Performance, Identifies CalPERS as One of the Worst “Negative Alphas”; Shows Folly of CalPERS’ Desperate Plan to Increase Private Equity and Debt and Go Bigger Using Leverage

Oxford Professor Phalippou: Since 2006, Private Equity Has Produced Only S&P 500 Returns While Reaping $400+ Billion in Fees

Private Equity Clearly Inferior to Public Equity: Delivers Similar Returns With Lower Liquidity

There’s plenty more where that came from.

And what is striking, if you look at some of the articles, is that CalPERS has been falling back on the same claim over and over and over again for private equity, that it provides returns that the giant pension fund can’t get anywhere else, as the evidence keeps mounting that it just ain’t so. But it’s easier to put on those wooden headphones and keep calling the Private Equity Cargo Gods and hope they make a big money drop soon.

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¹ The article simply parrots CalPERS’ rationalizations:

She [Frost] said a study by CalPERS and its outside consultants showed that private equity and distressed debt were the only asset classes powerful enough to boost the fund’s overall average gains up to 7 percent a year, over time.

To get that result, CalPERS and its experts have had to ignore private equity’s flagging results for the past decade plus and admit that they result from fundamental changes in the industry, mainly too much money chasing too few deals combined with the refusal of private equity firms to moderate their fee-grifing in light of deteriorating results. Of course, that result is no surprise, since they are conflicted by having business incentives to promote private equity investments. They are real-world examples of Warren Buffett’s cautionary tale of the Gotrocks family, who find their investment returns falling over time as the result of fee-earning “Helpers” recommending more and more complicated investment strategies, which have their own fee and cost drains.

And Frost also conveniently ignores, as we describe later in the post that other top experts in private equity that CalPERS has asked to endorse private equity have effectively or actually done the reverse.