One has to wonder how CalPERS and other large US institutional investors can justify paying egregious fees and costs to private equity firms and getting lackluster net returns. One approach is to just say no and stop throwing money at private equity. Another response, which we’ve advocated, is to bring private equity in house. By cutting out the pricey middleman, investors can increase net returns. As we’ll discuss below, Australian superannuation funds are gearing up to make investments on their own and alongside private equity firms, following the path blazed by Canadian pension funds. Even though Sydney is a long way from New York, this move has to discomfit private equity kingpins.
Despite investors made desperate by super low interest rates continuing to throw money at private equity, there are also signs that investors are finding it harder to deny that they are getting a raw deal. To the extent that private equity delivers better performance, the firms are hogging all the upside and leaving investors with crumbs.
For instance, the authoritative expert, CEM Benchmarking, which has many public pension fund clients, including CalPERS, recently published an article demonstrating that index funds beat private equity. As we wrote:
More and more studies have found poor performance of private equity for the last ten years or so, starting with just before or just after the financial crisis, when investors started reaching for yield. Private equity as a share of global equity more than doubled from 2004 to 2013, for instance..
The CEM study demonstrates that private equity underperformance is far more fundamental. 1996 was during the glory years of 1995 to 1999, when private equity was coming out of a period of disfavor and was trying to distance itself from its earlier “leveraged buyout” branding, which produced a lot of terrible end of cycle deals in the late 1980s that blew up in the 1990-1991 recession. The industry story line has been that if you participated in those “vintage years,” you reaped outsized results. CEM has demonstrated you would have done even better in a simple stock index, a full 67 basis points, which over the long investing horizon of pension funds and life insurers, adds up.
A few brave US public pension funds are starting to kick the private equity habit. Because they have commitments they have to fund, and holdings that have yet to be wound up, it’s not as if they could go cold turkey. Last November, the $59 billion Pennsylvania Public School Employees’ Retirement System was planning to cut its private equity allocation from 15% to 12%. This measure appeared to be in response to a state commission recommendation to reduce the level of illiquid investments. This year, the $35 billion Pennsylvania Public School Employees’ Retirement System followed suit. An article in Buyouts summarized a board presentation by Chief Investment Officer Seth Kelly:
But the revolt Down Under is even more striking. One has to wonder if by being relative latecomers, they haven’t drunk as much Kool Aid as their US counterparts. I was in Australia from 2002 to 2004. I read the Australian Financial Review, their Wall Street Journal, daily and also briefly wrote for a top business magazine. Venture capital was a relatively new activity back then. Private equity didn’t make the financial press radar.
Even with superannation funds swelling as the working population and annual contribution levels have increased, the Financial Times indicates in passing that private equity hasn’t been a major investment:
Super-sized Australian pension funds that collectively control more than $2tn are expanding their in-house investment teams to join up with or even bypass private equity firms to place big bets on companies directly…
Large Australian superannuation funds have historically managed most of their mainstream portfolios in stocks and bonds in-house — and focused mostly on domestic markets — while outsourcing their smaller allocations to more specialised areas such as private equity to big US and European players.
But in recent years, industry insiders say the sector’s behemoths have begun building their own private equity teams, as they seek to bring down costs for members. While maintaining internal teams is expensive, it can still be much cheaper than paying the fees that top investment firms charge…
Funds that have recently brought private equity teams in-house include Aware Super — the A$135bn super entity formed through the merger of First State Super and VicSuper in July 2020 and then by absorbing WA Super in December — and Australian Super, the country’s largest super fund with A$180bn under management.
Aware has partnered with private equity firm MIRA for a A$4.6bn bid on Vocus, a Sydney-based telecommunications group, while AusSuper has teamed with Melbourne-based BGH Capital to bid for Virgin Australia.
So one reason the Australians have been immune to private equity cognitive capture is they simply weren’t willing to take much foreign exchange risk by taking the plunge in American or European or Asian private equity funds.1
The article then goes on to assume that the Australians will follow the Canadian model of making their own private equity investments but often relying on major private equity firms to manage the business:
But analysts say there are limits to how much the pension funds can go it alone. Even direct investments were often in partnership with a private equity firm that still handles most of the operational aspects, said Mark Wiseman, the chair of the Alberta Investment Management Corporation.
Even though Canada and Australia are resource-based economies, Bloor Street is a very short flight from Wall Street. Canada’s economy is very much entwined with the US, while Australia is acutely aware of its distance and therefore its need to go it alone. At an INET conference, I met some officials from small countries who volunteered that when they were looking for ideas for how to devise and implement a new program, they’d look to Australia first, because Australia had a good record of doing thing well.2 So the Australians are not the sort to slavishly copy the famed “Canadian model”.
Note the Australian super funds are working with domestic players. That means it’s conceivable that some staffers might jump the fence for a less pressured and less stressful lifestyle. Experts in the US say that there are employees at US private equity firms who would make that trade, when the pay gap is almost certainly greater than in Oz.
Note the tendency to minimize what the Australian funds have done so far:
However, in some steady, uncomplicated sectors — such as toll roads, airports and property — pension plans are increasingly comfortable operating alone. On domestic deals, the bigger Australian funds were more likely to start sidestepping Wall Street entirely in the future, said [Con] Michalakis [Chief Investment Officer of Statewide Super].
In fact, Australian financiers parleyed their leadership in project finance, a Wall Street backwater because most firms found the deals to be too complicated relative to the fees, into leadership in infrastructure finance. Even though the assets might not be hard to manage, the deals are structurally complex. Big US and UK private equity firms woke up to find the “millionaire’s factory” Macquarie, rebranded as MIRA, eating their lunch.
In the strategy that dominates private equity, “buyouts”, the value added is largely through financial engineering and cost-cutting, which would be attainable skills for any Australian “super” funds that wanted to play a bigger role. And for the smaller, faster growing companies where private equity firms claim they boosted their performance, insiders debate whether private equity firms did markedly improve results, or were simply good at finding “growthy” companies and knowing when to sell them.
In other words, check back in a few years. Odds are decent that the Aussies will go further than the pundits expect now.
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1 Hedging a long-dated and uncertain-cash-flow profile would both be very costly and well nigh impossible to execute well.
2 Australia is now showing the signs of neoliberal infestation, for instance, witness the decline of a once premier institution, the Commonwealth Science and Industrial Research Organization.
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Just as a general point, I think small countries in ‘catch up’ mode can often do things much better than big countries, especially big advanced ones. There is a lot of benefit in being able to look at a distance at what works and what doesn’t work in similar but more advanced economies. Countries like South Korea, Denmark, Portugal and Ireland have benefited a lot in economic development in being able to look with an unbiased eye on what their neighbours have done. I think this is a key reason why Australia so often does some things so well (not everything of course). But its rarely the case the other way – there seems to be a point in development where countries simply refuse to accept that they can learn from anyone else – you can see this attitude from the US and UK to Germany and Japan. This growing attitude may well be what trips up China as its growing increasingly arrogant about the success of its model.
There is also the case that sometimes smaller countries are more likely to avoid some of the BS that goes with some reforms. South Korea, for example, was more successful than most when it liberalised and opened up its financial system in the 1990’s largely, I suspect, because they took the need for strict rules and regulation seriously, rather than just seeing them as a smokescreen, as in the US and UK and elsewhere.
Australian here. Tony Robbins he of life coach fame, wrote a book some years ago about money. I learnt all about it via an interview with him on the Tim Ferrris podcast. ( I disagree with Ferriss ethics and values quite considerably incidentally. He had Madelaine Allbright on his podcast recently. Amongst many others of such character. Although I still like his fitness and training stuff) Anyway the book was supposedly based on Robbins interiewing all his .P.E mates like Ray Dalio, and using his reality distortion jedi mind tricks to convince them to tell him the secrets of investing. It was designed as a post 2008 book to save lower income families, so they can create a nest egg for their children. Now I’m a bit younger than the mean on this blog. I thought the process of creating an all seasons portfolio, that was conservative, and exponential, designed to create a bounty over decades, was worth looking into. It was a long time before I learnt Australian superannuation is designed to be basically identical to the process espoused in Robbins book. I can finish by saying Australian Super – that’s the actual name of the group – has been reported to me by retirees as giving the most exceptional returns. I’ve had retirees tell me how amazed and surprised they were, to see 10% gain on their Australian Super investment year after year. They’d been able to live on the interest without depleting the principal. This is not an advertisment. Just some anecdotes of how, supposedly competent that particular fund is. By the way in Australia there are laws requiring employers to make compulsory deductions from income, for super contributions. If one is a government employee, I think the government has to double whatever you nominate their compulsory deduction to be.
credit where its due. Within the same interview I refer to above. Robbins was asked by Ferris who their most punchable person was. Robbins responded with Obama. And relayed a story of how frustrated he was with Obamas policies, that clearly wouldn’t work to help people in lower incomes. ( I can’t recall the specifics). He told a story of actually being in discussion with Obama at the White House, it sounded like a function perhaps. Robbins was saying, look, you could get all the billionaires in the US, kill them, take all their money – and with that money you still couldn’t solve the problems you claim you are trying to solve. ( that’s almost exactly how he put it). And the Secret Service were moving in as they sensed how agitated Robbins was getting, with Obama diplomatically responding ‘ it’s okay it’s fine just some creative tension here it’s okay..’ According to Robbins.
I suspect that a lot of Australia’s relative success here is simply a function of the size of the population. That is, if you are in the finance industry and screw the pooch by listening too much to a private equity firm too uncritically, that word gets around real quick. And if your mistakes result in your being terminated from your position, it is not exactly like there are a lot of other places you can go to get a new job in this industry. An advantage too of Australia’s relative isolation is that we are slow to take up trends from larger countries like the US and the UK and I read the same in a synopis on Australia. And what that can mean is that if a trend is so awful that it quickly blows up, we get a preview of this before we decide to adopt the same here.
But where Yves says ‘Australia is now showing the signs of neoliberal infestation, for instance, witness the decline of a once premier institution, the Commonwealth Science and Industrial Research Organization’, this is unfortunately true. Another example is the Commonwealth Serum Laboratories. This was founded back in 1916 as an organization founded on manufacture of penicillin, antivenoms, hormones, vaccines and blood products. You would be thinking great, just the thing for the present pandemic. Except back in 1994 it was privatized and was publicly listed and traded. So now we pay billions for stuff that we use to get to develop. And the investors, who got back 500 times what they paid, laughed all the way to the bank-
https://independentaustralia.net/business/business-display/paying-for-what-we-used-to-own-the-strange-case-of-csl,14558
I worked for the CSIRO in the 1990s near Monash University. Even then, the neoliberal infestation had begun with “rationalising” the workforce. (Then, Neoliberalism went by the name of “economic rationalism”.) In the year 2000, more than half the scientific team was made redundant and many of those who weren’t defected to universities like Monash, Uni Melbourne, RMIT, if they could. (Unfortunately, this might not work today. The universities are all run like businesses where “bums on seats” is all that’s important to maintain cash flow..especially from foreign students and faculty is viewed as a useless liability.) It’s been some years since I’ve been there. I’d be interested in how COVID has changed the situation.
The classical economists identified the constructive “earned” income and the parasitic “unearned” income.
Most of the people at the top lived off the parasitic “unearned” income and they now had a big problem.
This problem was solved with neoclassical economics, which hides this distinction.
Confusing making money and creating wealth does the job nicely.
Everyone had expected economic liberalism to unleash capitalist dynamism.
In 1984, for the first time in American history, “unearned” income exceeded “earned” income.
Instead there was a stampede towards the easy money of “unearned” income.
They had forgotten you can make money doing nothing.
With a BTL portfolio, I can get the capital gains on a number of properties and extract the hard earned income of generation rent at the same time.
That sounds good.
What is there not to like?
You’ve just got to sniff out the easy money.
All that hard work involved in setting up a company yourself, and building it up.
Why bother?
Asset strip firms other people have built up, that’s easy money.
Eventually the light bulb has come on over private equity firms in the UK.
They’re making money, not creating wealth.
See below.
Made same comment twice by accident.
What is real wealth?
They had the same problem the last time they used neoclassical economics.
At the end of the 1920s, the US was a ponzi scheme of inflated asset prices.
The use of neoclassical economics, and the belief in free markets, made them think that inflated asset prices represented real wealth.
1929 – Wakey, wakey time
The use of neoclassical economics, and the belief in free markets, made them think that inflated asset prices represented real wealth, but it didn’t.
It didn’t then, and it doesn’t now.
It took them a long time to disentangle the hopelessly confused thinking of neoclassical economics in the 1930s.
This is the second time around and it has already been done.
The real wealth creation in the economy is measured by GDP.
Real wealth creation involves real work, producing new goods and services in the economy.
That’s where the real wealth in the economy lies.
The rentiers are exposed again.
Real wealth creation involves real work.
Not sure how off base I am here. The whole idea of pension and other funds investing in buyouts, refinancing the “assets” and selling asap before more refinancing is necessary is a form of ski jumping. If you want to go beyond the next best jumper you must get way out over your tips. Maybe that’s a bad analogy. I’m thinking all this PE, whether in house or wall street, sets a standard to be competitive in a way that will also set a standard to extract revenue (whether profits or refinance) too soon and too often. If pension funds weren’t all going into the red because of the last decade of low interest rates, private equity models might not be necessary. Private equity investing, to me, is an accelerated gain model. Gain of function for “equity” – but not sustainable. And I’d love to see everyone taking a clear look at why pensions are structured so dysfunctionally and then do something basic and long term to shore them up. As in ‘regulate’. It wouldn’t be so egregious (to me) if pension funds invested in start-ups with an eye to a new economy. Or maybe some direct financing like mortgages, etc.
https://tim.blog/2014/10/15/money-master-the-game/
For completeness here is the interview I mentioned above, with Tony Robbins describing the details of his acquired method for investing he put together for Americans. It’s free to listen and the transcript is there also
Just for info:
Bay Street is the more appropriate Toronto analogue to Wall Street. ‘Bay Street banker’ remains common shorthand, even though banks and brokerages have long since proliferated elsewhere in town.
Bloor Street is one of the two major avenues that bisect Metro Toronto (the other being Yonge Street).