Private Eye: A look behind the latest CalPERS performance numbers

Is the much-discussed private equity portfolio of California Public Employees’ Retirement System performing even better than widely thought?

An examination of the performance and cost figures that CalPERS released late last month on its private equity program suggests that it is. Revelations include:

• Realized deals are outperforming the rest of the portfolio, suggesting untapped value in the unrealized portfolio.
• CalPERS has paid far less than the 20 percent market rate for incentive fees.
• Its sponsors have recycled billions of dollars of distributions into new investments.

Also noteworthy: About a third of private equity firms that have begun collecting carried interest have yet to return all capital drawn down from CalPERS. It is a fact that probably isn’t widely understood by those outside the industry. And it is one that could lead to further criticism of the high cost of the asset class.

Among the headline numbers disclosed in a November 24 press release, CalPERS put the carried interest paid to 256 active funds that responded to its request for carry data at $3.4 billion. For those same funds, it listed original investments of $29.3 billion, total realized proceeds of $53.5 billion, and net gains of $24.2 billion. The pension system noted that the data came from its “newly operational” Private Equity Accounting and Reporting Solution (PEARS).

I pulled out cash-flow data for most of those 256 funds (data on 17 was missing) from CalPERS performance numbers posted on the pension fund’s website to do some further analysis. I also received answers to several follow-up questions from Joe DeAnda, information officer at CalPERS.

At first glance you might assume that the $29.3 billion in original investments is the amount drawn down by sponsors into all investments in the 256 funds, both unrealized and realized. That would be a mistake. CalPERS confirmed that the $29.3 billion refers to the amount invested in realized transactions only.

At the same time, you might assume that the total realized proceeds number gets reduced by the more than $8 billion in distributions that have been recycled into fresh investments — just as distributions get reduced by recycled capital for funds listed on the CalPERS website. But again, that isn’t the case here.

Revealingly, having both these numbers lets us calculate a pure multiple of invested capital (MOIC) on realized deals of 1.83x. That compares to the 1.59x MOIC produced by dividing aggregate value (both unrealized and realized) by invested capital for all vintage 2010 and older funds listed on the CalPERS website. What this suggests is that sponsors are giving CalPERS interim valuations on unrealized deals that understate where they eventually end up once sold or taken public.

For comparison, funds in the Buyouts Insider performance database, including more than 2,000 buyout, venture capital and related funds spanning vintage years 1981-2010, have a median investment multiple of 1.4x.

“For most managers that we track, their exit values are typically higher than their carrying values,” said David Fann, president and CEO of LP advisor TorreyCove Capital Partners. One reason is the widespread use by sponsors of competitive bidding to sell their companies. “Ego gets involved and adrenaline [is] flowing and eyes get bigger and wider,” Fann said.

More good news for CalPERS comes when you divide the $3.4 billion in carried interest paid sponsors by the gross realized gains of $27.6 billion ($24.2 billion in net gains plus the $3.4 billion in carry paid). The resulting figure of 12 percent is far less than the industry standard 20 percent for incentive fees, also referred to as carried interest. In part, wrote DeAnda, that results from CalPERS’s “efforts to negotiate reduced fees and carry … For example, some investments only [charge] 15 percent carry.”

Two additional factors account for the remainder of the discrepancy. First, some firms, under the terms of their funds, don’t begin taking carried interest on profitable realizations until returning at least all contributed capital. And second, many firms must provide CalPERS with a priority return (typically 8 percent) before taking profits.

But giving all that good news its due, the emphasis on realized deals in this latest round of performance disclosures obscures a fact that could provide fodder for critics of CalPERS’s PE program. The pension fund would naturally prefer to get all its money back from a fund before paying carried interest. But it often concedes to a so-called “deal-by-deal” distribution waterfall that lets sponsors collect carry on profitable deals well before that. I count 53 funds on the CalPERS website that have been paid carried interest even as distributions have yet to exceed cash drawn down.

Could some of those firms have collected carried interest on deals that they shouldn’t have based on the final performance of the fund? The experience of the venture capital market in the aftermath of the Internet bubble suggests it’s possible. (CalPERS would have recourse through a partnership term called the GP clawback, which requires sponsors to return money taken in excess of their agreed-to profit-share.)

Those critical of how expensive private equity is relative to other asset classes could point to deal-by-deal distribution waterfalls as one more reason to be skeptical.

TorreyCove Capital’s Fann sees something else in these latest numbers, especially considering the size of CalPERS’s private equity portfolio. “For the dollar amounts they put out, to generate the gross and net returns they’re talking about is extraordinary.” He added: “I think private equity is doing what it’s supposed to be doing for that program, which is generating long-term capital gains.”

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