Perspectives on the Performance of Private Equity for Public Pension Plans

February 7, 2025

FYI Week of February 7, 2025

New research suggests that buyout strategies financed by private equity (PE) “exhibit modest risk-adjusted outperformance” and that public pension plans “tend to perform better in their private equity investments than other private equity investors.” However, the Reason Foundation, a frequent public pension critic, charges that the shift to more private investment by public plans “reflects the trend of many public pension plans taking more risks in an attempt to make up for chronic underperformance and growing unfunded liabilities,” and that PE investments – “often pitched as a way to generate returns higher than the public market and diversify portfolios” — frequently “fall short when risks, fees, and market realities are accounted for.” What’s the real story?

Public pensions have significantly shifted their riskier investments from publicly traded stocks to alternative assets such as private equity and real estate over the past two decades. Has their increased allocation to PE investments “enhanced the investment opportunity set” by producing positive risk-adjusted returns, or “are they merely high-cost vehicles for taking on risks similar to those available in public markets?”

These are the questions asked in a recent paper entitled “Private Equity for Pension Plans? Evaluating Private Equity Performance from an Investor’s Perspective” by Arthur Korteweg, an Associate Professor of Finance and Business Economics at USC Marshall School of Business; Stavros Panageas, Professor of Finance at UCLA Anderson School of Management; and Anand Systla, a Ph.D. Student of Finance at UCLA Anderson School of Management. In developing their answers, the authors determined whether the rates of return associated with PE investments “represent meaningful outperformance, or just compensation for the risk embedded in these investments.”

In answering these questions, the authors do not determine the riskiness of PE investments by computing the net present value of PE cash flows (capital calls and distributions) by discounting these cash flows using the cumulative rate of return of public equities over the same time period, rather than the rate of return on riskless bonds. They believe this approach “fails to properly account for risk, especially in cases where private equity cash flows cannot be replicated by a dynamic trading strategy in publicly traded stocks and bonds.”

Instead, they apply an alternative approach, which uses the cumulative return on the investor’s entire portfolio to discount the returns of PE. This approach “ensures that if a private equity investment is simply a levered version of a public equity investment, then it will automatically signal that the private equity investment exhibits no outperformance,” they explain. They also use an “investor-specific” measure, in that PE cash flows “are discounted more heavily when an investor’s portfolio loads on risks that covary more strongly with PE.”

As the authors explain, “[s]imilar to how a doctor evaluates whether a patient should take a medicine depending on its interactions with the other medicines that the patient is already taking, our measure evaluates a private equity investment differently depending on whether an investor is already taking risks similar to the private equity investment, or whether the addition of a private equity investment presents largely a small and diversifiable source of risk for the investor.”

Thus, because it is investor-specific, their measure allows the authors of the paper to distinguish whether a PE investment improves the risk-return tradeoff of an investor’s portfolio (“positive risk-adjusted performance”, or a higher ratio of expected excess return to standard deviation of the investor’s portfolio), or whether the investment “simply delivers a higher return by raising the riskiness of the investor’s portfolio in a manner similar to what the investor could achieve by taking on more risk in other publicly-traded asset classes.”

Using this methodology, the paper analyzes public pension plans’ PE investments from 1995 to 2018 and develops three key takeaways:

PE-financed buyout strategies exhibit modest risk-adjusted outperformance, whereas venture capital and real estate funds do not. Thus, “[p]ension plans appear to have pursued an optimal allocation to private equity investments overall, in the sense that there was no significant benefit in changing the investment in a representative PE fund,” the paper concludes.
Public pension plans tend to perform better in their PE investments than other PE investors. However, “this is mostly due to better access to private equity investments rather than selection ability,” the authors note. Specifically, they say that pension plans did realize higher risk-adjusted returns in the funds in which they chose to invest, compared to an average PE fund of the same vintage, but “this appears to be due to differences in access rather than skill in picking outperforming funds.”
While there is a material correlation between a pension plan’s underfunding and the internal rate of return (IRR) of their private-equity investments, the research finds this correlation is driven by the fact that underfunded pension plans appear to be choosing comparatively riskier private equity investments, which command higher risk premiums.

[Interestingly, the research also found that plans with boards that have a larger fraction of state officials and members of the public appointed by a government official take more risk but earn lower risk-adjusted returns in their PE investments. Specifically, the paper notes in its conclusion that “pension plan boards that have a higher fraction of state officials and appointed members of the public tend to invest in riskier funds but earn lower alpha.”]

Nevertheless, a recent commentary that appeared in the Los Angeles Daily News by Mariana Trujillo, a policy analyst with the Reason Foundation’s Pension Integrity Project, argues that the plan of the California Public Employees Retirement System (CalPERS) to increase its investments in private equity and private credit by 20 percent — so that it represents 40 percent of its portfolio — is dangerous, stressing that:

private post-2008 PE returns have been unimpressive, “failing to beat public markets on a fee and, importantly, on a risk-adjusted basis;”
the CalPERS portfolio achieved an average annual return of 6.7 percent during the past 20 years, while a passive 60/40 public stock/bond index portfolio achieved a 7.7 percent average annual return; and
CalPERS failed to beat the S&P 500, which delivered a 9.7 percent return over the last 20 years, and this holds true for the past 5-, 10- and 15-year periods.

Trujillo argues that the CalPERS shift to more private investment reflects the trend of many public pension plans “taking more risks in an attempt to make up for chronic underperformance and growing unfunded liabilities.” She concludes that CalPERS – and all other public plans – should adopt “efficient, low-cost investment strategies like using index funds, which have outperformed it by all measures.”

[The Reason Foundation is a long-time critic of public pension plans, believing pension reforms “should follow the clear and undeniable trend in the private sector and convert employees from DB plans to self-directed, 401(k)-style DC plans as much as possible.” It has received over a million dollars in grants over the years from the Laura and John Arnold Foundation (now part of Arnold Ventures). One of the Reason Foundation’s other policy analysts with their Pension Integrity Project, Steven Gassenberger, has said “most public pension systems that only offer a defined benefit pension plan are what they produce—a coercive and aristocratic benefit that garnishes the already limited compensation of new, shorter-term workers.”]

Interestingly, Emil Siriwardane, Harvard Business School’s Finnegan Family Associate Professor of Business Administration, has recently effectively addressed Trujillo’s premise that public plans are taking on more risks in an attempt to make up for chronic underperformance and growing unfunded liabilities.

In a recent interview with the Harvard Business School “Working Knowledge” digital publication – that “distills the latest Harvard Business School faculty research into practical insights” — Siriwardane discussed why state and local pension funds “are rethinking the riskier end of their portfolios.”

While acknowledging that the proportion of alternative investments by US public pensions have increased significantly — from 14 percent in 2001 to 40 percent in 2021 — he says that the “narrative floating around when we started looking at the data several years ago” – namely that as interest rates came down and public pensions became more underfunded, they therefore turned to alternative investments to help close their funding gaps – was questionable.

Why? Because “it was surprisingly hard to find evidence for this narrative, as the most underfunded pensions have shifted just as aggressively toward alternatives as the best-funded ones.” He points out.

Instead, Siriwardane and his colleagues have examined another potential reason: “as interest rates came down, a lot of institutional investors, including public pensions, were probably encouraged to rethink their views on different asset classes and what’s attractive and what’s not attractive.”

He says there is evidence that many pensions ultimately became more bullish on these alternative asset classes, like private equity, real estate private equity, and lately, private credit, because they believed “it has a good risk-return profile, or a better risk-return profile, than they thought 20 years ago.” And that seems to have driven a lot of capital flows, he suggests.

While Siriwardane thinks of alternatives as asset classes or investment products that are “illiquid, opaque, and [charging] relatively high fees,” he also suggests public pension investors “may be willing to accept the higher fees and opacity if they believe alternatives will deliver favorable risk-adjusted returns in the future.” He also points out that “historically, many of these alternative assets have delivered high returns relative to traditional asset classes like stocks and bonds, all while exhibiting a seemingly low correlation with these traditional investments.”

Finally, Siriwardane says he thinks the message of his recent paper, “The Rise of Alternatives,” is that “beliefs are important” for understanding why some pensions invest heavily in alternatives. “The point here is to have to an empirically grounded process by which your beliefs are formed,” he stresses.

“My view is that with alternatives, like most forms of active investing, there’s decreasing returns to scale when it comes to creating alpha,” he also notes. “In other words, the bigger you get, the harder it is to outperform, in part because there’s more competition.”

While “being early to the party in alternatives” was advantageous for endowments in the 80s and 90s, Siriwardane says “the landscape has significantly changed over the last thirty years” and there is “a lot more competition, especially among the larger alternative asset managers with whom pensions tend to invest.”

Have public pensions therefore “arrived at the party too late and are now paying fees in these asset classes that are not justified by their performance,” he asks? While his new research and the earlier paper noted above –- evaluating private equity performance – provide new insights into this important area of public plan investing, one things seems certain: arguably simplistic views of PE investing, such as that advanced by the Reason Foundation, do little to help policymakers and the public understand the dynamics and justifications for institutional investors’ continuing interest in this important asset class.

As teachers know, “knowledge is power.”