Calpers bets on leveraged stocks

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Calpers

From the Financial Times' outspoken pensions expert, Josephine Cumbo, yesterday:

Calpers, the largest public pension plan in the United States, aims to increase its holdings in the private markets. . . A proposal to increase the fund's $483 billion positions in assets such as private equity and private credit from 33 percent of the plan to 40 percent was approved Monday. . .

The formal approval comes two years after Calpers admitted that the decision to suspend its private equity program for 10 years cost it up to $18 billion in revenue.

However, a review of its investment policy found that despite the gains it had already missed, private equity was still the asset class with the highest expected long-term total return.

Calpers said this in announcing the change

Private equity will increase the fund's 13 percent target to 17 percent, while private debt will rise from 5 percent to 8 percent. . .

Targeted allocations to public equities and fixed income will be reduced under the new policy. Customize Calpers for [public] Equity will amount to 37 percent of the fund, and fixed income will be reduced to 28 percent.

The troubling aspect of this customization decision jumps right off the page: Calpers appear to be steering the car through the rearview mirror. The outperformance returns that private markets have achieved over the past decade will be a poor guide to their returns in the next decade, unless they are accompanied by a good theory about where that outperformance comes from and why it should continue.

As Unhedged has previously argued, there are at least three good reasons to believe that private equity will do worse in relative terms. At least one of them, and perhaps two, apply to private credit as well:

The rapid growth of the private equity industry has led to increased competition for assets, and thus higher buyout valuations. This results in lower returns compared to common stocks. This compression may explain the apparent outperformance of private equity firms; See the chart below from Bain & Company's Global Private Equity Report (remembering that internal rates of return are not the same as dividends). It would not be surprising if private credit returns followed the same pattern relative to high-yield bonds.

The critical component of private equity's historically high returns – very cheap debt – may not be available in the coming years. Of course, it is possible that, once inflation subsides, interest rates that were very low before the pandemic will return. But there are reasons to doubt this, ranging from shifts in the balance of savings and investment to higher levels of government debt. And remember that while higher interest rates help private credit funds through higher payments from borrowers, these funds also carry debt of their own, amplifying the returns.

If you consider a private equity portfolio roughly equivalent to a leveraged public equity portfolio — as Unhedged does — then the fundamental returns on US public stocks are a critical component of your private equity return (depending on your global equity weightings). But US stock returns are likely to be lower in the next ten years than in the past ten, for the simple reason that they have been extraordinarily high in the past decade, at 12 per cent a year relative to the broad Standard & Poor's 1500 index. Long-term stock returns pretty reliably return 7 percent or so.

Calpers' investment desk may have a theory about why private equity will continue to be the best asset class in the next 10 years. But I don't know what that theory is, and it's not in the slide decks from the bureau's recent asset allocation review or the 2023 confidence level review. What these slides show is, first, the fund's historical returns by asset class, with private equity leading the pack by 11.4 percent over 10 years, private debt with the second best one-year return. Apologies to those reading on the phone, who will have to squint:

Calpers also provides asset volatility and correlations (although it's not clear to me whether these are historical numbers or assumptions about the future):

Finally, here are the expected return assumptions for each asset class, derived from a survey of the fund's money managers. Special stocks on the left:

It is good to see, in this latest chart, that expectations for private equity returns do not call for a repeat of the past decade. Instead, the average forecast (blue dot) is an annual return of 8 percent, just a percentage point or two better than hoping for common stocks. The distance between the blue and orange dots shows that expectations have shrunk since the previous analysis, in 2021. This seems logical. But the key question still remains: Where do the higher return expectations for private equity versus public equity come from?

I think it comes from influence. Private equity is more leveraged than public equity – in terms of debt, it is similar to a stock index bought with 30 percent borrowed money. Stocks usually rise over the long term, so leveraged stocks usually rise more. The bet investors are making, then, is that the additional return from leverage will outweigh the fees of private equity funds. If this is the reason behind Calpers' higher long-term return forecasts, it stands to reason, and is another sign of prudence, that the long-term volatility that Calpers assigns for private equity is much higher than for public equity, at 25 percent versus 17 percent. 100 (second slide, upper left corner). More leveraged assets are more volatile than less leveraged assets, whether they are marked to market, such as public stocks, or not, such as private equity and private credit. If the high long-term volatility number is an acknowledgment of that, then that's a good thing for Calpers.

What doesn't make sense, if private equity is leveraged equity, is that the correlation between public and private equity should only be 0.6. Even more puzzling is that the correlation between private debt and high yield cannot be explained by 0.3! A private equity or global debt portfolio should be closely linked to a public equity or global debt portfolio. They have many of the same basic things, although exposure to industry or country may differ slightly. The absence of a private sector brand in the market, as well as the complete control of companies, may make it easier to overcome ugly spots in the markets. There is value in this. But if we're entering a really bad decade for stocks, leveraged private funds will only make things worse, and won't help brands.

One good read

Let's eat snakes! (Hat tip to the fringe revolution).

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