Arthur Korteweg is an Associate Professor of Finance and Business Economics at USC Marshall School of Business, Stavros Panageas is a Professor of Finance at UCLA Anderson School of Management, and Anand Systla is a Ph.D. Student of Finance at UCLA Anderson School of Management. This post is based on their recent paper.
Introduction
Public pension plans, like many other institutional investors, have steadily increased their allocation to private equity investments over the last two decades. (Figure 1) This trend prompts an important question: do these investments enhance the investment opportunity set by delivering positive risk-adjusted returns, or are they merely high-cost vehicles for taking on risks similar to those available in public markets? In the paper “Private Equity for Pension Plans? Evaluating Private Equity Performance from an Investor’s Perspective” we propose a new methodology to disentangle whether the rates of return associated with private equity (PE) investments represent meaningful outperformance, or just compensation for the risk embedded in these investments. We then apply the methodology to evaluate the returns obtained by public pension plans.
Our findings suggest that PE financed buyout strategies exhibit modest risk-adjusted outperformance, whereas venture capital and real estate funds do not. We also find that public pension plans tend to perform better in their private equity investments than other private equity investors, but this is mostly due to better access to private equity investments rather than selection ability. Finally, we identify a material correlation between a pension plan’s underfunding and the internal rate of return (IRR) of their private-equity investments; however, 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.
Background
To illustrate the issue of performance evaluation, it is helpful to start by noting that the returns of private equity investments exhibit high internal rates of return (IRR), substantially exceeding the yields in the treasury market. But this could simply be a manifestation of the riskiness of these investments. To account for the riskiness of private equity (PE) investments, a popular approach is to compute 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. As we explain in more detail in the paper, 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.
We propose an alternative approach, which uses the cumulative return on the investor’s entire portfolio to discount the returns of private equity (we also define a more generalized version that uses an appropriately leveraged version of an investor’s portfolio return, to account for the possibility that different investors may have different attitudes towards risk.) This approach has two theoretical advantages. First, it 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. Second, our performance measure is investor-specific. In particular, private equity cash flows are discounted more heavily when an investor’s portfolio loads on risks that covary more strongly with private equity. Similar 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.
Being investor-specific, our measure allows us to distinguish whether a PE investment improves the risk-return tradeoff of an investor’s portfolio (“positive risk-adjusted performance”, i.e., 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, we analyze public pension plans’ PE investments from 1995 to 2018.
Key takeaways
- Risk-Adjusted Performance: For our sample period, our outperformance measure is approximately zero, indicating that the representative pension plan would not have benefited from changing its allocation to PE. A notable exception is buyout funds, which show a positive risk-adjusted performance. This performance is partly, but not entirely, due to their value exposure. By contrast, VC funds underperformed on average (but less so than publicly traded small-growth firms).
- Selection vs Access: We do not find evidence that pension plans had market timing skill. We do find that the PE funds that were selected by public pension plans outperform the average PE fund of the same vintage year, but this does not seem to be due to a genuine ability to select the better-performing PE investments. Rather, it appears that the PE funds give certain investors preferential access to the better PE investments: pension plan “selectivity skill” disappears when we confine attention to the universe of private equity investments that are continuations of ongoing relationships with a given pension plan, or when we consider first time funds (which are likely to be less selective about their clients).
- Risk-Taking Behavior: We find that underfunded pension plans, and 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. Investments in PE funds that are located in the pension plan’s state do not differ from out-of-state funds in their level of risk, but they do earn lower risk-adjusted returns. Taken together, these results are suggestive of agency problems, such as gambling for resurrection and political influence, playing an important role in the selection of PE investments by pension plans.