At first glance, the most surprising aspect of CalPERS’s report about the private equity performance fees it pays is not the large size of the fees but rather the small size of the returns.
According to the report, CalPERS’s private equity portfolio has yielded only 11.1% since inception. In comparison and as Alexandra Stevenson of the New York Times points out, an investment across the Standard & Poor’s 500 over the same period of time would’ve yielded 9.4%. That means private equity provided CalPERS with only an additional 1.7% per annum. That’s small compensation for big risks and fees.
Private equity risks include illiquidity, debt leverage, and concentration. Illiquidity means investors can’t easily sell their shares. Debt leverage increases the risk of equity loss (e.g., if a private equity fund invests $20 in equity and borrows $80 to purchase a company for $100, just a 20% drop in the value of the company would wipe out 100% of the equity). Concentration means a portfolio is at risk to a small number of investments. Those risks can be worth it if one is paid enough. Does 1.7% seem like enough to you?
Worse, even 1.7% overstates the incremental benefit from private equity because one may choose to employ leverage to boost returns from S&P500 investments. Had CalPERS done so, it would’ve earned at least 11.1% — and retained liquidity and diversity to boot.
Worse yet, investing in the S&P500 requires small or no fees while CalPERS paid more in private equity fees than it earned.
It’s hard to see how CalPERS is justified in taking the big risks and paying the big fees associated with private equity. But perhaps there is more to the story.