Big returns not big enough for some this year

Are those huge private equity returns of the last fiscal year still disappointing? The portfolio could be suffering from the benchmark blues.

In the most recent fiscal year, eye-popping double-digit returns in private equity that handily outperformed other asset classes often failed to outperform their benchmarks. That's led some consultants and asset owner investment officials to blame the benchmark.

Unlike stocks, private equity lacks a clear, investible benchmark that can help investors determine whether the high fees, lack of transparency and long tie-ups are worth it. Many asset owners today measure their private equity portfolios against a stock index plus a premium that a number of investors have narrowed over the years. The rationale is that if private equity isn't performing better than the public markets, why invest?

Of the 37 endowments and public pension plans in Pensions & Investments' database that provided private equity benchmark results for fiscal year 2021, 20 outperformed their benchmarks, while 16 underperformed them and one broke even.

The $487 billion California Public Employees' Retirement System's best-performing asset class for fiscal year ended June 30 was private equity, with a net 43.8% return. However, the Sacramento-based pension plan's $38.9 billion private equity portfolio underperformed its benchmark in all periods including the 10 years ended June 30, the longest time period CalPERS reports.

CalPERS' private equity portfolio underperformed its benchmark by 1,730 basis points for one year, 56 basis points for three years, 209 basis points over five years and 147 basis points for 10 years.

Dan Bienvenue, CalPERS' interim CIO, noted at CalPERS' September investment committee meeting that part of the trouble with perceived underperformance is the custom benchmark that evaluates CalPERS' alternative investments portfolios against a public equity market equivalent. For fiscal year 2021, that means CalPERS' private equity portfolio was measured during a period when the stock market went from a low point in March 2020 through an equity market recovery to March 2021.

He also noted that "inconsistency in our (private equity investment) approach, and the lack of diversification within the asset class has led to our underperformance relative to our benchmark."

At the same meeting, Greg Ruiz, managing investment director for private equity, pointed out that the difficulty in measuring private equity's performance is that "there is not an investible benchmark, as you have with public equity."

As a result, CalPERS does not just rely on its investment policy custom benchmark of FTSE All World and FTSE All Cap Equity index plus 150 basis points, he said. CalPERS officials also take into account other measures including peer benchmarks, other asset classes and absolute performance, Mr. Ruiz told the board.

CalPERS private equity underperformed its benchmark due to a lack of consistency, a lack of diversification and high costs, Mr. Ruiz said. In addition to these factors, "private equity is likely to underperform in periods of rapid value appreciation in the public markets, as a result of private equity portfolio company valuations adjusting at a more measured pace," Mr. Ruiz said. Fiscal year 2021 was just such a year, resulting in the private equity portfolio's underperformance.

Lawrence Kochard, Menlo Park, Calif.-based CIO at money manager Makena Capital Management, said that when it comes to asset owners' private equity portfolios, there is "no silver bullet" to benchmarking private equity investments. Some use industry benchmarks such as those provided by an alternatives consultant.

But most industry benchmark providers do not identify which funds are included in their benchmarks, which could include funds that are extremely difficult for all but an exclusive group of institutional investors to access, Mr. Kochard said. "That's the beauty of a public benchmark," he said.

Benchmarking private equity "requires a mosaic" of measures, Mr. Kochard said. "If you are looking at one benchmark, you will miss something."

The challenge for private equity managers is that they "stick to their knitting" and continue to focus on beating the public markets, said Jase Auby, CIO of the $193.1 billion Teacher Retirement System of Texas, Austin. Speaking at the Milken Institute Global Conference at the Beverly Hilton hotel in Beverly Hills, Calif., in October, Mr. Auby acknowledged that outperforming public markets can be a challenge because "you can't live the highs so high … and can't live the lows so low."

Measuring private equity performance of individual managers against a benchmark and other private equity managers isn't easy.

Mr. Auby said that right now the biggest differentiator between private equity managers — other than their size — is how much a firm has leaned into a growth strategy rather than value.

Private equity was traditionally a value strategy in which managers "won on the buy," he said. In the past, private equity managers went into an underappreciated area or sector and bought companies cheaply, Mr. Auby said at the conference. These managers added value with such things as organizational changes and cost-cutting and made money selling the company for more than they had invested.

Today, many managers have pivoted to a growth strategy. He cautioned investors to "keep styles in mind" when comparing managers' past performance and attempting to decipher what future performance might be.

"I don't think there is any perfect benchmark that can be used as an industry standard," said Scott Voss, Boston-based managing director and head of the global fund investment group at alternative investment fund-of-funds manager HarbourVest Partners LLC. "One of the largest buyout fund managers in the world told us that the only real benchmark is how you perform against the public markets."

Even so, 2021 has been "one of the most unusual and amazing years" for private equity performance since he has been at HarbourVest, Mr. Voss said.

Venture capital is up 90% for the one-year ended March 31, he said. Within the asset class, Mr. Voss said, referring to industry and HarbourVest data, that private equity portfolios that were more heavily invested in venture capital and growth had the best performance, earning between 800 and 1,000 basis points more than portfolios overweight buyouts.

Indeed, Liza Crisafi, CIO of the $10.8 billion San Diego City Employees' Retirement System, said at the board's Sept. 10 meeting that while private equity along with public equity were the pension plan's two best-performing asset classes, both earning a net 46.7% for fiscal 2021 ended June 30, private equity underperformed its 58.3% benchmark. The reason, she said, was SDCERS' exposure to buyouts, distressed and special situation investments in its private equity portfolio. SDCERS has a 10% target allocation to private equity.

HarbourVest's Mr. Voss explained that venture capital and growth equity have benefited from the rapid growth of the technology and health-care sectors.

But this rapid growth makes it difficult to judge what percentage of a manager's performance is from investing in the right sectors and what percentage is from asset selection, Mr. Voss said.

"Were they (the private equity managers) alpha creaters or beneficiaries of being in a sector," he said. "It's a king tide moment ... a high tide that happens infrequently."

And this king tide moment is probably not sustainable, Mr. Voss said. In this environment when all private equity managers have "great returns," investors should put less weight on returns and focus on other criteria such as what differentiates a manager from the rest of the pack, he said.