Academic studies have noted the declining returns. Buyout funds outperformed the S&P 500 by 1.75% annually in the 1990s and 1.5% in the 2000s, but since 2006 have had the same returns as that index, according to a 2015 study by finance professors Robert S. Harris, University of Virginia; Tim Jenkinson, University of Oxford; and Steven N. Kaplan, University of Chicago.
Some trustees are starting to question whether private equity is worth it. Given falling expected returns, they wonder if they are being fully compensated for the risk. At a minimum, institutional investors are realizing private equity won't boost their portfolio's overall returns in the future unless they can reduce the cost of these pricey investments.
When CalSTRS officials changed the system's private equity benchmark in July, Trustee Keith Yamanaka questioned why the West Sacramento fund was bothering to invest in private equity at all.
Private equity was supposed to be a higher-returning asset class due to risks presented by the investments, Mr. Yamanaka said. "The risks have not changed but the return we are hoping to get is a little bit lower. I would want some assurance … that, in fact, despite the lower potential return, the risk still justifies our investment in the asset class. We may not want to overlook a potential issue that might come back to haunt us."
Like many institutional investors, CalSTRS is banking on changes to its investment strategy in the form of its collaborative model to cut costs and more efficiently invest its capital, including bringing more aspects of its investment activity in-house.
Currently, 8.7% of CalSTRS' private equity portfolio is in co-investments. Under the pension plan's collaborative private equity model, that is expected to increase substantially.
The collaborative model could be one tactic CalSTRS can use to reduce costs and gain more return, said Steven Hartt, principal at CalSTRS' private equity consultant Meketa Investment Group Inc.
The Oregon Investment Council, which runs the $76.6 billion Oregon Public Employee Retirement Fund, lowered private equity's annual expected return to 9.25% from 9.5% when it changed its asset allocation in April. The council did not change its 17.5% private equity allocation target or its benchmark.
Earning outsized returns in private equity is far from guaranteed, experts say.
"Performance of private equity is not that high unless you select the very best funds," said Ludovic Phalippou, professor of financial economics at Said Business School, University of Oxford.
"I do not see a drop in private equity returns just yet, but would expect one for future returns due to silly fee structures'' negotiated during boom times, Mr. Phalippou said.
Private equity and venture capital managers had a combined $3.3 trillion in assets under management, including $1.1 trillion in dry powder — capital raised but not yet invested — at the end of 2018, according to a recent PitchBook Data study. All that capital chasing private equity deals has led to a five-fold increase in transaction value over the last nine years, to $1.7 trillion in 2018, the report noted.
Whenever the stock market performs well, investors wonder why they are bothering to lock up their money in private equity, said Sasha Grutman, co-founding partner of merchant bank Middlemarch Partners LLC.
"If you have a long-term perspective, there is absolutely a place for private equity," Mr. Grutman said.
Mr. Phalippou said large investors have the edge because they can push back against their general partners on certain terms. "They can co-invest and get other side benefits. They may save on transaction costs compared to deploying large amounts on public markets," Mr. Phalippou said.
CalPERS and CalSTRS are doing just that. CalPERS' new investment plan will boost co-investments but also invest directly alongside a new outside entity that it will seed.