Why CalPERS Private Equity is Underperforming Their Benchmarks

by Michael Roth

We recently conducted an analysis of CalPERS’ private equity portfolio since 2000 using peer benchmarking analysis and PME analysis. As the largest private equity investor in the US, CalPERS is often viewed as an influential LP in the private equity community. While they are good at picking managers from its peer universe, PME analysis showed CalPERS to be insufficient at selecting managers that deliver alpha.

To be sure, private equity has been their best performing asset class in their portfolio over the long term but it has been underperforming CalPERS’ benchmarks over the 1, 3, 5, and 10-year horizons. Looking at investments made since 2000, CalPERS has committed 63% of their capital to above average managers. However, PME analysis showed that 57% of their capital is committed to funds that underperformed the Russell 2000.

Takeaways

• Link between 1^st quartile funds and PME outperformance – 75% of first quartile funds outperformed the market.
• PME analysis shows peer analysis not comprehensive enough – 42% of funds that outperformed market were not in first quartile of peer universe.
• Buyout funds performed best against the markets – 53% of their capital committed to buyout funds outperforming the market.
• Fund of Fund performed the worst against the markets – 17% of the capital committed to fund of funds outperformed the market.

Conclusions

PME analysis has existed for close to 20 years but it’s use in fund analysis has really been perfunctory until recently. Most analysis is focused on peer universe analysis but PME analysis is increasingly being seen as a necessary and additive analysis that should be a part of the due diligence process. Bison believes this analysis could have aided CalPERS in their manager selection and investment style allocation.

Introducing Bison PME

by goksor

CHANGING HOW YOU THINK ABOUT PME BENCHMARKING

Today Bison is announcing the Bison PME methodology for estimating an IRR for a public market index. The new methodology addresses shortcomings of other public market equivalent (PME) IRR methods and how they handle cash flows. It is built on the work of Steven N. Kaplan and Antoinette Schoar presented in a 2005 paper titled Private Equity Performance: Returns, Persistence, and Capital Flows and introduces a way for estimating public market index cash flows for PME analysis. Investors can use the Bison PME alongside Kaplan Schoar PME to evaluate the speed and size by which alpha is generated relative to public markets.

IRR AND ESTIMATING PME PERFORMANCE

Investors increasingly use PME calculations to determine whether a fund manager is able to outperform the public markets. Where investors calculate public market returns using a time-weighted return calculation, they calculate private equity returns using a money-weighted return calculation (IRR). This has led to apples and oranges comparisons that are hard to evaluate. PME calculations enable investors to calculate a money-weighted return for a public market index.

Most of the PME calculations generate an IRR for a certain market index. This allows for apples to apples comparison of a fund’s IRR versus a public market index. It means, however, that PME calculations are exposed to some of the problems inherent in evaluating returns with only an IRR metric. For instance, we have previously shown that an early distribution can inflate a fund’s IRR and similarly that a fund with a lower TVPI multiple can generate the same IRR as a fund with higher TVPI multiple. There are two major points to remember about why IRR is best understood in combination with a TVPI:

IRR is a money-weighted measure – The IRR calculation is impacted by the size and timing of cash flows. This exposes the calculation to manipulation since multiple variations of cash flows can generate the same IRR. For PME IRR calculations, we believe it is important to replicate the pace of value realization in the fund when calculating an IRR for a public market index. At the same time, the PME calculation has to be sensitive to the impact of the market on the cash flows.

IRR measures speed and not size of returns – The IRR calculation assumes that realized returns can be re-invested at the same rate of return. This means that a proportionally large distribution occurring early in a fund’s life will have a disproportionate impact on the IRR for the life of the fund. When evaluating a private equity fund, it is important to look at the fund’s IRR alongside its TVPI multiple. This standard should also be followed when conducting PME analysis.

INTRODUCING BISON PME

Bison PME is a calculation that enables investors to measure public market IRR and TVPI performance. We developed the methodology after closely evaluating other PME methodologies and their shortcomings that result from how they handle the private equity fund’s cash flows. Specifically, we believe that it is important to leave constant the speed and proportionate value generated in the fund when calculating a PME IRR. We want to lower the risk of PME IRR being impacted by how IRR is calculated market. Based on early testing of 125 funds, Bison PME showed less volatility than other PME methodologies while accurately reflecting changes in public market index value.

CLICK HERE TO LEARN MORE ABOUT CALCULATING BISON PME AND READ OUR INITIAL WHITE PAPER.

We believe PME methods are important for understanding private equity performance and encourage investors to incorporate it into their fund performance analysis. The Bison PME method is an open standard provided for free. We believe it is best used side-by-side to Kaplan Schoar, but also encourage comparison with other PME methods.

Bison PME is available today for free to all Bison Performance Calculator users.