CalPERS, the $360 billion California’s state pension fund, just announced plans to increase its investments in private equity. It’s not hard to see why. Despite the high fees charged by private equity funds, CALPERs claims there are huge payoffs. Its private equity portfolio returned 16.1% in 2017, compared to just 11.5% for its stock portfolio, and it delivered a 10.5% annual return over the last two decades.
In the last 20 years, private equity has grown as an asset class, and a once small part of the market is now a major part of the economy. But there is no free lunch in finance, and the rise of private equity may pose risks to the economy, and to the tax payers who will have to make up the shortfalls in public pension funds if their investments don’t pay off.
How did private equity get so big?
Private equity can mean many different things. It includes everything from venture capital, which finance start-ups, to large firms like Blackstone and KKR that buy existing companies, turn them around, and resell them. Its growth has been fueled by pension funds, insurance companies, endowments, and other rich investors all looking for higher yielding assets and, in the case of pensions, make up for their underfunded benefits. The result is more capital entering the industry.
There are also more companies raising capital in private markets instead of going public. Ownership by private equity can be an appealing option for tech companies because their value lies in intellectual property, which is harder for markets to price than in traditional industries where capital lay in machines and land. In theory, private markets make it easier for knowledge-driven industries to grow and thrive. Raising money privately also spares companies onerous regulations like those under the Sarbanes-Oxley Act, which puts a heavy compliance burden on small growing companies. Staying in private markets is easier. It’s no surprise that as private equity has become more popular, the average age of firms in public markets increased.
Private equity is often cast as a destructive force that slashes employment and dismantles companies, but the funds argue they provide struggling companies with capital and management expertise to become more profitable. There is evidence that the industries where private equity dominates tend to be more successful. But private equity’s size is becoming its own obstacle, and with only so many good investment opportunities out there, big firms are either making riskier bets or keeping their power dry. According to McKinsey, private equity’s uninvested assets sitting on the sidelines have been rising since 2012 and now exceed $1 trillion. That is capital that could potentially be deployed to more productive use elsewhere in the economy. There have also been fewer exits, according to McKinsey, which could mean investments aren’t paying off like they used to.
Is it a smart investment?
Pension funds claim their private equity investments outperform their other assets. Estimates indicate that, even after very high fees, the funds offer impressive returns. But the returns may not be as good as they appear.
To properly evaluate the claims, it’s important to adjust the returns for risk, because otherwise comparing different asset classes can distort the picture. Make no mistake, private equity is a risky asset class. Many private equity strategies involve heavy borrowing to amplify returns and it’s hard to know if private equity funds’ high returns reflect value and superior performances, or if they just took more risk and got lucky. Because the investments are illiquid, investors can be locked out of their money for several years and won’t have it when they need it, another form of risk.
To complicate matters, data is hard to come by. Many firms report returns irregularly so it is hard to get a sense of how the fund evolves and provides a hedge against other kinds of asset classes.
Firms in private markets often face less oversight than public companies, which could lead to fraud, like at notorious biotech startup Theranos. No accountability to shareholders helps explain why some thriving unicorns, like Lyft, attract millions of dollars in funding, despite never earning a profit. Perhaps all that capital would have been better invested in a profitable firm.
There are also distributional concerns. In the last 40 years, public markets have become more democratic. While once only rich people tended to own stock, now more than half of Americans do. If the best investments, especially in fast growing new companies, remain in private markets, fewer Americans will be able to invest in them and share in the wealth.
There is a useful role for private equity, and in the best cases it can make companies more efficient and provide a useful source of capital in the fast-growing knowledge economy. But it is worth asking if private equity has become so large it is starting to pose new risks. There can be too much of a good thing, and as pension funds expand their investments in private equity, we could be reaching that point.