Los Angeles-based Cliffwater LLC has recently updated a report it prepared a year ago on how state pension systems have fared by way of their investments in private equity.
The report as updated finds that PE created on average a 10.7% annualized return across 21 state pensions over its 16-year database. This meant that the pensions’ returns from PE outperformed stocks. But averaging masks a very wide spread of results, from 8.1% to 14.3%. Cliffwater says that this range signals “the importance of fund selection.”
Cliffwater says that it finds “some evidence” that PE excess returns have compressed over time, but it can’t be definitive about this; its results are not statistically significant.
Market Cycles and Return Series
The study period is 2002-2017. As the report observes, there are two full market cycles within that period. The bear market if 2002-02 was followed by the bull of 2004-07, the next bear (a monster of a bear) of 2008-09, then the bull beginning in 2010.
From the Comprehensive Annual Financial Reports of the state pensions through that period the authors of this report created two composite performance series: One is a return series, representing a hypothetical investment at the start of 2002 that consisted of equal weights of each of the 21 state pensions that were invested in PE as of 2002 and that have continued in PE every year since, a return series calculated without any rebalancing. The other is the average return of all state systems reporting PE returns for each year in the database. The number of state systems included in this calculation grows steadily from 21 in 2002 to 51 by 2017.
The return on the 21 state composite through the whole period was, as noted above, 10.7%. Within the bull markets it was 17.5%, within bear markets -7.5%. This gives a standard deviation of 14%.
The return on the second series, the private equity composite, was 10.2%. Within the bull markets it was 17%, within bear markets -7.7%. This gives a standard deviation of 13.4%.
The author of the Cliffwater report, Stephen L. Nesbitt, compared both of these series to the return on a public equity benchmark. The return on public equity was 6.6%. Within the bull markets it was 14.6%, within bear markets -14.1%. This gives a standard deviation of 16.5%.
The first series of private equity data outperforms the second, and Nesbitt is not sure why that is so.
More important, though, the data seems to contradict the common idea that PE is simply levered public equity. If that were the case, one would expect PE to perform better than the public benchmark in bull markets, more poorly than the same public benchmark in bear markets. What one finds, though, is that PE, for state pensions, outperforms in both good times and bad, with a larger outperformance in the bad times.
Will this outperformance last or is it compressing? The Cliffwater author writes that he ran a multiple regression in which the private equity composite return is the dependent variable. He used three independent variables for this: the concurrent public equity benchmark; the same benchmark with a one-year lag; and the passage of years.
The result shows “a negative, but statistically insignificant coefficient associated with the passage of time, suggesting that compression in private returns should remain a concern but any conclusion now would be very premature.”
A 1997 Article Recalled
Nesbitt has done other work on the comparison of public and private equities. For example, more than 20 years ago the Journal of Portfolio Management published an article he co-authored with Hal W. Reynolds, on “Benchmarks for Private Market Investments.” There, too, the authors took issue with the notion that PE is levered public equity. The idea doesn’t seem to have gone away so it remains available for debunking.
The bottom line of the 2017 study, with its 2018 update, is that PE has produced a significant (4%) annualized excess return vis-a-vis the public benchmark of “similar geographic composition.” This comes with the caution that the data “ignores the selections, weightings, co-investments, and other decision factors that state pensions make in managing a private equity portfolio.”