How the Pennsylvania treasurer missed the mark

Is private equity worth the fees?

The question was thrust into the spotlight recently when Pennsylvania state treasurer Joseph Torsella accused Pennsylvania Public School Employees’ Retirement System (PSERS) and Pennsylvania State Employees’ Retirement System (SERS) of squandering billions of dollars on fees to private equity managers.

In a speech made at the Pennsylvania Association of Public Employee Retirement Systems conference in May, Torsella claimed the pair had wasted up to $5.5 billion in investment expenses, and that “at least one simple, low-cost passive strategy would have performed far better, and saved a fortune”.

Torsella’s comments were first reported in the Financial Times.

A “simple 60-40 global index strategy” would have delivered better returns in seven of the past 10 years for PSERS, and in six of the past 10 years for SERS, Torsella said.

The Pennsylvania treasury has initiated a review of the two pension systems, part of which will include a plan to identify $1.5 billion in cost savings over 30 years for each. The review will also recommend improvements to SERS and PSERS’ stress testing and fee reporting transparency, and analyse the pensions’ assets, investment strategies, investment performance, fees, costs, and procedures against established benchmarks.

Did Torsella have a point? We asked two industry thought-leaders to weigh in.

Professor Claudia Zeisberger, professor of entrepreneurship & family enterprise at INSEAD and academic director of its global private equity initiative:

Mr T appears to suffer from time-horizon selection bias, fee aversion, home bias and FOMO [fear of missing out]. Not all 10-year periods are created equal, net return is more important than just the expense side of the business, growth-oriented emerging markets require you to look beyond public markets for opportunities and extrapolating returns – and the fear of missing out on that future hypothetical wealth – is rarely a wise investment plan.

Most pension plans have a conflicting twofold mandate of both maximising and preserving their investors’ wealth. They are expected to generate a decent return without exposing their constituents to potential impoverishment, as the public markets’ 2008 global financial drawdown threatened.”

The S&P Total Return Index (dividends reinvested) delivered a 96 percent return (7 percent annualized) over the 10-year period ending December 2016. The same index was down 13 percent for the 10-year period ending 2008. Gold rose 600 percent during the 10-year period from 2001 to 2010 and has subsequently dropped by 30 percent. Basing an investment decision on the most recent 10-year performance is rarely a wise investment philosophy. And a consideration of possible drawdowns balances an unrestricted desire to maximise returns.

Focusing on fees alone is meaningless – net returns matter. A fee-focused investment strategy may expose one to higher volatility of returns and prohibit entry to growth-oriented emerging economies where public markets rarely provide the juicy deals.

LPs should always negotiate fees to get the best deal possible for the value provided by the fund manager and monitor those fees to keep the GPs honest. Nevertheless, LPs must realise that top-performing managers will rarely offer discounts.

Cyril Demaria, head of private markets at Wellershoff & Partners, a Zurich-headquartered financial and risk advisory firm:

Costs are a known and certain factor. If you can act on them, the reward is immediate in financial – and political – terms. You can show you’ve acted and you get praise for that. And the benefit is almost immediate – it shows in the next tax exercise, the next fiscal year.

It’s been 10 years now in which passive players have been quite well rewarded because of the bull run. Even if you invest in private markets, the time lag of performance means that even if you start to catch up with this 10 years of bull run, it’s still ongoing. So, in one way or another, active investors have been a little bit on the back foot.

It’s easy if you’re a small or mid-sized institution that’s been actively playing the passive thing to show very impressive net results. It’s a combination of luck and active choice. It might turn out to be a little riskier when there are some fluctuations.

Investing is about risk-return-liquidity evaluated over the long term. Maybe some investors have had a good run over 10 years with listed stocks, but the crash just before puts in perspective the risk this entails.

As a benchmark, over 20 years, the Norwegian Global Pension Fund Global, generated 6.1 percent returns, Yale over the same period 12.1 percent. This is strictly comparable, not IRR versus returns. That should give pause to investors willing to go all too passive. At the end of the day, someone designs indexes. Is there any empirical or theoretical proof that index designers are creating more value than private equity investors? Knowing that the stock exchange is shrinking in terms of number of listed companies, I would assume that concentration risks increase, and therefore going fully passive further might increase the actual risk of an investor.

Finally, stock exchange returns have failed to bridge funding shortfalls of pension funds. Putting more money there does not seem the answer to address that question: more of the same is not the answer to the woes of pension funds.

“As for the world of ‘alternatives’ that is bewitching many of us, I’ll leave that for another day… But I just want to note, there really aren’t “alternative” assets, there are alternative structures to hold assets. Those structures, in some way, simply amount to an elaborate and expensive bets on a manager’s skill. To take those bets, we have to be certain we’ve properly benchmarked them, adequately adjusted for risk, for leverage and for illiquidity, that we really understand the correlations, not just the ones in the past, the ones to come, that we’ve fully accounted for all the fees including ones that we’re just now discovering, like subscription line financing, and we’ve reckoned our return in real dollars not in easily-manipulated IRRs, and we need to be entirely confident that we have the institutional capacity to regularly pick the top quartile managers, between whom and the rest of the pack there is a huge gulf. That is, to put it mildly, a challenging list, so for today, just put me down as a sceptic.”

Joe Torsella

– Reporting by Rod James, Adam Le and Isobel Markham