1. 1 Eileen Appelbaum Center for Economic & Policy Research and University of Leicester Rosemary Batt ILR School Cornell University

2. Prologue: Performance of CalPERS Private Equity Investments Investments in private equity are riskier than investments in public equities (the stock market) – They should have higher returns than stocks (beat the market) – not just high absolute returns Median PE fund beat stock market 1995-2005 but not in last decade CalPERS PE investments haven’t beaten its stock market benchmark in YTD, 3-year, 5-year and 10-year windows – Despite high absolute returns, CalPERS would have done better in the last decade by investing in stock market index fund 2

3. Overview of Presentation Private equity performance – Measurement – Persistence – CalPERS performance PE Fees: Why the house never loses 3

4. Measuring Pension Fund Performance Internal Rate of Return (IRR) is a flawed measure Academic researchers and many financial firms (e.g., Goldman Sachs) use Public Market Equivalent (PME) PME compares an investment in a PE fund to an equivalently timed investment in the relevant public equity market (e.g., S&P500, Russell 3000) A PME of 1.20 implies that at the end of the fund’s life, investors will earn 20% more than if they had invested in the stock market – If fund has 10-year life span, outperformance is less than 2%/year 4

5. Pension Fund Performance Harris, Jenkinson & Kaplan (2014) PME compared to S&P 500 PME compared to S&P 500, Russell 3000, Russell 2000 5 Buyout Funds PMEs VintageAverageMedianWtd. Average 2000-08 average1.271.251.29 Sample average1.221.161.27 Buyout Funds PMEs VintageS&P 500Russell 3000Russell 2000 2000-08 average1.271.251.28 Sample average1.201.181.11 Sample median1.111.091.02

6. Pension Fund Performance Harris, Jenkinson & Kaplan (2014) Things to note: – Data are from only LPs that use Burgiss system to track performance – In the 2000 – 08 vintages, a large majority of investments by the median fund had not been realized at time of analysis – Difference between average and median in sample  average driven by top performers PME shows performance over the life of the fund – If funds have 10 year life span, PME of 1.27 is outperformance of 2.4% a year – PME of 1.11% is outperformance of just over 1% a year If Russell 2000 is right benchmark, investors in half the funds in sample would have done better in stock market 6

7. Performance of Fully Liquidated Funds Source: Robinson and Sensoy (2011, 2013), Tables 2, A-2* * Data: 368 pre-vintage year 2006 funds, liquidated by 6/302010 ** “Tailored PME”: Fama-French size tercile index according to whether the fund is self-described a small-cap, mid-cap, or large-cap buyout fund 7 S&P PMETailored PME** Mean1.181.10 Median1.091.00 25 th %ile0.820.77 75% %ile1.461.37

8. Persistence of Performance Likelihood that next funds are in same performance bracket Kaplan and Schoar (2005): pre-2000 Harris, Jenkinson, Kaplan, Stucke (2014): post-2000 8 BottomMiddleTop Bottom Tercile49%31%20% Middle Tercile30%38%32% Top Tercile21%31%48% 4321 Bottom Quartile32% 14%21% Third Quartile18%39%28%15% Second Quartile21%32%23%24% Top Quartile19%30%29%22%

9. PE Hasn’t Beaten Stock Market Since 2005 (PitchBook 3Q2015 Benchmarking Report)

10. CalPERS Monthly Update Performance & Risk 10 Net Return (Absolute Return) Private EquityFYTD3-YR5-YR10-YR20-YR As of 6-30-158.9%14.1%14.4%11.9%12.3% As of 8-31-153.1%15.2%14.9%12.0%12.5% Sources https://www.calpers.ca.gov/docs/board-agendas/201508/invest/item04c-03.pdf https://www.calpers.ca.gov/docs/board-agendas/201510/invest/item04c-01.pdf

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12. Absolute Returns – Wrong Measure for PE Absolute return strategy not appropriate for risky investments – No benchmark – No adjustment for risk LPs continue to invest in PE based on absolute return measures – U.S. stock market has been at or near record highs  PE can sell portfolio companies at high prices – PE distributions to LPs are high now, but may not beat their benchmark – LPs are looking at absolute returns and re-investing in PE CalPERS staff focused on absolute returns at a recent board meeting 12

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14. CalPERS Stock Market Benchmark The CalPERS benchmark comprised of – 2/3rds of the FTSE U.S. Total Market Index + – 1/3rd of the FTSE All World Total Market Index (ex US) + – 300 basis points (outperformance of 3% a year) CalPERS staff are now questioning this benchmark 14

15. CalPERS Monthly Update Performance & Risk 15 CalPERS Performance Returns vs. Benchmark Private EquityFYTD3-YR5-YR10-YR20-year As of 6-30-15-2.21%-2.64%-0.61%-3.00%0.93% As of 8-31-15+0.04%-6.13%-2.08%-2.80%1.20% Sources https://www.calpers.ca.gov/docs/board-agendas/201508/invest/item04c-03.pdf https://www.calpers.ca.gov/docs/board-agendas/201510/invest/item04c-01.pdf

16. Why the ‘House’ Never Loses: Management Fees PE collects management fees from LPs & charges expenses to LPs that should be covered by the fees – KKR and Capstone – Failed transactions – Indemnification clauses: settlements with SEC paid out of fund profits, costly but invisible to LPs Management fee waivers – GP waives management fees from LPs in exchange for priority claim on profits – taken off the top – So LPs still paying; money comes out of right pocket instead of left – Taxed as capital gains rate – benefits GP, but taxpayers’ are losers – Fee waivers circumvent tax code 16

17. Why the ‘House’ Never Loses: ‘Advisory Fees’ PE charges advisory and monitoring fees to portfolio companies – Reduces: Resources for growth, price at exit, & LP returns – Uses accelerated fees, evergreen fees Illegal use of monitoring fees if services not specified – Monitoring fee contract must specify services to be provided – Fees must be commensurate with services provided – Otherwise, dividends disguised as monitoring fees – Fees reduce portfolio company’s tax liabilities, dividends don’t 17

18. PE Returns Net of Fees Carried interest is a share of the fund’s profit paid to the GP based on fund performance -- > performance or incentive fee Most GPs report returns to LPs ‘net of performance and management fees’ – lack of transparency Without full disclosure of these fees, LPs can’t evaluate what GPs are charging for their services or the effect on returns CalPERS estimates that the combined fees [performance fee + management fees] = 7% of pension fund investments in PE 18

19. 19 Thank You