Private equity sleight of hand makes so-so investments look superb, critics say

At CalPERS, private equity funds reported an average 12.1% annual return over the last five years. But what's behind those returns?
At CalPERS, private equity funds reported an average 12.1% annual return over the last five years. But what’s behind those returns?
(Max Whittaker / Getty Images)

Pension funds are taking aim at private equity firms for exploiting a financial sleight of hand that can make even mediocre investments look brilliant.

Discontent has been simmering for a couple of years, but now the California Public Employees’ Retirement System and others are more forcefully pressing their case. The dispute centers on a common — and legal — practice: To make an investment, private equity funds are increasingly borrowing against clients’ commitments, then asking for the cash later.

This strategy packs a powerful, if obscure, punch: goosing the reported return on investment. How? It shortens the time that a customer’s actual money is deployed. That changes the math that private equity firms use to calculate their results. Consultant Cambridge Associates figures the approach can inflate a fund’s return by as much as 3 percentage points a year.

Private equity firms say the retirement pools benefit from holding on to their cash longer. They are “pursuing this in droves, like a Black Friday shopping mob,” Andrea Auerbach, head of global private investments research at Cambridge Associates, wrote in a blog post last month.

In contracts over the last year, CalPERS, the largest U.S. public pension fund, has tried — so far without success — to eliminate these kinds of loans, known as subscription credit lines, according to people briefed on its concerns who requested anonymity to discuss private conversations. At CalPERS, private equity funds reported an average 12.1% annual return over the last five years, the most of any major asset class in the fund, which manages about $350 billion on behalf of 1.9 million public employees, retirees and their families.


APG Group, which manages about $550 billion on behalf of government and education employees in the Netherlands, is opposed to private equity firms’ growing and what it considers excessive use of the loans, according to people with knowledge of its concerns. Low interest rates are encouraging more private equity firms to borrow aggressively and extend the terms of the loans, these people said.

Some of the biggest private equity firms, including Apollo Global Management, Ares Management, Carlyle Group and KKR & Co., have disclosed in securities filings that they use these credit lines, without indicating their precise effect on investment performance. Ares and KKR said their reported returns would generally have been lower without the loans, though they didn’t say how much lower. Apollo and Carlyle declined to comment, and the other companies either didn’t respond or referred to their filings.

TPG, co-founded by billionaires David Bonderman and Jim Coulter, appears to have been among the most transparent. By using a credit line, TPG was able to boost the “net internal rate of return” on its 2015 buyout fund to 22% from 15%, as of the end of last year, according to a March fund document viewed by Bloomberg News. TPG declined to comment.

Tough comparisons

The juicing of returns with borrowed money makes it harder for pension funds and other institutions to compare the actual investment skills of private equity funds, according to Oliver Gottschalg, an associate professor at French business school HEC Paris.

“You can have a situation where even after 10 years, a fund is reporting an overstated level of returns,” Gottschalg said. “In more than 15% of cases, this could put them into a different performance quartile.”

For their part, private equity groups say such borrowing is merely a short-term tool that helps firms invest money between “capital calls,” when institutional investors are required to follow up their commitments with cash. By using credit lines, firms can react quickly and invest in new deals, providing a “win-win” for both institutional investors and the private equity firms, says Jason Mulvihill, general counsel of the American Investment Council, a Washington group that represents private equity firms.

Some customers agree, such as Karl Polen, chief investment officer of the Arizona State Retirement System. Polen calls the loans an efficient way to manage cash, as long as they’re repaid every three to six months and aren’t used simply to increase returns. The Wyoming Retirement System sees the credit lines as mostly beneficial as well, and appreciates the way they can minimize multiple calls for capital, said a person familiar with the pension system.

‘Bad rap’

“They are getting a bit of a bad rap,” said Zachary Barnett, a partner at law firm Mayer Brown who represents banks that make loans to private equity funds. “Investors are only on the hook for the money they already promised the fund, which would be the case with or without a credit facility.”

Representatives from Wyoming and APG declined to comment. CalPERS spokeswoman Megan White declined to comment beyond saying that the pension giant backs guidelines from the Institutional Limited Partners Assn. that call for limited use of borrowing and enhanced disclosure. The association represents customers of private equity funds.

Still, even some within the private equity world acknowledge their own risk in investing with borrowed money. What happens if the customer can’t come up with the cash later? Oaktree Capital Group, one of the largest alternative asset managers, is developing guidelines it expects to help mitigate those risks, which could arise during a financial crisis.

Hidden risk

“It’s mostly during crises that weaknesses are exposed,” Howard Marks, co-chairman of Oaktree, wrote last year in a memo to clients.

For now, it’s unclear whether the pension funds will be able to change this practice. Private equity firms, which took in a record $453 billion last year, are being flooded with money and can basically dictate their terms. Customers are then forced to make decisions with incomplete information on a fund’s performance, said Jennifer Choi, managing director of industry affairs for the private equity customer group.

Private equity funds “are telling you what the terms of trade are to participate,” Ashby Monk, a researcher on pension and sovereign wealth fund design at Stanford University’s Global Projects Center, told the CalPERS board in Sacramento last month. “They are using scarcity. They’re using side letters. They’re using more tricks than I could probably fit into a 20-minute conversation.”

Perlberg, Willmer and Gittelsohn write for Bloomberg.