- Public pension plans, like many other institutional investors, have steadily increased their allocation to private equity investments over the last two decades. (Figure 1) This trend prompts an important question: do these investments enhance the investment opportunity set by delivering positive risk-adjusted returns, or are they merely high-cost vehicles for taking on risks similar to those available in public markets? In the paper “Private Equity for Pension Plans? Evaluating Private Equity Performance from an Investor’s Perspective” we propose a new methodology to disentangle whether the rates of return associated with private equity (PE) investments represent meaningful outperformance, or just compensation for the risk embedded in these investments. We then apply the methodology to evaluate the returns obtained by public pension plans.

- Our findings suggest that PE financed buyout strategies exhibit modest risk-adjusted outperformance, whereas venture capital and real estate funds do not. We also find that public pension plans tend to perform better in their private equity investments than other private equity investors, but this is mostly due to better access to private equity investments rather than selection ability. Finally, we identify a material correlation between a pension plan’s underfunding and the internal rate of return (IRR) of their private-equity investments; however, this correlation is driven by the fact that underfunded pension plans appear to be choosing comparatively riskier private equity investments, which command higher risk premiums.

Key takeaways:

- Risk-Adjusted Performance: For our sample period, our outperformance measure is approximately zero, indicating that the representative pension plan would not have benefited from changing its allocation to PE. A notable exception is buyout funds, which show a positive risk-adjusted performance. This performance is partly, but not entirely, due to their value exposure. By contrast, VC funds underperformed on average (but less so than publicly traded small-growth firms).

- Selection vs Access: We do not find evidence that pension plans had market timing skill. We do find that the PE funds that were selected by public pension plans outperform the average PE fund of the same vintage year, but this does not seem to be due to a genuine ability to select the better-performing PE investments. Rather, it appears that the PE funds give certain investors preferential access to the better PE investments: pension plan “selectivity skill” disappears when we confine attention to the universe of private equity investments that are continuations of ongoing relationships with a given pension plan, or when we consider first time funds (which are likely to be less selective about their clients).

- Risk-Taking Behavior: We find that underfunded pension plans, and plans with boards that have a larger fraction of state officials and members of the public appointed by a government official, take more risk but earn lower risk-adjusted returns in their PE investments. Investments in PE funds that are located in the pension plan’s state do not differ from out-of-state funds in their level of risk, but they do earn lower risk-adjusted returns. Taken together, these results are suggestive of agency problems, such as gambling for resurrection and political influence, playing an important role in the selection of PE investments by pension plans.