Weak private equity returns force US pensions to rely on stocks

The slump in private equity returns has increasingly pushed US pensions and endowments to lean on an old and familiar investment: Stocks.

Large public pension funds including California Public Employees’ Retirement System, Alaska Permanent Fund, and Teacher Retirement System of Texas, and endowments at Ivy League schools such as Columbia University, have been heavily reliant on public market investments to both bolster performance and free up cash. 

But chief investment officers concede they’ve partly been playing for time, leaning on stocks until private equity starts to pay out again. It worked for the fiscal year that ended June 30 for most big institutional funds, but the recent selloff is a reminder of the risks. 

In Alaska, for example, the state’s $80 billion fund will draw entirely on equities to make its next payment to the state treasury. It would typically rely on returns from all asset classes to do so, but not this time, said Marcus Frampton, the fund’s chief investment officer.  

“It’s so nice that stocks have been up so much — that’s freed up the money needed,” he said, noting that their private equity investments haven’t made a meaningful contribution since 2021. For Alaska and its peers, that raises the stakes for stocks, he said: “If you have a 10% or 20% correction, it’ll be really painful.” 

The S&P 500 gained 22.7% from July 2023 to June 2024, and pensions with higher proportions of stocks are expected to report better performance for that fiscal year, according to a projection by Markov Process International, a research firm that studies pension fund and endowment investment returns. 

Funds are just beginning to report performance for the 2024 fiscal year that ended June 30. Calpers, the largest pension system in the country with more than $500 billion of assets, reported a 9.8% gain driven by a 17.5% return in public equity investments. The private equity return, which lags one quarter, was 10.9%.

Similarly, the California State Teachers’ Retirement System with $341.4 billion of assets reported an 8.4% return, bolstered by a 19% gain for public equity investments.

Under the circumstances, investors have begun to reconsider their enthusiasm for private equity. A decade ago, it seemed reasonable to expect the asset class to return4% over a similar basket of stocks, leading institutions to increase their allocations. Pension funds built their private equity stakes to 13% on average, up from 8% in 2014 and 3.5% in 2004. University endowments went further, with between 25% to 45% of their assets now in private market investments. 

That expected premium is down to 1.5%, and deal-making has dried up, pushing private equity payouts to their investors to their lowest level since the financial crisis. Last year, distributions by some of the biggest private equity investment managers fell almost 50% compared with 2021.

This month the Texas teacher’s pension fund, which manages $202 billion of assets, decided it will shift almost $10 billion out of private equity investments and into public equities. It expects continued pressure on returns from the illiquid assets and will take several years to exit the private investments.

For endowments, which typically contribute 5% of net assets annually to a school’s operating budget, the lack of returns from private equity puts double the pressure on the public stock and bond portfolio to perform well, said Kim Lew, CEO of Columbia’s $13.6 billion endowment. 

Even with the increased allocations to private equity over the last decade, stocks still make up the lions’ share of institutional portfolios. 

Alaska’s Frampton recalled that 2022, the worst year on record for public stocks since 2008, was also terrible for pension returns. Many public pensions and six of the eight Ivy endowments reported negative returns that year. Both Calpers and Calstrs had their worst performance in more than a decade due to the market rout. 

“Any small catalyst that causes a repricing of markets now could mean more pressure on an investment portfolio,” said Yup Kim, the chief investment officer for the $40 billion Texas’s Municipal Retirement System. The “strong equity markets year-to-date are masking problems if folks have any.”