Banking on “A Superior Form of Capitalism”

For over two decades Minnesota public pensions plans’ investments in private equity have delivered the outsized investment returns needed to meet Minnesota’s defined benefit plans’ high return expectations.  In today’s persistent low interest rate environment, the demand for private equity is greater than ever.  But all is not well in Camelot.

The Minnesota State Board of Investment (SBI) has reported a 4.2% return for FY 20 for its Combined Funds which includes the assets for both active and retired public employees in the statewide retirement systems.   Considering the economic chaos engulfing the second half of the fiscal year it’s a welcome achievement, even though many are scratching their heads over the disconnect between the economy and stock markets.   Regardless, a 4.2% gain still falls short of the assumed 7.5% on which Minnesota’s defined benefit plans are based.   That will be reflected in the valuation reports later this year.

With fixed income yields hovering around historic lows and expected to continue for the foreseeable future, defined benefit pension plans face challenges achieving their expected returns.[1]   As the Wharton Pension Research Council notes, defined benefit plans have “three options to improve their funding levels in a chronic lower-return future: increase contributions, reduce costs, or increase risk.”[2]   Assuming more risk has been a staple of Minnesota pension funding in part because of SBI’s excellent track record in ”alternative investments”—particularly the world of private equity.   Whether past performance is predictive of future returns is another question.

The Appeal

Private equity are investments made in companies that are not publicly traded.   Participation in control-oriented investments/buyouts and venture capital investments are the two key private equity sub-segments; the former making up the majority of private equity investment activity in the country.   Over the years private equity has come to play a hugely expanded role in the nation’s economy.  According to the Institutional Limited Partners Association, businesses backed by private equity employ more than 8.8 million Americans accounting for a stunning 5% of U.S. GDP.   And according to the Milken Institute, by the middle of 2018, private equity owned more companies than the total number of businesses listed on all the U.S. stock exchanges combined.  

The stated investment appeal for Minnesota pension funds has several dimensions.  They include:[3]

  • Necessary diversification -- to industry type, capitalization, stage of business development, location, and other considerations
  • Value improvement through operational improvement -- in many if not most cases, the investment is associated with ownership or majority control of the company allowing the ability to make changes to business strategy, operations, and capital structure to improve efficiency and profitability
  • “Patient” capital / resistance to “short-termism” -- Private equity takes a longer term view of the business and is immune from the pressure to forsake long term strategy/business objectives for short term results that can be endemic to publicly-traded companies
  • Greater flexibility -- ability to reach into areas of the global economy that have large demands for capital that public markets are unable to provide.

Put all this together and many see an asset class able to offer the rarest of combinations – the potential for obtaining higher returns with lower volatility/risk as compared to public equity markets.  That belief is reflected in the enthusiastic statements made by institutional investors around the country.   The Chief Investment Officer of the mammoth $372 billion California Public Employees' Retirement System has said “we need private equity, we need more of it, and we need it now.”[4]  Others go even further extolling private equity’s role and contributions to the economy and society in general.  The head of Yale University’s endowment has declared private equity, “a superior form of capitalism.”[5]

Minnesota’s historical experience with private equity bears the accolades out.   According to the most recent SBI performance report dated June 30, 2020, the state’s 5, 10, and 25 year private equity returns are 12.6%, 13.5%, and 15.3% respectively.    These returns are all net of the expensive and often criticized fees routinely charged by private equity managers (routinely 2% for assets under management and 20% of any gains on its investments after a certain return is achieved.) making them even more impressive.   Currently, the SBI has 140 investments in private equity funds spread across 54 investment managers representing $16 billion in multi-year commitments.

There are two other important aspects of private equity that don’t get discussed as much but contribute no less to the popularity and attractiveness of this asset class to public pension funds.  The first is lower return volatility resulting from valuations that are established by the judgments of an accounting firm that works for the private equity fund, not by the market.  As Kurt Winkelmann, former Managing Director at Goldman Sachs and currently Chair of the Advisory Board for the Heller Hurwicz Economics Institute at the University of Minnesota, told us:

“An investor (such as a public pension fund) wants to smooth out accounting statements from the effects of large economic shocks.  Large drops in public equity returns can have significant adverse effects on pension accounting and required contributions. Including assets whose returns are naturally smoothed can dampen the effects of such shocks even if the true economic exposure is the same. Private equity is such an asset, because of the infrequent valuations.”  

In a moment of considerable candor this natural smoothing effect of reported and actual risks has been described by the Chief Investment Officer of the Public Employee Retirement System of Idaho as “phony happiness.”[6]

The second is the use of large amounts of debt.  The high return targets for public funds can’t be achieved without using some form of leverage.   As Winkelmann notes, “Private equity gives public funds leverage without having to tell anyone.”   Private equity tends to substantially increase the amount of leverage in the firms over which they take control.  A 2018 study by the global asset management firm Verdad found that private equity firms leverage up the businesses they buy 70 percent of the time — typically doubling the amount of debt on the balance sheet from 2.5 times EBITDA (earnings before interest, taxes, depreciation, and amortization -- a common measure of cash profitability) to 5 times EBITDA.   Today, according to the Bain 2020 Global Private Equity Report, deals with debt multiples higher than 6 times EBITDA now constitute more than 75% of the total.   Bain adds, “the true leverage of many deals may be even greater, as banks commonly allow borrowers to calculate multiples based on projected earnings instead of actual results.”

There is a difference between a beneficial capital restructuring by assuming a reasonable amount of new debt and taking a company’s leverage to levels far beyond industry standards and what is serviceable endangering the company itself.   Crossing that line has given private equity a public black eye in many circles (perhaps best captured by the satirical news website The Onion in its recent headline, “Protestors Criticized For Looting Businesses Without Forming Private Equity Firm First”).  One development that has mitigated this risk for private equity investor interests is the increasing use of “covenant-lite” loans.  These loans lack the usual safeguards protecting lenders.  Covenant-lite loans can even turn traditional finance topsy-turvy by subordinating debt to equity and allowing private equity holders first claim on assets.   A record 89% of institutional loans issued last year by private equity backed borrowers were covenant-lite — compared to only 6% in 2010.  Institutional Investor has described this lending behavior as a “potential disaster in the age of private equity.”[7]

Headwinds in Creating Value

There is no sign that interest in private equity is diminishing.  Private equity today has a record $1.5 trillion cash on hand ready to be put to use.   However, value creation and obtaining the type of superior investment returns that have come to be expected from private equity is a lot more difficult today for several reasons.

Asset inflation is at the top of the list.  Cheap debt and eager investors have driven prices up for private companies of all types.  Private equity firms historically bought companies at much lower valuations making larger returns easier to engineer.  At the same, deals now entail much larger amounts of debt than before.   As one private equity observer notes,  “there is a big difference — bigger than most realize —  between what private equity used to do (buy companies at 6-8 times EBITDA and a reasonable 3-4 EBITDA of debt) and what private equity does today (buy companies at 10-11x EBITDA with a dangerous 6-7x unadjusted EBITDA of debt).”[8]  The average multiple of enterprise value to EBITDA for a leveraged buyout has now reached 11.5x in the US. Over 55% of US buyout deals in 2019 had an EV/EBITDA purchase price multiple above 11x.[9] 

According to the Bain’s 2020 Global Private Equity Report the number one source of anxiety among private equity executives (70% of respondents) is overheated asset valuations.   The global head of private equity for the megafirm Blackstone has said, “this is the most difficult period we have ever experienced…You have historically high multiples of cash flows and low yields (as) I’ve ever seen in my career.  It’s the most treacherous moment.”[10]

In difficult macro conditions and amid stiff competition for assets, creating the value private equity investors have come to expect is difficult.   One of the biggest red flags is found in the Bain report: since 2010, the main driver of private equity investment returns has not been business and operational improvements like revenue growth or operating margin expansion but rather “multiple expansion” – a willingness by others to pay more for a dollar of company earnings.    In Bain’s study of fully realized buyout deals completed in the last decade, growth in multiples led to nearly half of the increase in enterprise value.  In another examination, Bain found average operating margins were 3.3% below deal model forecasts, with 71% of investments falling short, including 14 of 18 that identified margin improvement as critical to value creation.    The report concludes, “the game is getting harder as asset prices soar,” while noting “returns of private and public equities have started to converge in the U.S.”

No Substitute for the Fundamentals: A Modest Proposal

Many factors are still working in private equity’s favor.  One consequence of COVID is that it’s likely creating some very ripe conditions to snap up troubled companies at bargain basement prices.   Cheap money does not appear to be going away anytime soon.  Specific sectors especially in enterprise software and IT services are still said to present considerable opportunity.  But perhaps the biggest thing private equity has going for it is that it is approaching “too big to fail” status — if it hasn’t already achieved it.[11]   As noted earlier, private equity has fundamentally woven itself into the very fabric of the U.S. economy, affecting millions of workers directly and millions of others through their retirement plans.   It is worth noting some of the strongest advocates for enabling private equity to access PPP and other federal COVID support programs have been Democrat congressional leaders.

But even with these supporting factors, it’s clear with the headwinds facing this sector the State Board of Investment will likely face more challenges delivering the outsized returns private equity has been provided for the past couple of decades.   The key success factor appears to be “Minnesota exceptionalism” – managing the investment program carefully and prudently and being able to do the due diligence necessary to find and participate with above average performers.

Even more importantly, regardless of how well the SBI manages its private equity program, how much it grows, and how big the returns are, it will never supplant adequate contributions as the key to state pension sustainability.  In their study examining different strategies to improve funding levels in a lower return future, the Wharton Pension Research Council concluded “increased contributions deliver the most powerful combination of certainty and impact on portfolio performance” as compared to cost cutting or assuming greater portfolio risk via alternative investment strategies including private equity.[12]   Unfortunately, as we have learned over the years, increased contributions also deliver the most powerful combination of indigestion and annoyance to lawmakers, government administrators, and public employees.   

As the University of Minnesota’s Heller Hurwicz Economic Institute has observed, “the root cause of public pension funding woes is poorly designed governance.” Contribution policy is Exhibit A of this malady.  Constitutionally-mandated balanced budgets automatically tilt policy towards the management of short-term budgets.  In addition, since pension deficits are not included on state balance sheets, there is no natural accounting mechanism that penalizes long-term underfunding. As the Institute concludes, states have few, if any, incentives to maintain their required contributions.[13]

Minnesota’s track record of meeting its annually required pension contributions over the years has been abysmal.   Necessary contributions have been ignored, put off, then when reluctantly adopted, gradually phased in over time to maximize their political acceptability while reducing their beneficial impact.   According to the plans’ annual actuarial valuations, since FY 2002 contribution deficiencies by themselves have added $7 billion to the state’s unfunded pension liabilities.  It’s a major reason why the funded ratios for state plans have not improved all that much during a period when SBI has routinely thumped its investment targets.

All this hints at a radical pension proposal that would also be a fascinating test of just how deep the confidence among lawmakers and government administrators really is in our pension system:  enact a constitutional amendment requiring the actuarial annual required contributions to be made.

Minnesota could pass a law requiring the annual required contributions to be paid every year, but lawmakers can always change laws as circumstances demand and as they see fit.  An amendment to the state constitution, however, could make that requirement permanent.   Such a proposed amendment presents an interesting thought exercise.   Would elected officials support the idea knowing the political distress it would likely trigger and the additional demands it would place on state and local budgets if passed?  If not, what would the arguments be for opposing what actuaries and defined benefit experts tell us we need to do to deliver on our long-term promises and be fiscally responsible while doing it?   State contribution requirements are already based on five years of “asset smoothing” to avoid unnecessary overreactions to the market, so any arguments of that nature would be irrelevant.  

We won’t hold our breath that such a proposal will materialize.  But it would jump start a real pension reform discussion and examination.  In one way, a constitutional amendment could be thought of as the “private equity version” of pension reform:  a higher risk strategy one might prefer not to have to rely on but because of problems elsewhere, it has to be pursued.


[1] The same low interest rate environment also increases the present value of pension plan liabilities but we pretend that Is not the case by using expected asset returns as discount rates.

[2] “Getting More from Less in a Defined Benefit Plan: Three Levers for a Low-Return World,” in How Persistent Low Returns Will Shape Saving and Retirement, Wharton Pension Research Council, University of Pennsylvania, 2018

[3] Summarized from “Tab P” in the Minnesota State Board of Investment’s “Investment Policies and Management Practices,” 2013, pp 371-379

[4] “Calpers Wants to Double Down on Private Equity,” Wall Street Journal, March 17, 2019

[5] “Private Equity: Overvalued and Overrated?” American Affairs, February 20, 2018

[6] Ibid

[7] “When Buyout Firms Step In, Watch Out” Institutional Investor, April 3, 2019

[8] “Private Equity: Overvalued and Overrated?” American Affairs, February 20, 2018

[9]  Global Private Equity Report, 2020, Bain and Company

[10] “Private Equity: Overvalued and Overrated?” American Affairs, February 20, 2018

[11] “To Big To Fail, COVID Edition: How Private Equity is Winning the Coronavirus Crisis” Vanity Fair, April 9, 2020

[12] “Getting More from Less in a Defined Benefit Plan: Three Levers for a Low-Return World,” in How Persistent Low Returns Will Shape Saving and Retirement,   Wharton Pension Research Council, University of Pennsylvania, 2018

[13] ”Revisiting Why Pension Reform Is So Hard” Pension Policy Brief #11, Heller Hurwicz Economics Institute, University of Minnesota,