California Public Employees' Retirement System (CalPERS), the largest public pension fund in the United States, is making a major move into private equity. On Monday, the board approved a plan to increase its target allocation to private assets, which includes private equity and debt, to a whopping 40% of its total portfolio. This is a significant jump from the previous target of 33%, and it reflects CalPERS' belief that private markets offer the best potential for high returns.

The shift in strategy comes after a strong performance by private equity in CalPERS' portfolio. Over the past ten years, private equity has delivered an annualized return of 11.8%, compared to 8.9% for public equities, 2.4% for fixed income, and 7.7% for real assets. With traditional asset classes like bonds struggling to keep pace with inflation, CalPERS is looking to private equity to help them meet their long-term investment goals.

Reducing Reliance on Public Markets

This decision by CalPERS reduces their allocation to both public equities and fixed income. Public equities will see a decrease, while fixed income is likely to take the biggest hit. The reasoning behind this is simple: CalPERS believes they can achieve better returns by moving away from these traditionally lower-growth asset classes and towards the higher-potential world of private equity.

There's a mixed bag of factors to consider when it comes to CalPERS' move towards private equity for potentially better returns. Here's a breakdown of the realism:

Potential Benefits:

• Higher Returns: Historically, private equity has offered higher returns than public equities, especially in recent years. This aligns with CalPERS' goal of achieving their long-term investment targets.

Potential Challenges:

• Lower Liquidity: Public equities are easily bought and sold on exchanges. Private equity investments are illiquid, meaning it can be difficult and time-consuming to sell them if CalPERS needs cash quickly.

• Higher Fees: Private equity funds typically charge higher fees than passively managed public equity funds. These fees can eat into returns if performance isn't exceptional.

• J-Curve Effect: Private equity investments often experience a J-curve effect, meaning they might show negative returns in the initial period before generating positive returns later. This can be concerning for a pension fund with ongoing liabilities.

• Competition: With more institutions chasing private equity investments, valuations can become inflated, potentially leading to lower overall returns.

Overall Realism:

It's possible for CalPERS to achieve better returns with private equity, but it's not guaranteed. Here's why:

• Market Performance: Private equity returns are highly dependent on overall market conditions. A downturn could significantly impact valuations and returns.

• Selection & Management: CalPERS' success hinges on their ability to select high-performing private equity funds and actively manage their portfolio. This requires significant expertise and resources.

The Bottom Line:

CalPERS' decision is a calculated risk. While private equity offers the potential for higher returns, it comes with increased complexity and challenges. Only time will tell if their strategy pays off. It's important to monitor their performance and see if they can navigate the complexities of private equity effectively.

Is This a Smart Move?

While private equity has historically offered strong returns, it's not without its challenges. Private equity investments are typically less liquid than publicly traded stocks, meaning it can be difficult to sell them quickly if needed. Additionally, fees associated with private equity funds can be high.

Only time will tell if CalPERS' decision to increase their allocation to private equity pays off. However, this move signifies a growing trend among institutional investors who are looking for alternative investment options in a low-interest-rate environment.