The news headlines for private equity have not been great over the past several months. The private capital industry on average lost money during Q2 of 2022 and barely reported any earnings during Q1. The S&P Listed Private Equity Index showed a -22.2% return for the one year period July 1, 2021 to June 30, 2022.

So, it is rather surprising that the first 21 state retirement systems to publish detailed fiscal year 2022 data are reporting an average return of 24.9% on their private equity investments. What explains such stellar countercyclical investment performance?

The simple answer is the timeframe used to measure private equity performance happens to average out to a positive return. It is unlikely the same dynamics will help pension funds reporting results later this year. But there might also be a deeper problem in the way that the private equity industry itself reports results.

1. Preliminary Returns for Public Pensions

Most state and local pension funds end their fiscal years on June 30th, which makes it a good time to start measuring performance. In the three months since that date, 101 retirement systems have issued a preliminary accounting of their investment returns for the 2022 fiscal year. Some of these were reported via press releases. While others were published in quarterly reports and/or board meeting publications.

The average rate of return from these 101 retirement systems is -3.8%.

The average rate of return for all 228 of the top state and local retirement systems is -6%, based on data through September 30, 2022.[1] This includes estimates for systems that have yet to finish their fiscal year or report data. Both of these figures are notably better than the -10.4% projected in July using benchmarks to estimate returns.

When reviewing the data for those 101 plans, there isn’t much detail. Most public plans at this point have only published a single number for the 2022 fiscal year. But 21 public investment funds have published how various asset classes in their portfolios have performed. (These 21 funds manage investments for about four dozen retirement systems in total.)

Looking at the data broken out, the stocks, bonds, and real estate numbers all appear to mirror market trends. But there is a glaring difference in the actual private equity returns compared to benchmarks.

2. Private Equity Returns for the 2022 Fiscal Year

Below is a list of the 21 public retirement investment funds and their reported returns for the 2022 fiscal year:​​

At first glance, these private equity returns are so good in the broader financial climate that they raise suspicion. Private market valuations do not necessarily rise and fall with the same patterns as public markets. But private company prices also don’t always move in the opposite direction to publicly held company stock prices, either.

Consider the first and second quarters of 2022.

The value of publicly traded U.S. stocks fell by -20% to -28% between January and June 2022 (depending on whether you are looking at the S&P 500, Russell 3000, or NASDAQ index).[2] The value of private equity investments in the United States fell around -1.5% during Q1 of 2022 (January to March). During Q2, they declined by about -6.1%, according to the Burgiss Manager Universe.[3]

Despite a difference in the scope of losses, public and private equities both experienced a similar downward pressure. So far, the pattern is intuitive.

But that is only data for a six month period.

Expanding the scope of measurement to the full July 2021 to June 2022 fiscal year, a different story emerges. The 21 pension investment funds noted above reported a -12.9% average return on their stocks (public equities) for the fiscal year that ended on June 30.[4]

By contrast, these same systems reported a 24.9% average private equity return for the same fiscal year.

Those are fiscal year returns pointing in very different directions. Public equities declined 12.9% while private equities gained 24.9%. And all of this is despite the private equity benchmarks showing negative returns.

Which leads back the original question: How are pension funds reporting such strong results compared to the negative returns for private equity during the first six months of 2022?

3. Timing and Calendars

Part of the answer to this question is related to the weird way that fiscal year calendars work.

The "2022" investment returns that pension funds have reported include Q3 and Q4 of 2021, plus the first two quarters of 2022. The full period spans July 1, 2021 to June 30, 2022. And while performance has been bad this calendar year, last calendar year investment returns were soaring.

Let’s go back to the assets measured in the Burgiss Manager Universe. Venture capital returned 47% gains in the 2021 calendar year across the Burgiss universe. Buyout funds returned 36% during the same period. Natural resource investments returned 28%.

This means that the 2021 investment returns were so strong that they have balanced out the bad 2022 performance to result in a positive average. When put together, the July 1, 2021 to June 30, 2022 return for all global private capital in the Burgiss universe is 7.5%.

This 7.5% private equity increase for fiscal year 2022 is still pointing in a different direction than the -12.9% return for public company stocks. But the scale of difference isn’t as large. And with the data broken down, it is much easier to see how the strong 2021 calendar year returns could work their way into the 2022 fiscal year returns.

This makes the positive private equity returns from state and local pension funds less suspicious. The 24.9% average return for the 21 investment funds is pretty good, and just is coming in larger than the 7.5% average reflected for the entire Burgiss universe. There is no fundamental reason private equity returns for pension funds would be better than the performance for all investors in private equity.

It is possible there is a selection bias, where the better performing pension funds were more keen to share detailed data. But, since much of the data we collected came from internal board of trustees or investment committee reports, that is unlikely.

Still, this is only part of the answer.

Burgiss Manager Universe’s 7.5% average return might be a more comprehensive assessment of private capital returns for the 2022. But it is still notably different than the -22.2% return for the S&P Listed Private Equity Index. So what else might be causing that divergence?

4. Private Equity Industry Valuations

With trillions in private capital under management, there is a lot known about companies, valuations, and the performance of private equity funds. But there is also a lot that is unknown. For a state or local pension fund to report how well its private investments are doing, they need to get data from the private equity managers they’ve assigned money to. Then those managers need to collect data from the companies they’ve used capital to invest in.

The timeline for this process often takes several months. It is not standardized, and can be subjective. The value of public funds is based on the price of the daily trades of their stocks. The value of private funds is based on, well, it depends.

When a private company is sold or a private equity fund invests in a company, it provides a valuation. But how this valuation is determined can be manipulated based on the specific terms of the deal. Or, if there hasn’t been a recent transaction, private capital managers are required to take a reasonable guess to estimate the value of an asset if an orderly transaction were to occur.

There are plenty of people making value judgments for or against this nature of private equity markets. Whether or not this process is good or bad is irrelevant. But there are clear incentives within private capital markets to delay the value reduction of assets.[5]

The uptick in deals where private equity firms sell companies to themselves in a way that could artificially manufacture high valuations is evidence of these incentives. During the summer of 2022, the CIO of Europe’s largest asset manager said:

“The vast majority of deals are currently done between private equity players… One private equity player will sell to another one who is happy to pay a high price because they have attached a lot of investors. When you know you are able to exit your stake to another private equity house for multiple of, let’s say, 20, 25 or 30 times earnings, of course you won’t mark down your book… That’s why I’m talking about a Ponzi because it’s a circular thing.”

Since then, others have argued that private equity could become a Ponzi scheme. Others have made the case that these concerns are overblown.

Whether or not that's true, if firms are selling companies to each other as a way to keep valuations higher than they otherwise would be, the downstream effects of this could be negative for public pension funds.

It is possible that the full 2022 fiscal year story could reveal private equity managers were slow to mark down the valuations of their investments to a realistic market value.

Note [1]: Equable’s Defined Benefit Finance Database covers 228 of the largest statewide and municipal retirement systems in all 50 states. The average fiscal year 2022 return for these systems is -6%, based on data through September 30, 2022. Some of these plans have not yet finished their fiscal years (or had not reported at the end of September). For these plans we use a benchmarking approach to estimate their returns. That methodology is available as part of our State of Pensions 2022 analysis. Limiting the scope of this analysis to only the 101 retirement systems who did announce their 2022 fiscal year returns, the average reported is -3.8%.
Note [2]: January 1, 2022 to June 30, 2022 public equity performance was -20% for S&P 500’s Total Return index, -20.1% for the Russell 3000 broad public market index, or -28.6% for the technology heavy NASDAQ Composite index.
Note [3]: Consider the returns from the Burgiss Manager Universe. This is a set of information from over 1,000 firms that provide anonymized performance figures to the Burgiss investment advisory service. Private equity returns this year as measured by the Burgiss index have not been great:
  • Global private equity had -5.4% returns during the second quarter of 2022.
  • U.S. specific private equity returned -6.1% for the same period.
  • Private equity returns in 2022’s first quarter were slightly better, but still reflected losses of -1.6% globally and -1.5% for the U.S. alone.
  • Private debt and private real estate investments had better performance during the first two quarters of 2022, but they were still either negative returns or single digit returns. As a result, global private capital (equity, debt, plus real estate) in total returned -3.9% in the second quarter, and -0.1% in the first quarter.
While Burgiss doesn’t measure every private equity fund, their data is comprehensive enough to provide a clear sense of the direction of private equity returns. And all of the signs in 2022 are in a negative direction.
Note [4]: State and local pension fund public equity performance is broadly in line with the fiscal year performance for standard benchmark indices: -9.7% for S&P 500’s Total Return index, -14% for the Russell 3000 broad public market index, or -23.28% for the technology heavy NASDAQ Composite index. So generally, we know that public markets had a bad fiscal year and pension fund investments in public stocks were similar to the average.
Note [5]: As clear as these incentives are, there is some academic evidence to suggest that private valuations are biased toward under reported valuations.