With interest rates pinned to the ground, and returns from public equity markets looking uncertain, the California Public Employees’ Retirement System came up with a plan last year to boost returns in order to meet its growing obligations to retirees.
Towards the end of 2021, the $495 billion retirement fund announced that it would be changing its strategic asset class allocation, to deploy more money into private equity and deploy a small amount of leverage in the portfolio to juice returns.
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CalPERS announced that it would increase its private equity portfolio from 8% to 13% of total assets and sell some Treasury bonds and stocks to fund its push into private investing. On top of that, the fund announced that it would be looking to add leverage of 5% to the portfolio to improve diversification and reduce risk.
At the time of the announcement, some analysts expressed skepticism about the plan. The retirement fund was criticized for increasing its risk exposure to private equity when valuations of private companies had surged. Adding leverage would only increase the risk of buying overvalued companies at the top of the cycle, others argued.
CalPERS believed that the historically high rates of return from private investments would more than compensate for the additional risk and help it meet its annual returns target.
Private Investments Turn Sour
It now looks as if the fund might be regretting its decision to go all in on private equity at the end of last year. According to Bloomberg, the public retirement system sold $6 billion of its positions in private equity funds to second-hand buyers at a discount of around 10% in recent weeks.
Having cycled through four investment chiefs since 2009, the fund has hired Jefferies Financial to explore ways to clean up the portfolio and sell off a swath of assets according to the report.
The fund is unlikely to be the only investor with buyer’s remorse.
Klarna, once Europe’s most valuable private tech company, has had its price tag slashed from $46bn to $6.7bn in recent weeks, as tech valuations have crashed back to earth. The lower valuation came as the company agreed a $800m funding round featuring new investors including Mubadala, the sovereign wealth fund of the United Arab Emirates, and the Canada Pension Plan Investment Board.
This is not a one-off case. Valuations are taking a hit across the market. Chase Coleman’s Tiger Global, which is already nursing brutal losses in its public equity portfolio, having lost more than 50% in the first five months of the year, has marked down its venture capital investment by about 9% overall.
The fund was one of the most aggressive funders of startups in Silicon Valley in recent years and its venture capital business has grown to around two-thirds of total assets under management (nearly $100 billion at the end of 2021).
Still, Tiger’s growing pains don’t seem to have put off investors. It closed its latest $12.7 billion fund in March, and this fund has reportedly notched up double-digit net internal rate of returns since its inception last year.
According to Pitchbook, for the firm’s funds that started in 2018 or later, 90% of the value they have created is unrealized gains, but the beauty of investing in the private market is the fact that there’s no mark-to-market.
While funds must write down unrealized gains if a company achieves a lower valuation in a funding round or if it goes bankrupt, large liquid backers like Tiger can stave off these events by supplying more capital and helping businesses manage through the downturn.
Sequoia Capital’s Pain From Falling Tech Valuations
Tiger’s strategy stands in stark contrast to that of Sequoia Capital, one of the most successful venture investors in the world. The firm has long touted its desire to buy into private businesses and then hold onto the shares after the IPO, standing alongside founders rather than selling out at the first opportunity.
Unfortunately, as the market has turned away from high-flying growth stocks over the past 12 months, this strategy has inflicted large losses on the business.
According to Bloomberg research, Sequoia’s portfolio companies that listed in the US last year have lost more than $7.7 billion of market value since their debuts. But while the firm is having to weather some large mark-to-market losses, its ability to get into these deals at the early stages means it’s still up overall for the most part.
Venture capital investors are still willing to back businesses, but they’re being a lot stricter on conditions and valuations. According to the Wall Street Journal, valuations are sharply lower than they would have been last year, and funders are seeking preferential rights in deals.
The paper quotes one startup CEO who believes there is a “30% haircut” in valuations. The co-founder also noted that one potential investor had asked for so-called participating preferred shares. These guarantee the holder to recoup the original investment, plus a percentage of the remaining proceeds if the business is sold. The structure had died out in recent years as investors had rushed to get onboard with deals. However, it now appears to be coming back as investors speculate about the outlook for startups.
