Pension funds frequently benchmark their private equity portfolios against public market proxies, such as the S&P 500 or Russell 3000, creating an inaccurate view of PE performance. This practice often leads to the conclusion that private equity significantly underperforms public markets, or that benchmark choices within the pension plans are flawed. However, the private equity market, with its typically larger mean and median market capitalizations, is fundamentally different from a public market index where companies might have far smaller market values, making direct comparisons problematic.
Evidence from ten U.S. public pension plans for 2024 shows that while their private equity returns might lag behind public market indices, when measured against a specialized index like the private2000, performance aligns more closely with broader private market trends. For instance, in 2024, the private2000 index was up 4.5%, compared to a median return of 6.5% for the plans. This contrasts sharply with the S&P 500, which was up over 20% in 2023, the previous year, highlighting the discrepancy created by inappropriate benchmarking. Despite this, only two of the ten pension plans in the sample used a private equity-specific benchmark.
The underperformance of private equity, when compared to public market proxies, can be attributed to several factors. These include substantial costs, such as typical 2% annual management fees and 20% profit shares, which significantly drag on performance compared to the fractional costs of passively managed public equities. Additionally, the illiquidity of private assets creates portfolio balance issues for pension funds, especially as they approach their "endgame" and transfer obligations to insurers, who are often reluctant to accept illiquid assets or demand significant haircuts. The opacity of private equity valuations, which rely heavily on managers' assessments, further complicates accurate performance evaluation relative to public markets, where real returns are only known upon asset realization.
The issue extends beyond private equity; some UK-focused pension funds have also significantly underperformed their benchmarks. Analysis revealed that nine out of ten UK-focused pension funds underperformed a FTSE All-Share tracker over a decade, with almost three-quarters underperforming by at least 10% and over a third by at least 20%. One notable example is the Standard Life UK Equity 4 Pen Fund, which returned around 44.5% over ten years, making it one of the poorest performers. This emphasizes a broader problem within pension fund management regarding appropriate benchmarking and the frequently perceived underperformance relative to chosen indices.
