Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Public Pensions Fund Private Equity
Transcript
- Lucas: Look at the balance sheets of most mid-sized American cities right now, and you will see a very specific kind of panic. It is not in the cash accounts, it is buried deep in the pension obligations that local governments have been carrying for decades. Luna: Right, because those promises were made when interest rates were high enough to make the math work without needing risky bets. Lucas: Exactly. For years, public pension funds could rely on steady, low-risk government bonds to cover their liabilities. But as rates dropped to historic lows over the last decade, those safe assets simply stopped generating enough yield to meet the promised payouts. Luna: So they had to find somewhere else to park the money, and private equity looked like the only place offering decent returns. Lucas: That is the headline story, but the reality is more subtle. We are seeing a massive shift where municipal funds are moving into illiquid, complex private equity vehicles that they barely understand. It is not just about chasing yield; it is about trying to close a gap that might be mathematically impossible to close safely. Luna: But aren't private equity managers supposed to be good at finding those hidden efficiencies? Why would a city treasurer trust them? Lucas: Because the performance data is seductive. When you look at the average return of a large public pension fund versus a top-tier private equity firm, the spread is enormous. Over the past twenty years, private equity has consistently outperformed public equities by a wide margin, especially when you factor in leverage. Luna: I remember reading about how some cities allocated twenty percent of their portfolio to alternatives just five years ago. Now it feels like half. Lucas: It is faster than that. In certain regions, we are seeing allocations to private credit and private equity push past thirty percent of the total fund. That is a dramatic departure from the traditional sixty-forty stock-bond model that defined public finance for fifty years. Luna: Thirty percent seems incredibly high for a fund that has to pay teachers and police officers every single month. Lucas: That is the liquidity mismatch. Private equity capital is locked up for seven to ten years. You cannot pull your money out whenever a budget shortfall hits in January. If a city faces an unexpected crisis, those private equity commitments are essentially dead weight until they mature. Luna: So they are taking on illiquidity risk just to get the higher return, which makes them vulnerable if something goes wrong. Lucas: Precisely. And here is the kicker: private equity firms charge much higher fees than mutual funds. We are talking about two-point-zero percent management fees plus twenty percent of the profits. When you compound those fees over a decade, they eat a huge chunk of the alpha you were hoping to gain. Luna: Two and twenty is brutal. Does anyone actually calculate what that costs the taxpayer in the end? Lucas: Most do not. The fee structures are opaque. A city manager might sign a deal with a private equity partner without fully grasping that the underlying assets are leveraged debt instruments. If the economy slows down, those debts become harder to service, and the value of the investment drops. Luna: It feels like we are outsourcing financial risk to private firms that don't have the same accountability as a public institution. Lucas: That is exactly what is happening. When a public pension loses money in the stock market, everyone sees it on CNBC. When a private equity fund underperforms, the details are buried in quarterly reports that only the wealthiest investors can access. There is a transparency deficit here that is genuinely concerning. Luna: And yet, the pressure to perform remains. If a pension fund doesn't hit its target return, who gets blamed? Lucas: The elected officials. City councils and mayors face immediate political backlash if they raise taxes to plug a pension hole. So they give their investment managers an incentive to take bigger risks. It is a classic principal-agent problem where the agent takes risks that benefit them, while the principal bears the downside. Luna: So the system is rigged to encourage gambling with public money because the political cost of being boring is too high. Lucas: Beige is the enemy of politics. If your fund grows steadily at seven percent, you look incompetent compared to the neighbor whose fund grew at twelve percent using private equity. The comparison is unfair, but it drives behavior. Luna: Have any cities tried to pull back from this trend recently? Or is the momentum too strong? Lucas: Very few. Most are trapped in their existing commitments. They have already signed deals with private equity firms that require them to commit capital over time. Unwinding those positions would mean realizing losses at the worst possible moment, so they stay the course. Luna: That sounds like a slow-motion train wreck. Is there any regulatory guardrail that could stop this? Lucas: Not really. The oversight is fragmented. State-level regulations vary wildly, and federal guidelines are mostly focused on fiduciary duty rather than specific asset allocation limits. Without strict caps on alternative investments, the drift toward private equity will continue. Luna: It feels like we need a new framework for how public money is managed, one that prioritizes stability over growth. Lucas: Stability should be the primary goal for a pension fund. These are promises to workers who relied on them for their livelihood. Chasing high returns with illiquid assets undermines that core purpose. Luna: Do you think the current market environment is making this worse? Rates are rising again, which changes the calculus. Lucas: Higher rates actually make private equity less attractive because the cost of borrowing goes up. Private equity relies heavily on debt to amplify returns. If borrowing becomes expensive, the entire model comes under pressure. Luna: So maybe the correction is coming naturally through market forces rather than regulation. Lucas: Possibly. But it will be painful. Many private equity funds are maturing now, and if they cannot exit their investments at a profit, the public pension funds holding those stakes will see significant write-downs. Luna: Write-downs that will eventually force tax increases or service cuts for communities. Lucas: Exactly. The ripple effects will be felt in schools, in road maintenance, and in public safety budgets. It is a chain reaction that starts with a bad investment decision made ten years ago. Luna: It is fascinating how interconnected these financial decisions are. One city's pension strategy affects its entire social fabric. Lucas: It reminds us that finance is not just numbers on a page. It is the infrastructure of society. When we ignore the risks in that infrastructure, we are playing with fire. Luna: Speaking of supporting the infrastructure of independent journalism, if walking through the economy with us has made something click... Lucas: We deliberately do not run ads on these episodes. It keeps the focus sharp and free from corporate influence. If you want to support that choice directly, the link is buy me a coffee dot com slash fexingo. Luna: Your contribution helps keep this research rigorous and our conversations honest. Lucas: Back to the data. The key takeaway is that public pension funds are overexposed to illiquid assets, and the correction cycle is approaching. Luna: Will we see a wave of municipal defaults as these private equity bets fail? Lucas: Defaults are unlikely, but fiscal stress is inevitable. Cities will have to make hard choices about services and staffing. The era of easy money for public pensions is ending. Luna: A sobering reminder that every dollar spent today has a future consequence.