Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Public Pension Funds Fuel Private Equity
Transcript
- Lucas: If walking through the economy with us has made something click, know that this show runs on listener support, not ads. A small group chips in monthly at buy me a coffee dot com slash fexingo, which keeps the research deep and the audio clean. It is literally what funds making this many episodes possible. Luna: And it lets us keep talking about the quiet shifts in finance without chasing clicks. Thanks for keeping the lights on. Lucas: Let's talk about where that money actually goes once it leaves your paycheck. For decades, the standard playbook for a public pension fund was simple: sixty percent stocks, forty percent bonds. You bought liquid assets you could sell if a local government needed cash for a school roof or a police force. But look at the last fifteen years, especially since the zero interest rate era started around twenty ten, and that model broke. The returns on safe bonds collapsed. They couldn't hit their targets anymore. Luna: So they had to chase yield somewhere else. Where did they end up? Lucas: They moved into private markets. Specifically, private equity. And I mean private equity in the traditional leveraged buyout sense, not just venture capital startups. We are talking about funds that buy established companies, load them with debt, cut costs, and flip them three years later. The big pension funds like CalPERS, the California Public Employees' Retirement System, started allocating huge chunks of their portfolios here. We're seeing allocations jump from single digits to over twenty percent in some cases. Luna: That seems risky. These aren't stocks you can sell on Tuesday morning if things go south. Lucas: Exactly. That is the core tension. It is called illiquidity. When you put money into a private equity fund, it is locked up for seven to ten years. You cannot touch it. But pension funds have daily obligations. Teachers need salaries next month. Retirees need checks. So the pension fund takes on more risk, hoping the higher return compensates for the fact that their money is tied up. It is a massive bet on the idea that these private deals will consistently outperform the public market. Luna: But does the data actually support that? Are they really beating the S&P five hundred after fees? Lucas: It is complicated. On paper, yes, top-tier private equity firms have generated higher internal rates of return than public markets over the long haul. But those numbers are smoothed. They don't reflect daily volatility. And then there are the fees. In public markets, you might pay a fraction of a percent to trade an ETF. In private equity, you pay a two and twenty structure usually. Two percent management fee on your committed capital, plus twenty percent of the profits. That eats into the alpha significantly. Luna: So the pension fund is paying premium fees for premium access, but they can't see the real-time price. Lucas: Right. And here is the kicker. Because they can't mark to market every day, they get to decide what their portfolio is worth every quarter. They report it as such. If the underlying companies are doing okay, they say the value went up. It creates a feedback loop where the reported returns look steady and smooth, even if the actual economic reality is shaky. It hides the true risk profile from the taxpayers who ultimately back these pensions. Luna: Is that a problem until the market actually crashes? Or do they have safeguards? Lucas: The safeguards were supposed to be diversification and due diligence. But we saw what happened during the great financial crisis. Many pension funds got burned because they thought they were diversified across asset classes, but everything was correlated. When credit froze, private equity valuations dropped too, but slowly. Then suddenly everyone wanted out. You can't exit a private equity position quickly. So when the cash crunch hits, the pension fund is stuck holding the bag while its liabilities remain fixed. Luna: So now we are in September of twenty twenty six. Has the tide turned? Lucas: It is shifting. Interest rates have normalized. Bonds are yielding four percent again, which is decent. The desperate need to chase yield has cooled slightly. But the infrastructure is already built. The relationships between limited partners, which are the pension funds, and general partners, which are the private equity firms, are entrenched. There is also the issue of size. There is so much capital chasing so few deals now that valuations are stretched. It is harder to find those magic bullet acquisitions that double your money in three years. Luna: It sounds like the easy money phase is over, but the momentum is still there. Lucas: Momentum is strong. Look at the secondaries market. This is where existing private equity stakes are sold to other investors before the fund matures. It is growing fast because pension funds need liquidity. They are trying to free up some cash by selling older positions to newer funds. It is a way to manage their exposure without waiting for the full ten-year lockup to expire. It shows they are actively managing the risk, but it also highlights how dependent they are on this ecosystem. Luna: Does this affect regular people who aren't in a pension fund? Lucas: Indirectly, yes. When pension funds pour billions into private equity, they are buying companies. Those companies often take on debt to pay dividends to the owners. That debt stays on the company's books. If interest rates stay high, servicing that debt becomes expensive. Companies might cut jobs, raise prices, or delay investment to make those payments. So the public pension system, designed to secure retirement, is indirectly fueling leverage in the broader corporate sector. Luna: That is a fascinating chain reaction. From our taxes to corporate debt loads. Lucas: Precisely. And there is another angle. Private equity firms are getting better at operating companies. They aren't just financial engineers cutting costs anymore. They are bringing in operational expertise. Some studies suggest that productivity actually improves in companies owned by private equity. If that is true, it benefits the economy. Consumers get better products, workers might get higher wages if the firm is successful. But the distribution of gains is skewed. The general partners make millions in carried interest, while the pension fund hopes for a modest boost to close its funding gap. Luna: So it is a win-win unless it isn't. What happens if the underlying businesses fail? Lucas: Then the pension fund takes the hit. And because these assets are opaque, it is hard to know how bad it is until it is too late. We saw hints of this in the retail sector. Private equity bought many chain stores, loaded them with debt, and when consumer spending shifted, those chains collapsed. The pension fund lost billions. The employees lost jobs. The landlords lost tenants. But the private equity firm had already collected its fees and perhaps exited with a profit earlier in the cycle. The downside risk sits heavily with the limited partners. Luna: It feels like a transfer of risk from the private sector to the public sector. Lucas: That is a common critique. The private equity firm gets the upside, the pension fund bears the downside. And if the pension fund underperforms badly enough, the state or federal government often steps in to guarantee benefits. So the ultimate backstop is the taxpayer. It is a socialization of risk in a very specific, complex way. Not through direct bailouts, but through implicit guarantees of defined benefit plans. Luna: Are regulators looking at this? Does the SEC care about this opacity? Lucas: They are starting to. The SEC has been pushing for more disclosure on private markets. They want to know what fees are being charged, what the valuation methodology is, and what the risks are. But private equity firms resist. They argue that detailed reporting would reveal their strategies to competitors and hurt their performance. It is a battle between transparency and competitive advantage. Right now, the compromise is thin. Pension funds get quarterly reports, but they are often generic. Luna: So we are flying somewhat blind on trillions of dollars of assets. Lucas: Effectively. And the scale is massive. Total private equity assets under management are approaching ten trillion dollars globally. A significant portion of that is held by institutional investors, with public pensions being the largest category. If that market turns, it won't just be a niche correction. It will ripple through the banking system, the real estate market, and the labor market. It is too big to ignore. Luna: What should listeners watch for? Is there a signal that things are tightening? Lucas: Watch the fundraising climate. If private equity firms start struggling to raise new funds from pension boards, that is a warning sign. It means trust is eroding or yields are no longer attractive enough. Also, watch the default rates on corporate debt. Since private equity loads companies with leverage, a spike in defaults would indicate stress in the underlying portfolio. We haven't seen a mass wave yet, but the cracks are forming in sectors like healthcare services and middle-market manufacturing. Luna: Healthcare is interesting because it is a staple industry. Hard to predict shocks there. Lucas: Exactly. It is defensive. But that is why it attracted so much capital. Stable cash flows, predictable demand. Private equity loved it. Now, with regulatory scrutiny on hospital mergers and pricing, those margins are compressing. If a pension fund holds a large stake in a private equity-backed healthcare provider, and that provider struggles, the pension fund's reported returns drop. It is a subtle drag, but compounding over time. Luna: Do you think pension funds will pull back from private equity soon? Lucas: Unlikely to pull back entirely. They will rebalance. Maybe reduce exposure from twenty percent to fifteen percent. But they won't abandon it. The structural need for higher returns remains, especially as populations age and life expectancies increase, stretching the payout period. They need every basis point they can get. So they will stay in the game, but they will become more selective. They will demand better terms, lower fees, and more transparency. The power dynamic is shifting slightly toward the limited partners. Luna: So the pension funds are waking up to the risks and using their weight to negotiate. Lucas: Yes. We are seeing more pension funds hire their own internal teams to evaluate private equity deals, rather than relying solely on the general partner's pitch deck. They are doing more homework. This professionalization of the limited partner side is good for the market. It forces the general partners to perform better and justify their fees. It raises the bar for entry. Luna: It makes sense. If you are putting up billions, you need a serious process. Lucas: Absolutely. And this trend is likely to continue. As the first wave of private equity investments matures, we will see more exits. Some will be profitable, some will be painful. The winners will reinforce the model. The losers will force conversations about risk management. It is a natural evolution of the asset class. It is moving from the wild west to a regulated, scrutinized component of modern finance. Luna: One last thing. Does this change how we should view our own retirement accounts? Lucas: If you have a 401k, you might indirectly hold some private equity through your fund manager. Most index funds do not. But if you have an actively managed fund, check the prospectus. It might be a tiny slice. It probably doesn't change your strategy. Stick to low-cost index funds if you can. Let the professionals handle the complexity of private markets. Your job is to save consistently, not to pick the best private equity firm. Luna: Simple advice for a complex world. Keep it boring, keep it liquid. Lucas: Exactly. The allure of high returns is strong, but the hidden costs and risks are real. Understanding where the big money is going helps you understand the macro environment. It explains why certain industries are consolidated, why debt is everywhere, and why the ground feels unstable beneath our feet. Knowledge is the only hedge that never loses value. Luna: Thanks for breaking down the plumbing today, Lucas. It is unsettling, but necessary to hear. Lucas: My pleasure. Next week we will look at how infrastructure bills are changing the cost of building bridges. Until then, stay curious.