(Bloomberg) — The California Public Employees’ Retirement System, the biggest U.S. pension, may change the benchmark it uses to measure private equity performance as $31.3 billion in investments underperform.

The $294 billion pension, known as Calpers, currently uses a custom benchmark its staff designed based on global and U.S public equity plus 300 basis points. That benchmark is imprecise in measuring private equity performance and encourages riskier investments to meet the goal, officials said.

Calpers’ current staff-designed benchmark creates “unintended active risk for the program, as well as for the whole fund,” Réal Desrochers, the system’s senior investment officer in charge of private equity, said in a report today to the fund’s governing board. Calpers’ 10-year return on private equity of 13.3 percent as of June 30 fell short of its own benchmark by 2.1 percentage points, according to the pension system’s data. The performance also missed in one-, three- and five-year periods.

Calpers has been working to reduce risk in its portfolio after the global financial crisis wiped out more than a third of its wealth, forcing it to increase contributions from taxpayers to cover losses.

As public pension funds have poured money into private equity in search of higher returns, they have sometimes struggled to set accurate benchmarks to determine the holdings’ value. Some benchmarks are devised by firms such as Prequin Ltd. and State Street Corp. One, called AARM-FOIA Global PE Benchmark, uses data on private equity performance reported by pension funds such as Calpers, the California State Teachers’ Retirement System, or Calstrs, and those in Florida, New York and Wisconsin.

Internal Benchmark

Calstrs, the second biggest with $190 billion, in August switched from an internal benchmark to the GX Private Equity Index offered by State Street, which services institutional investors and manages financial assets worldwide.

“After seeking a better private equity benchmark for years, we have decided that State Street’s Private Equity benchmark has achieved enough mass and history to replace our own internal index,” Calstrs Chief Investment Officer Christopher Ailman said in a statement at the time.

Private-equity firms use borrowed money to buy companies, improve profits and resell them. The top 25 percent of private- equity funds delivered better returns than the Standard & Poor’s 500 stock index by 37 percent over the life of the fund, according to a 2011 study that looked at 450 buyout funds from 1984 to 2010. Peer Group

Pension funds typically use peer group and public benchmarks of private equity performance, according to a study by Kellogg School of Management at Northwestern University. Public market benchmarks are based on time-weighted returns of private equity funds and public market equivalent indexes or an index plus a premium, such as the one now used by Calpers. Because private equity lags public markets, a lagged benchmark may be preferable, according to the report.

Calpers announced in September that it was divesting from hedge funds, saying they are too complex and too expensive while contributing too little to returns.

The Calpers board is scheduled to review all its benchmarks in 2015.

State Legislation

Calpers board members today were also urged to seek state legislation allowing the fund to bypass competitive bidding rules when it hires some types of investment services.

Current state law requires that agencies seek competitive bids when seeking to buy most goods and services. The pension fund needs an exemption so it can be more nimble and timely when considering potential investment opportunities, Danny Brown, the fund’s chief of legislative affairs, told the pension’s investment committee.

“It just doesn’t make sense” for the fund to require a request for proposals to rehire top-performing money managers or to pay for an RFP process that can take as long as nine months, Brown said.

California seeks bids for everything from building roads and schools to buying portable toilets and fire extinguishers. The process is used to ensure that the state pays a fair price for goods and services.

Calpers paid Wall Street firms almost $1.2 billion to manage investments in the fiscal year that ended June 30, 2013.

California grants a blanket exemption from bidding requirements for the state’s Health Benefits Exchange and the California Housing Finance Agency. Calpers already has exemptions for health, vision, and long term care benefits and services.

 

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