Pennsylvania’s public-school employees’ pension fund is $41 billion short of what it needs to pay promised benefits. Last year, it missed the investment benchmark that officials set, a result they said was “primarily due to performance within private equity.”

As of Dec. 31, Pennsylvania’s Public School Employees’ Retirement System held $85.3 billion in assets, making it one of the nation’s largest public pension funds. PSERS invested $10.1 billion in private equity with a goal of earning a 10.06% return. It returned just 2.59%. According to PSERS, private equity reduced the fund’s overall return by 0.59 percentage points — more than any other asset class.

The $41 billion shortfall is more than an accounting figure.

Pennsylvania taxpayers will ultimately bear much of the cost as the state spends more to keep its promises to the fund’s 500,000 members and their beneficiaries or survivors, said Leonard Gilroy, senior managing director of the pension integrity project for the Reason Foundation, a free market think tank.

Private equity has put state officials in a bind, he added.

“For most state pensions, they’re not getting outsized returns; they’re taking on a bunch of risk; and they pay fees to limited partners at private equity firms,” he said in an interview. “That puts state officials in the position of either needing to invest more taxpayer funds or find better investments.”

An investigation by The Center Square found that private equity was the only one of PSERS’ eight asset classes to miss its benchmarks over one-, three-, five-, 10- and 15-year periods.

A record of underperformance

PSERS officials declined a request for an interview.

Instead, Chief Investment Officer Ben Cotton emailed a statement. He said the benchmark doesn’t precisely match its private equity portfolio because it has a different mix of investment strategies and older and newer funds than the benchmark.

PSERS is “underweight in some strategies and newer vintages have outperformed over the most recent periods,” he wrote.

Cotton’s explanation echoed comments from PSERS’ head of private markets last year.

“Assets held for 10-plus years tend to have diminished return potential thereafter, often underperforming the portfolio’s cost of capital,” James Del Gaudio told the trade publication Markets Group.

The possible end of a ‘golden era’

Private equity invests in companies that aren’t publicly traded. Pension funds have embraced the asset class. It had outperformed stocks and bonds, although it charges higher fees and ties up investors’ money for years.

That may be changing.

PSERS has pulled back from private equity. As of fiscal year 2024, it held $12.2 billion. By last December, that had fallen to $10.1 billion. Private equity’s share of the portfolio fell from 16.3% to 11.8%.

“We have consciously chosen to reduce our allocation by moderating our investment pacing in recent years and selectively and opportunistically selling some of our exposure in secondary markets,” Cotton, PSERS’ CIO, wrote in his statement.

Other states reduce private equity

Since last year, pension systems in at least six other states have reduced their private equity holdings–Alaska, Maine, Washington, Ohio, Nevada, and Virginia.

Last October, Alaska pension officials concluded that “key drivers of private equity’s ‘golden era’ in the past couple of decades may have reversed,” referring to tightened credit, geopolitical tensions, and increased borrowing costs.

“That period was unusually favorable and it’s unlikely PE returns will snap back to those averages.” They predicted returns from private equity investments to fall to high single-digits to low double-digits from the mid-to-high teens that many investors expected.

“If the expected future returns are not adequately higher for private equity,” the Alaska Permanent Fund Corporation, a state agency, wrote in a report last October, “the rationale for taking on higher risks (illiquid, levered, idiosyncratic, high fees) may have eroded.”

Private equity has not always lagged.

PSERS began investing in private equity in 1998. Since then, the asset class has produced an annualized return of 10.96%, according to state records.

Last year, PSERS invested through 67 private equity firms overseeing 209 funds. Some investments generated strong returns. Others lost money.

HgCapital 8 and New Mountain Partners III and V more than doubled investors’ money. First Reserve XII, an oil and gas fund, generated only 55 cents of value for every dollar invested. Interactions returned 2 cents.

Gilroy said private equity firms have a tall order. They must pick not only the right companies and industries but also at the right time.

“Timing matters a lot,” he said. “If you’re California’s pension funds, you got into private equity early and made money. Other pension funds haven’t done as well.”