Private equity promises outsized investment returns but a report prepared on behalf of the California State Teachers' Retirement System (CalSTRS) highlights the challenges of outperforming public markets even in the long term.

In an update on CalSTRS's $49.3 billion private equity portfolio, advisers to the pension fund manager said on Friday that the investments had collectively underperformed their targets, based on public and private market benchmarks, on a one-, three- and five-year basis.

"They seem to have selected fund managers poorly in the last few years," said Steven Kaplan, a University of Chicago finance professor whose research focuses on private equity.

Faced with growing obligations and shrinking returns, many of the largest U.S. public pensions have raised their exposure to alternative investments to record levels this year, despite criticism of the risks and costs.

The report, which was published on Friday but whose valuations are dated March 31, shows how difficult it can be even for large sophisticated investors to build a private equity portfolio worthy of tying up their money for a decade or more.

On a ten-year horizon, the portfolio earned a net internal rate of return (IRR) of 11.4 percent versus CalSTRS's 9.6 percent public markets target and a 10.3 percent private markets benchmark.

But on a three-year basis, the portfolio earned a net internal rate of return (IRR) of 17.2 percent versus CalSTRS's 27.4 percent public markets target and a 19.1 percent private markets benchmark.

Weighing on the portfolio were leveraged buyouts that represented 71 percent of the value of the assets. Funds over $5 billion in size, which make up 63 percent of the portfolio's value, have yet to recover from the 2008 financial crisis.

But many of these funds do not have to return their money to investors soon and future performance will depend on a relatively strong public equity market along with robust merger and acquisition activity, the report cautioned.

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