First it gave up on hedge funds. Now the largest U.S. pension fund isn’t sure how much it can count on private equity.

“We anticipate it may be moving from a gusher to a garden hose and then maybe even a trickle,” Wylie Tollette, chief operating investment officer of the $305 billion California Public Employees’ Retirement System, said this week in a telephone interview.

The bleaker cash-flow outlook for private equity adds to uncertainty at Calpers and other pensions facing shrinking gains as they strive to meet future obligations. The private-equity industry, which makes long-term investments such as leveraged buyouts in operating companies, shows signs of coming off its best years after distributing a record $443 billion to global clients in 2015, according to Preqin.

Now investments are shifting to early-stage pools that throw off less cash. At the same time, buyouts, the majority of Calpers’s private-equity portfolio, are rising in cost as firms with an unprecedented $1.47 trillion in stockpiled cash, known as dry powder, compete for acquisitions -- a trend that could further crimp returns.

Calpers shook up its alternative-asset strategy two years ago when it decided to divest its entire $4 billion held at hedge funds, saying those investments were too expensive and complex.

The pension’s private-equity holdings earned 1.7 percent in the fiscal year ended June 30, the weakest performance since 2012. Over 20 years it’s been the strongest asset class, with annualized returns of 11.5 percent, compared with 7 percent for the full portfolio.

Masking Gap

The California State Teachers’ Retirement System, which is the second-largest U.S. pension fund and oversees about $193 billion, and the New York State Common Retirement Fund, the third-biggest, both posted their lowest private-equity returns in at least four years for the 12 months ended March 31.

Since 2011, $24 billion in cash from private equity has helped mask Calpers’s growing gap between beneficiary costs and revenue generated from contributions and investing. The flow is expected to decline to $2.4 billion in the fiscal year ending next June from a peak of $6.9 billion in 2012-2013.

The pension’s total cash flow has been negative for five of the past seven years, according to Calpers Chief Investment Officer Ted Eliopoulos.

“This is a changed circumstance for Calpers in our history since the Depression,” Eliopoulos told the board last month. The shortfall is forecast to reach $9.2 billion by fiscal 2032, by which point Calpers could be forced to sell as much as $500 million a month in liquid assets to cover its obligations.

Optimistic View

The cash-flow estimates are based on forecasts of 7.5 percent annualized system-wide investment returns, which could turn out to be optimistic. Consultant Wilshire Associates projects long-term gains will be closer to 6 percent, based on current asset allocations.

Investors traditionally expect private-equity funds to offer an illiquidity premium over stocks and bonds in exchange for lock-up periods that typically last 10 years. The premium, roughly 3 percentage points, may narrow to 2.5 as the crowded field and low-interest climate take their toll, according to Faraz Shooshani, a private-markets consultant with Verus, which advises institutions and has worked with Calpers in the past.

“All assets are expected to return less,” Shooshani said.

Buyout funds paid a record 10.3 times cash flow in 2015 and a 10.1 multiple in the first half of this year for U.S. companies, according to S&P Global Market Intelligence. Deal leverage is lower than before the 2008 financial crisis because of regulatory restrictions, another factor likely to reduce returns, according to Marina Lukatsky, a director at the firm.

“If you pay a lot more these days versus a couple of years ago and you have to put a lot more equity in, in theory when you sell it, it does impact your ultimate return,” she said.

Instead of 20 percent to 25 percent net internal rates of return, private-equity investors are now accepting closer to 15 percent, according to David Rubenstein, co-chief executive officer of Carlyle Group LP, which manages $176 billion. The metric captures the cash flow and resale gain over the life of a project.

Major Change

“That’s one of the biggest changes I’ve seen in the industry since the Great Recession,” Rubenstein said in May at a conference in Beverly Hills, California.

Blackstone Group LP and Carlyle are Calpers’s biggest private equity managers, with $4.7 billion and $2.8 billion in allocations, respectively. Buyout firms and their clients should tread cautiously with newer funds because of high valuations and diminishing exit opportunities, according to Joe Baratta, Blackstone’s top private-equity dealmaker.

“Don’t over-allocate to the vintage,” Baratta said at a New York conference last week.

Oaktree Capital Group LLC, which oversaw $121 million for Calpers as of June 30, is being more choosy with deals in this low-return environment, according to co-Chairman Howard Marks.

“We have very, very low prospective returns at the same time that we have macro uncertainty,” Marks said last week at another industry event. “That’s an unattractive situation.”

Trimming Managers

In anticipation of weaker returns, Calpers has taken steps to bolster its private-equity program.

The pension slashed the number of managers it uses to about 100 from more than 300 in 2014, according to Tollette, the investment executive. Its goal is 30 managers by 2020, with a focus on advantageous terms from top firms.

“We want to negotiate fees very aggressively around larger allocations to fewer managers,” he said. “The key in private equity is really selecting the best managers, because if you select the average manager, you’re going to underperform.”