At the end of a tumultuous decade, US public pension funds are re-evaluating their relationship with private equity firms. Disappointing returns, high fees and a number of scandals are pushing pension fund managers either to quit investing in this asset class or to take more control themselves. But no solution will be easy as the gap between promised benefits and available funds widens.

In 2008, total unfunded liabilities for all US states reached a record $1trn (€718bn), according to the latest report by the Pew Center on the States. In 2000, more than half of the states had the funds to cover liabilites; by 2008 that number had shrunk to just four: Florida, New York, Washington and Wisconsin. Since 2008 the situation has worsened, and state public pension funds - which account for about 35% of private equity assets and are far the industry's largest backer, according to data provider Preqin - have reacted by stopping nearly all venture capital investment activity, according to Keith Larson, vice-president at Intel Capital.

Being one of the country's most prominent venture capitalists, Larson understands the relationship between the venture capital world and pension funds. "Part of what attracted pension funds to venture capitalism was that the industry was growing," Larson says. "What had previously been a smaller, cottage industry turned into a sector where multi-billion dollar funds became commonplace. As public pension funds chased higher and higher returns in private equity and venture capital, the massive influx of money inevitably drove returns down as more money chased the same deals, and prices for stakes in viable early-stage companies inflated to historic levels. Against this backdrop of inflated company valuations, in 2008 illiquidity struck on a broad market scale."

According to Larson, we are in a remarkable period of innovation despite the economic downturn. This may be a good time to invest, but most public pension funds cannot take advantage of it. Larson also predicts that state politicians will eventually face the choice of either switching to a defined contribution model or to a greatly reduced defined benefit model.

The largest public pension fund in the US, the $207bn California Public Employees' Retirement System (CalPRS), is taking a different approach, embracing even more risk despite having lost $70bn in 2008-09. CalPERS has earned an annualised 3.39% return on its assets through the 10 years ended on 31 July, far below its 7.75% assumed rate of return. Trying to boost its returns, the fund increased the target allocation for private equity investments from 10% to 14% as of June 2009.

Additionally, after a corruption scandal involving middlemen who helped money managers win private equity deals from CalPERS, the fund approved new rules requiring investment firms to disclose when they hire placement agents, how much they are paid and what services they perform. And earlier this year, in an attempt to take more control over its private equity investments and to find ways to increase returns while cutting costs, CalPERS announced plans to create portfolios with outside managers that would charge lower fees and offer more customised strategies.

The $25bn South Carolina pension fund is going even further. In September it decided to create an independent firm to oversee its $5bn private equity portfolio. The purpose was to achieve greater transparency and lower costs, according to Robert Borden, CIO of the South Carolina Retirement System Investment Commission. The Commission also decided to raise the fund's private equity exposure to $8.7bn keeping its current external managers in place.

The plan was to spend $15m in start-up costs, to hire 30 professionals, and to establish a headquarters in Charleston and an office in New York. The new firm is believed to be the first of its kind in the US, similar to the direct investment funds created by two of Canada's biggest pension plans, the Ontario Teachers' Pension Plan and the Canada Pension Plan Investment Board. However, the project has been slowed down by the South Carolina State Budget and Control Board. Governor Mark Sanford claimed the decision to set up the firm was not transparent enough, and senator Greg Ryberg said that the goal of reaching an 8% expected investment return was unrealistic and should be lowered. Pending a new evaluation, the plan is on hold.