Private equity has been in the news frequently in the last few weeks, and not in a good way.
The Teachers Retirement System of Texas this month announced plans to reduce its PE allocation by $9.7 billion, while the American Federation of Teachers issued a report that said labor practices at PE-owned firms endanger the portfolios backing pension benefits.
The reports came on top of concerns about rising interest rates eroding returns on the industry’s highly levered investments, plus rich equity valuations making it difficult to find attractive new acquisitions. A moribund deal environment has also led to lower-than-expected cash flows to investors since it’s hard for PE firms to take profits on old deals. There’s no shortage these days of warnings about the risks that this multitrillion-dollar industry now poses for pension funds, banks and the whole financial system.
If ever there was a time to rethink PE allocations, now would be it. Does the move by Texas Teachers show institutional investors are growing impatient with the sector? No, it’s the old story of “can’t live with ’em, can’t live without ’em.” The rigid mathematics of actuaries clashing with the hardball politics of pension funding make PE indispensable for most public pension funds, however much criticism showers down on the managers.
Texas Teachers is typical of large state and local pension plans in being severely underfunded, with only enough assets to pay 77.5% of its liabilities — and that’s under official reporting that most independent analysts consider highly optimistic. Its PE allocation, at 16.7% of its portfolio, was higher that its target and the average of 13% for all US public pensions — perhaps helping explain the pullback.
Underfunding is a big reason why many other pension plans, including California Public Employees’ Retirement System, California State Teachers’ Retirement System and New York City’s pension funds, are increasing their PE allocations.
In a typical pension fund, PE is assumed to return about 2.5% more per year than public equities. PE behaves like a levered investment in small capitalization stocks, so the extra return is required to compensate for the additional risk. Moving 1% of a portfolio from public to private equity will thus add around 0.025% to the assumed portfolio return. That will have a similar effect on the official funded ratio as asking employees to contribute an additional 0.3% of pay, such as from 8% to 8.3% of their gross salary.
Pension plan managers and board members are, of course, responsible fiduciaries. Nevertheless, it’s hard to ignore the political difference between approving the transfer of 1% of the portfolio from public to private assets — which might generate some griping from both ideological progressives and financial conservatives — and asking employees or taxpayers to kick in substantially more money — which will cause more than griping. The third alternative, letting the funding ratio decline, is also problematic politically.
The 2.5% annual advantage of private over public equity was justified in the first decade of the 21st century. Private outperformed public equity by a compounded 5.56% per year from 2001 to 2010, according to a study of pension fund allocations to PE by investment adviser Cliffwater. But in the following 10 years, the advantage dropped to 1.17%. While PE did well in the Covid-19 recovery years of 2021 and 2022, it underperformed public stocks by 16.7% in 2023 (due to reporting lags of both PE funds and pension funds, we don’t have much data yet for 2024).
In addition to the historical decline in performance, more and more people are questioning the economic basis for PE in a higher-interest-rate, higher-equity-valuation world.
One particularly influential paper was Demystifying Illiquid Assets: Expected Returns for Private Equity, by Antti Ilmanen, Swati Chandra and Nicholas McQuinn, published in the Journal of Alternative Assets. The paper concluded that PE needs to offer exceptional returns to justify its place in pension portfolios given the high fees, illiquidity, high leverage and unpredictable cash flows; and that PE seemed unlikely to deliver adequate returns in the future. And the paper did not even consider the additional drawback of unpopular optics, some from progressives critical of the layoffs and cost-cutting associated with PE acquisitions and some from fiscal conservatives suspicious of the leverage, complexity and fees.
In my view, which I think is common among investment professionals, historical PE returns were heavily dependent on either low interest rates or low public equity valuations. When a few exceptional and experienced PE managers were choosing the best prospects from many opportunities, there was significant additional value added from improved management and restructuring. Moreover, the returns were reported in a manner that hid much of the volatility and correlation with public equities.
Returns from low interest rates or equity valuations are beta returns, or those tracking the market, that investors can get with low-fee, liquid, public investments. Improved management is alpha, or excess returns, and it’s worth paying premium fees and accepting illiquidity for that. But with lots of new PE managers in bidding wars for a limited supply of attractive acquisitions, there may not be much of this in the future.
On the other hand, PE remains the only major investment available in large size that can plausibly be assumed to return substantially more than public equities in the long run. So, PE will have its appeal to managers of underfunded pension plans as long as pension actuaries give such investments the 2.5% extra return assumption boost.
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