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The Latest Trend for Pension Funds: Private Equity Investment

With hedge fund performance under scrutiny, pension fund managers are finding private equity an increasingly attractive option.

When one of the largest institutional investors in the world talks openly about its investment strategy, people listen. In September the California Public Employees’ Retirement System (CalPERS) announced it was getting out of hedge funds, closing its Absolute Return Strategies portfolio, worth $4 billion — a sum roughly equivalent to the gross domestic product of Fiji. Soon after, reports followed of other large funds in the U.S. and U.K. reviewing their own allocations to hedge funds.

Ultimately, the issue is one of performance. The HFRI Fund Weighted Composite index shows that hedge funds posted annualized returns of 5.42 percent over three years. By contrast, the MSCI World index measured equities up 12.77 percent over the same period. Why pay higher hedge fund fees when plain-vanilla equity strategies are more profitable?

Although the CalPERS withdrawal did dominate headlines, a State Street Corp. study published in November shows that an exodus from hedge funds has yet to materialize. Only 3 percent of pension fund managers surveyed said they were planning to reduce allocations. There was another notable finding on the institutional investment in alternatives front. Large institutional players are heavily favoring private equity as the alternative-investment strategy of choice. Of the managers surveyed, 60 percent would increase private equity allocations, whereas 20 percent planned to do the same with hedge funds.

One thing is clear: Private equity is quickly becoming the attractive third way for pension funds.

Any investment decision, big or small, will begin and end with a simple question: How much do I stand to make? After the lean years that followed the 2008–’09 financial crisis, private equity funds whose performance ranks in the top two quartiles are starting to outpace the markets. It’s not just superior returns that make these investments an attractive choice for pension funds, however. The contrasting perceptions of volatility in public and private markets offer another concrete benefit. Unprecedented volatility characterized equity and fixed-income markets this past October. By October 15, the S&P 500 had plummeted 7 percent before rebounding to close the month up 2.3 percent. Sharp, short-term movements like this lead investors to question the long-term viability of equities.

Private equity, by contrast, isn’t subject to the same daily volatility. Its movements in value aren’t splashed across major news outlets. Funds typically invest over ten-year horizons, while valuations are infrequent and rarely publicized. Paradoxically, the complexity and opacity of the private market benefit pension funds, as investors don’t have the same emotional reactions to its movements despite the high-risk nature of its assets.

Consider the investment goals of typical pension fund investors. Most are looking for long-term capital appreciation, commonly over a period of ten years or longer. Sharp fluctuations in bond and equity markets, although usually corrected over the longer term, run contrary to those goals — at least in the minds of most pension plan holders. Add to this writer Michael Lewis’s assertion that markets are “rigged,” and the result is a widespread lack of faith in mainstream financial investment.

Private equity strategies allow institutional managers to escape the skepticism felt toward the public markets and align returns with long-term growth. Similarly, perception of the asset class is changing as the private equity industry matures and becomes more diverse.

Historically, private equity didn’t provide institutional money managers the diversification they needed. Many pension funds did invest in large private equity vehicles, to be sure. Yet those vehicles alone didn’t allow managers to spread their risk effectively, a key element of their mandate in serving their retail customers. Before the crisis, such investments by institutional managers were confined to the big-box stores — the Walmarts — of the private equity world. A new, smaller breed of boutique fund that specializes in specific sectors or geographies is emerging.

The 2014 Preqin Global Private Equity Report shows that a spate of new funds is leading to a diverse, fragmented market. It states that 873 funds reached a final close last year, raising almost $454 billion, the highest figure since 2008, with 2,080 funds still on the road.

That’s not to say institutional managers will completely turn their backs on private equity behemoths. In all likelihood, they will remain loyal to the funds that delivered impressive returns before — and in some cases during — the financial crisis. The benefits of a fragmented market are obvious. Greater competition for capital means greater variance in fee structure, more specialized funds mean institutional managers can focus on individual sectors of interest, and more investment options make it easier to manage risk. Ultimately, however, the buck stops with measurability — and it is here that private equity is truly developing.

A private equity investment is much more manageable now than it was before 2008. Investors can track cash flows, monitor performance and analyze risk. Just as in public markets, sophisticated technology and specialized personnel will make private equity a much more attractive proposition — and even more so for pension funds, where comprehensive oversight is mandated.

The death knell has yet to toll for hedge funds, as top managers will still attract capital. But in the coming years, we will see pension funds invest more in private strategies. The opportunity for growth is excellent, and the private equity market is especially suited to the goals and investment profile of pension funds. It is private equity’s ongoing maturation, however, that will bring the asset class to the forefront of the institutional investment landscape.

Eric Bernstein is chief operating officer of North America at eFront, a company that produces financial software, much of it dedicated to the alternative-investments industry.

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