Recent regulatory changes that have expanded the prescribed assets regime by according prescribed assets status to privately issued instruments has brought much hype and relief to the pension fund industry. It had been a long-time plea of the industry.
Private equity is one asset class directly benefiting from this regulatory relaxation. With a 20% minimum allocation requirement into prescribed assets, we can expect to see significant flows into prescribed assets status investments, of which private equity will likely command a sizeable chunk of it.
In the heat of the moment though, with all the hype and excitement, a word of advice to the trustees would be a noble gesture we think. Private equity investing, as with many other alternatives asset classes, is no walk in the park. With any risky asset class, pouring money into it does not necessarily mean that money will be poured back out, and private equity is no exception.
That a private equity investment has been accorded prescribed assets status by the regulator does not, in and of itself, automatically qualify it for inclusion into a pension fund’s investment portfolio. Trustees still need to carry out, with guidance from their appointed professional investment consultants, thorough due diligence on each and every private equity project coming through the prescribed assets status pipeline that could be of interest to them. That thorough due diligence cannot be assumed to have been carried out by the regulator on their behalf. They cannot, and should not, abdicate such a crucial role to the regulator – else, they would be doubly guilty of both negligence and upward delegation.
We are on record advocating for some serious allocation into the alternatives asset space, and maybe this is an opportunity for us to qualify our advocacy. Before we overly dwell on what it is about private equity that should make trustees treat them with caution, first let us start with why private equity is such a great addition to a pension fund’s investment portfolio. This, of course, applies more to situations where it is not indirectly mandated, or is a forced consideration under a prescriptive regime, as is in our case here.
Private equity funds have historically yielded, on average, better long-term returns than public equities and other asset classes within the alternatives space. Even today, globally, private equity investments are performing well, outpacing other private market asset classes and most measures of comparable public market performance. In a sustained low-yield environment, as that prevailing in the global markets, investors are consistently turning to private markets for higher potential returns. Of course, caution is required to avoid the temptation of extrapolating the global environment into our local one.
Private equity funds are known to aim for internal rates of return of 20-30% with multiples on invested capital of two to four times following a ten-year investment period.
One of the key benefits of private equity funds is that there is diversification within the fund itself across a range of different portfolio companies. A typical private equity fund would have anything north of ten different portfolio companies or projects. This would be spread across companies from different sectors, of different ages, of different sizes, profitability, and other several metrics of interest.
More importantly, not only is private equity diversified within the funds itself, it is also a diversifier in and of itself as an asset class. Private equity returns are generally lowly correlated to those of other asset classes that pension funds invest in.
That private equity funds value and report only quarterly is an additional benefit as it leads to smoother valuations and less short-term volatility. Public listed investments are weak in that attribute as, in the short-term, markets are moved more by sentiment and behaviour, factors that have very little to do with changes in the stocks’ underlying fundamentals.
Alignment of Interests
Usually underrated, but those that have been in the trade long enough have come to appreciate the value of appointing an asset manager whose interests are genuinely aligned to yours as the investor and owner of the capital. Private ownership of companies, as opposed to public ownership on a stock exchange, allows management to focus on running the business, as opposed to feeling pressured to meet quarterly earnings targets. This gives private equity managers and the management of the portfolio companies they invest in a long-term perspective to managing money and their companies, respectively. Pension funds, with their long-term objectives, find this an ideal match.
Whereas most traditional investments focus on providing funding to entities that have the potential to grow, private equity offers something in addition to capital growth – private equity managers are active investors. Using various tools such as operational improvements, corporate governance enhancements, or environmentally friendly renovations, private equity has positive ripple effects. When done well, not only does it generate significant returns – its hands-on nature also helps build better businesses, leading to numerous knock-on effects including job creation, a broader tax base, and sustained economic growth – a much needed resultant combination for our economy.
With all that is being said, why all the cautioning then, one would ask.
No Garden of Roses
By their nature, private assets are a high dispersion space. There is a big difference between the best and worst private equity managers, making manager selection such a vital part of the portfolio allocation process. With members’ money involved, it is certainly an area that trustees cannot afford to take gambles in. While it is easy for money to pour into the asset class, there is no guarantee that it will deliver big returns.
Due to the considerable spread of returns, diversification is of utmost importance for pension funds. Trustees would need to make appropriate asset allocation decisions to allow for an effective diversification rather than invest with just one or two managers.
There is a problem with that though, a much bigger one for that matter. There are just not that many fundable, commercially viable, projects of the right quality to start off with. Where the stakes are that high, and the risks are that huge, diversification is every investor’s best friend. Unfortunately, in our case, trustees’ hands are very tied, with only a very limited range of choices and options.
Rushed attempts to gain exposure to the few projects that are there, with or without prescribed assets status, bears the risk of creating crowded trades and subdued gains resulting from overpaying for the assets.
In the search for opportunities, trustees should overcome the overwhelming temptation to invest in start-ups – not with members’ money. Start-ups investing is not private equity investing, that is venture capital and is more ideal for high-net-worth and ultra-high-net-worth individuals investing their own money. Where third party money is involved, it would be considered a dereliction of duty if trustees were to pile up members’ retirement savings into venture capital projects.
Illiquidity is also a key challenge of the private equity asset class. It is a long-term investment where capital is locked away for many years with investors only holding on to the hope that when the private equity manager finally dissolves the investments, they will receive reasonable multiples of their initial capital in returns. That, coupled with the high-risk nature of the asset class, demands a much higher degree of analysis and evaluation before making that all-important decision of making an allocation to it.
There is no secondary market for private equity investments.
Lack of Transparency
Private equity investments lack transparency, and are difficult to value. As opposed to publicly traded securities, private equity managers do not provide frequent performance updates. Shares of companies owned by private equity funds are not publicly traded, so their values can only be estimated, which is subject to potential bias. Private equity firms are also not obligated by law to publish their lists of assets, so trustees will be at the mess of how much the private equity manager would be willing to disclose. Industry guidelines aimed at self-regulation and disclosure are not universally complied with. There are others of course that have argued that the real attraction of private equity lies precisely in the absence of regulated disclosure. We do not buy into this.
The complexity of the asset class is made worse by the fact that it does not come cheaply. The fees levied by private equity managers are significantly higher than for other standard publicly traded asset classes – equities, bonds, and others. The industry argues that these higher fees are balanced by higher expected returns and are justified by the labour-intensive nature of private equity investment compared to public equity.
Furthermore, there is also criticism of the high “carried interest” fees, which work as performance incentives for the private equity managers. Such very high incentives pose the danger of encouraging the managers to embark on bigger, higher risk, deals.
The lack of publicly available performance data also complicates the allocation process. The clear message is that trustees should consider how they will identify the best funds, and how they might achieve a diversified exposure to private equity. A diversified approach should both help mitigate the impact of initial negative returns and address the spread of returns.
Not all private equity managers are made equal. Managers whose funds outperform the industry in one fund are likely to outperform the industry in the next one they raise and vice versa. This highlights the need for trustees to ensure that they are sufficiently informed to identify the funds most likely to perform well and/or the need to diversify in order to avoid the risks of poor choices. This is no easy feat for the professional fund allocator – certainly a mammoth task for a board of trustees who are not investment professionals themselves.
In fact, it would be very remiss of us not to emphasise that the assessment of track records and selection of private equity firms – skills that have a large impact on the returns of a private equity portfolio – require an expertise which is quite different from analysing public equity markets.
It is not all gloom and doom though as there are very effective ways of accessing private equity opportunities that help minimise the risks.
High Quality Projects
There are a number of key areas that trustees should focus on when considering whether and/or how to invest in private equity. First is that trustees need to take a long-term view but simultaneously be alert to the fact that private equity funds come with a clear fixed term – they will, at some point, be forced to completely disinvest once the term of the private equity fund comes to an end.
Choosing a private equity fund requires that trustees satisfy themselves that the private equity manager ticks most of the key boxes including, but not limited to, a good performance record and demonstrable ability of the manager to add value to portfolio companies. Deal sourcing ability is also critical. The private equity fund manager should have an active and long pipeline of projects seeking funding. Rarely considered, but of equally critical importance, is the private equity manager’s exit ability. Not having a clear exit route right from the outset should immediately raise red flags about the investment.
There are three ways in which pension funds might invest in private equity – through a limited partnership, through a fund-of-funds, or through an investment trust.
Trustees might also consider direct investments. However, it should be noted that this is a far more complex, demanding, and committed way to invest in unquoted companies. It is probably only suitable for the largest pension funds which have sufficient in-house expertise to undertake the commitment and exercise effective oversight.
With regards to fund-of-funds, they give pension funds access to a diversified portfolio with a single capital commitment. The money is then pooled with the capital of other investors and is invested in multiple private equity funds.
The fund-of-funds model has largely remained a foreign concept here though. However, with more and more capital being set aside for allocation into the private equity space, we expect to see more of such fund models emerging not in the too distant future.
The word of caution remains, trustees need to thoroughly evaluate, with the help of professionals, the downsides of private equity investing before making any allocations into this asset class.
With that said however, a thoughtfully constructed private equity portfolio, diversified across a variety of fund managers, investments regions, vintages, and sectors, provides a fitting investment profile to that sought by pension funds.
Our monthly publication is aimed at inviting conversations from like-minded individuals with a view to engaging in forward-thinking-led discussions on how we can collectively improve the state of our industry.