US pension funds have taken to private equity and done well, report Ariane Leuftink and Tom Lynch of Wilshire Associates

Private equity continues its rapid growth as an institutional asset class and, for many pension funds, allocations surpass those for such asset classes as real estate, emerging markets, or high yield bonds. Assets invested in private equity, commonly defined to include (leveraged) buyouts, venture capital, and distressed opportunity funds, now exceed $200bn. Commitments to private equity partnerships, as contrasted with actual investments by partnerships, are growing even faster. Last year $55bn was raised by US private equity partnerships and $33bn was raised by non-US partnerships, primarily Europe. And despite a sharp third quarter market correction that has put investors on edge, indications are that 1998 will again be a record year for commitments to private equity partnerships.

Why private equity? The primary reason for investing in private equity is a higher return. There must be a high probability of achieving a level of return which exceeds public equity market averages by a wide enough margin to compensate fully for the additional risks inherent to private market investments. According to Venture Economics, a US performance survey firm, buyout funds and venture capital funds returned an annual 23.7% and 28.1%, respectively, for the five years ending March 31, 1998. Based upon the level of returns earned in the past, pension funds have set benchmarks for private equity at 3% to 5% over publicly traded stocks.

Today, private equity investing has much wider acceptance among investors. Sophisticated European institutional investors recognise private equity as a separate asset class or include it as a return enhancer within their public equity allocation. Available opportunities have increased to meet this new demand. The number of private equity partnerships has grown as have the number of investment deals. New company formation, M&A activity, and corporate divestitures are all at record levels.

The collapse of global equity markets provides better purchase opportunities for private equity funds, though the temporary 'sudden death' of the high yield bond market limits a firm's ability to acquire companies at acceptable rates of return.

Investors also recognise that they can further diversify their portfolios with private equity. The correlation of private equity returns with the public equity markets has been surprisingly low, as have fluctuations in reported values.

How to acccess private equity There are two common methods for investing in private equity. Many larger pension funds use internal staff and outside consultants to identify and recommend partnerships for investment.A diversified private equity portfolio will generally require 10 to 15 partnership investments and a minimum $50m allocation. Some insurance companies and very large pension funds sometimes tend to co-invest alongside these funds in direct deals or make direct investments themselves which is quite labour-intensive and gives a higher risk profile and not necessarily better returns.

A popular alternative is to invest in a fund-of-funds. These are discretionary pooled vehicles offered by advisers expert in private equity that invest in a diversified portfolio of partnerships. They are ideal vehicles for investors allocating smaller amounts to private equity or for larger investors who wish to use the fund-of-funds to access partnerships that are smaller or harder to access.

Importance of partnership selection Selection of private equity partnerships has proven much more important than in the public markets. While a top performing public equity manager may add 1% over the market averages over long time periods, studies show that top private equity funds can add 5% to 10% above the average fund. Therefore, investors look for a premium return both from the private equity asset class and from the opportunity to select top partnerships. Unlike the public markets where past performance has been a poor predictor of future performance, the past performance of private markets partnerships does provide an indication of future performance. Wilshire is able for example to draw up the past partners experience in making, managing and exiting investments as selection factors. Top-down risk is also important to risks associated with vintage year supply-demand imbalances and the use of leverage. Due diligence on specific investment opportunities should incorporate explicit bottom-up modelling of how returns will be achieved and a clear identification of the risks to be undertaken. Reliance upon past returns and general partner references is not enough for a long-term commitment. Likely returns have to be tested exclusively via corporate financial modeling and prospective risk needs to be measured.

Private equity performance The table below from Wilshire's Co-op universe of large pension funds investing in private equity shows returns by category. This universe presently covers 400 partnerships, which have been funded from 1979 through December 1997 and represents cumulative contributions of $6.7bn.

Is now a good time to invest? The best course in implementing an allocation to private equity for the investor is to opportunistically select partnerships whose expected returns exceed a pre-set hurdle rate. Market timing efforts in private equity have proven as difficult as publicly traded stocks and bonds, and are discouraged.

There is investor concern about the growing pool of private equity capital. Partnership offerings have been increasing in response to investor demand but most of the capital raised has gone to a few multi-billion dollar partnerships. Some investors are concerned that too much capital has been raised, particularly in a US environment where 'strategic' corporate buyers could use their high priced stock to outbid 'financial' buyout partnerships. If there is a silver lining to the third quarter market correction, it is that 'financial' buyers are again in the driver's seat and that capital can be put to use at attractive multiples. It also creates new investment opportunities for distressed debt investors who take advantage of situations where good businesses are over-leveraged.

The areas which we currently favour include small-to-medium buyout funds, 'first time' buyout funds and early stage venture capital due to the supply-demand characteristics of these categories.

Arianne Leuftink and Tom Lynch are with Wilshire Private Markets Group. Leuftink is vice president responsible for fund selection and monitoring in Europe, based in Amsterdam. Lynch is co-heading the Private Markets Group from Pittsburgh in the US

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