Saints or sinners?
The rise and rise of private equity as a force within global investment has been fuelled, at least in part, by pension funds. They have been piling into the asset class in their hunt for diversification and above-average returns. But there may now be signs that pension funds’ interest has peaked.
It was the sweeping losses suffered by pension funds in the first years of the new millennium that helped galvanise them and other institutions in their search for other sources of return. Even when the stock markets were in the doldrums in 2001 and 2002, private equity returns were “pretty robust” relative to quoted equity, says Nick Shaw, deputy managing director of Gartmore Private Equity.
In the 2005-2006 Russell survey on alternative investing, the percentage of respondents investing in private equity increased in most areas around the world. But in the US - where trends often foreshadow European investment patterns - the number was down slightly.
Russell said allocations were fore-cast to reach record levels in all markets in 2007, with the largest increases coming in Europe and Japan - markets that have traditionally had lower allocations to private equity.
n Europe, mean strategic allocations to private equity were expected to rise to 6.1% in 2007, up from 4.5% in 2005, and 4.0% in 2003. Median private equity returns in Europe were forecast at 10.5% on an annualised basis for 2005-2007.
“There is less correlation between quoted equity and private equity than there is between different geographies of quoted equity,” says Shaw. So by mixing quoted and private equity, investors spread their risk, he says.
While diversification is an established argument for sprinkling quoted equity allocations with private equity, some in the industry dispute that there is any real benefit.
In a letter to the Financial Times, Michael Gordon, chief investment officer of Fidelity International, said that in many instances, investors in private equity are simply investing in the same companies that they formerly held as listed groups.
“Performance over time will be driven by the same factors: earnings growth, cost management and so on,” he wrote. “The difference is leverage. Strip out the leverage and the correlation with quoted equities is tight.”
But Shaw believes there is a diversification benefit: “The data says there is. You can argue that the observation period is longer with private equity, but we think it goes beyond that.”
Bald correlation between the two asset classes may be high, says Reitze Douma, portfolio manager PE at PGGM, but doing well with private equity is all about getting the most skilled managers. “Based on research, private equity returns are comparable with the S&P, but if you can get access to the upper half you can achieve substantially higher returns,” she says.
Finland’s Ilmarinen mutual pension insurance company has increased its new private equity commitments, though its allocation to the asset class has stayed constant over the last year.
“Our balance sheet increases in time, and excellent returns recently have had some impact on our total PE allocation,” says Esko Torsti, head of alternatives. “In net terms, our allocation has been more or less unchanged.”
He adds: “Correlation [with quoted equity] is definitely positive but it is clearly below 100%, which means that PE allocation works well as a diversifier, especially if we take into account the high returns provided by PE asset class.” Ilmarinen’s allocation to private equity is between 1.5% and 2.0%, and the total investment portfolio is around €22bn. It is the returns - both expected and realised - which are the real draw of the asset class, he says. “Also, the rate of diversification increases in our portfolio with increased [private equity] allocation, which is of course good news.”
Fees charged the asset managers are high for private equity, adds Torsti, but so far, the Ilmarinen has been able to justify them given the high post-fee returns it has experienced.
During the 1990s, few pension funds were investing in private equity, says Shaw, but a 5% allocation to the asset class is now becoming the norm. The fees for private equity are high relative to indexation, he acknowledges, but says good quality managers have more than paid for their fees.
In the UK, at least, private equity is enjoying - or suffering - a much higher media profile in the last few months. Questions are being asked outside the financial sphere about the social accountability of those involved.
In January a UK trade union staged a protest outside a dinner attended by private equity bankers, over job losses at businesses owned by one private equity firm. And at the World Economic Forum in Davos this year, the international trade union federation warned that private equity funds ought to be screened by third parties, fearing that the risk of private equity investments would only be clear in an economic slowdown.
The extra attention is simply a result of the huge volumes of private equity activity now being undertaken, says Shaw. “Private equity is becoming so much more significant,” he says. In the early 1990s, private equity deals accounted for around 5% of all M&A activity in the UK, but now the level is around 20%, he says: “It has transformed into a significant part of corporate ownership.”
In the Netherlands, the healthcare fund PGGM is set to boost its private equity allocation to the long-term exposure target of 7%. In the last quarter of 2006, the fund held 5.4% of assets in private equity, up from 4.7% in the first quarter. The neutral weight for private equity in 2006 was 5%.
“It takes five to 10 years to build a well-diversified portfolio,” says Douma. “You have to accept negative returns in the start-up phase of the portfolio because of the
If an investor is going to have real success with private equity, the private equity manager selection process is key, she says. The dispersion of returns in the asset class is such that investors should aim to get access to the top quartile managers.
In the UK, private equity allocations at pension funds remained relatively stable over the last year, says Gavin Orpin, investment partner at Lane Clark & Peacock in London. Whether a pension fund invests in private equity or not often depends on how its advisers view the asset class, he says.
“At LCP, it is not one of our favoured asset classes at the moment,” he says. “We are in favour of diversifying away from equities and bonds, but think there is a wide range of good alternatives, such as hedge funds, active currency and infrastructure,” he says.
The two reasons to steer clear of private equity are market timing and the changing maturity profiles of pension schemes, says Orpin.
“There is just so much money out there, and the potential leverage being involved is increasing,” he says. Some private equity managers are now saying themselves that many deals are inflated in value, he says.
More and more UK pension schemes are now closed to new members, says Orpin, which means the length of time until the average pension payment is shortening. In such cases, private equity - with its 10 to 15-year lock-in periods - may be unsuitable, says Orpin.
In Italy there are still very few pension funds investing in private equity, despite the increasing trend in Europe as a whole, says Lara Pederzolli, partner at MangustaRisk Italia in Rome.
“Before the recent series of legislative reforms, pension funds were concentrating on capital preservation, but now the focus has shifted to the liabilities side,” she says. “This means that a liability increase has to directly correspond to an increase in return.”
As a result, pension funds are becoming more and more demanding, and private equity has to be part of a well-diversified portfolio. But Italian legislation does not allow most pension funds to invest in offshore private equity funds, she says, and the domestic market is still very poor. “There are very few good Italian players in this market and most of them are closed to new investors,” she says.