Pension funds have picked a tricky time to increase their appetite for private equity investments. The market is currently sending out mixed messages. One the one hand, potential deal flow is increasing after a long stretch in the doldrums, and record amounts of money are flowing into top-ranked funds. On the other hand, many private equity groups are sitting on large piles of unspent cash and charging investors management fees for the privilege.
Even so, these are short-term considerations and pension funds have long time horizons. As an asset class, private equity fits particularly well with this profile because private equity funds typically have a long term agenda of about 10 years. Pension funds are therefore well-placed to take advantage of the illiquidity premium that private equity offers.
So although private equity investment is renowned for the high costs and disproportionate time and effort needed to build up a diversified portfolio, we believe that the asset class does have a significant part to play in the make-up of many defined benefit pension plans.
The obvious attraction of private equity investing is that it can reduce risk at the total portfolio level because it is imperfectly correlated with equities and bonds. At the same time, private equity offers enhanced returns over the long term.
The prospective new accounting standard, FRS17, has in fact strengthened the case for investing in private equity. Investors rely on the managers’ interim valuations on their unrealised private equity portfolios, estimates that are typically ‘smoothed’ from one year to the next. This ‘smoothing’ reduces both short term volatility and short term correlations with quoted markets.
Under FRS17, bonds are a good, if imperfect, match for liabilities. But quoted equities introduce significant volatility relative to a fund’s liabilities, so any diversification within this more volatile area is likely to be beneficial. This is where alternatives, such as private equity, come into their own, in reducing the risk that pension funds incur relative to their FRS17 liabilities.
Whatever their definition of risk, trustees need to set a finite limit on how much risk they are willing to undertake, and they will want to allocate that limited resource as efficiently as possible.
So in theory, private equity is a very valuable addition to most pension portfolios. However, pension funds that want to put the theory into practice should be prepared to encounter some difficulties.

To start with, picking private equity funds is very demanding of time and resources. Then the financial commitment must be substantial to make the investment worthwhile, the draw downs and distributions are unpredictable, and periodic reviews are required to maintain a targeted level of investment.
Picking private equity managers differs from selecting traditional managers in two key ways. Most importantly, private equity managers cannot instantly invest the funds. Instead, they call upon the allocated or ‘committed’ funds gradually and then pay funds back when investments have been realised. As a result, building up a specific allocation to private equity is less than exact. What is more, once the managers have been selected, the trustees will need to review them and identify new ones, as well as re-assessing the levels of commitment at least annually.
The second major difference to traditional managers is that private equity managers tend to be highly specialised in terms of deal size, industry focus and geographic area. So to build a properly diversified portfolio may require ten or more managers, depending on the geographical spread required. This means that trustees will have to spend three or four times as much time and effort on private equity as they do on the other asset classes.
This clearly means that the level of time, effort – and indeed specialist knowledge – required is disproportionate to the amount of money involved. Another issue, which is philosophical as well as practical, is that many trustees are uncomfortable with the idea of their managers returning money and telling them when to send more. All this may be worthwhile in terms of additional return and potential risk reduction at the total fund level.
Given the need for diversification, and the existing demands on trustees’ limited time, most pension funds will look to fund of funds managers to access the private equity market. This approach has a strong advantage in addressing many of the drawbacks of the asset class, and provides ready access to diversification. However, of particular interest to those investing in private equity for the first time, or those increasing their exposure, is secondary investment.
Secondary investment is the purchase of existing investments in funds, usually three or more years after initial investment, and usually at a discount to the latest disclosed value. Buying into positions some years after the initial investment clearly reduces the time until the cash flow becomes positive, allaying some of the concern over liquidity. This strategy also gives a better understanding of the potential for the portfolio companies, while buying in at a discount will improve the potential returns. A further advantage to secondary investment is that it affords exposure to a greater diversity of funds raised in earlier years, and can often be a means of gaining access to funds that would otherwise be unavailable, for example some ‘invitation only’ venture funds.

Building positions
In any portfolio it is essential to build positions over time, as well as ensuring diversification by geography, deal size and industry. The nature of private equity leads to uncertain cash flows and little control over the level of investment. The outstanding commitments and the actual build up of investments needs to be monitored and compared to the expected build up. The process is broadly an administrative procedure that helps determine the correct level of ongoing commitments needed to maintain the desired level of investment.
The first graph shows a series of annual commitments, which builds up to the residual portfolio shown in the second chart. The third chart shows the impact on cash flow, which it should be noted becomes positive reasonably early on. Clearly this type of planning relies on a continuing consistent experience of ‘average conditions’, and life is never so simple - hence the need for annual reviews to maintain a suitable level of investment.
Managers and consultants clearly have more work to do in this area. Many consultants do not even conduct detailed research in private equity, which is understandable given the low level of interest from clients, and the negligible commercial reward for such research. Many managers, for their part, have more than enough funds from clients who are not subject to pension fund restrictions. They simply cannot justify the time and effort required to resolve the problems encountered by pension plans.