Worth the risk?

Although private equity has been in existence for a long time, it has only recently come to the attention of institutional investors including pension schemes. Long associated with high risk and high returns, it is today becoming a viable option for schemes who are able to take a long-term view on their investments.

Traditionally cautious, schemes have been surprisingly willing to invest in private equity ventures in recent years.

Pantheon partner Sally Collier believes there are several factors driving this growth: attractive historic returns; schemes’ desire to increase strategic allocations and geographic coverage; an element of “catch-up” for investors who have previously ignored the asset class.

She says: “Attractive historic returns and the high profile of the asset class are convincing institutions with minimal or no exposure to private equity to date that private equity should be a meaningful part of their portfolios in future.

“There is also an element of catch-up to compensate for under-commitment or lack of over-commitment strategies among investors whose overall asset base has increased quite significantly over recent years.”

HSBC Investments’ consultant relationship manager Chris Gower offers up a different explanation.

Gower hypothesises: “The equity market falls of 2001 and 2002 significantly impacted pension scheme funding levels. As a result, the positive effect of diversification was there to be seen, in that the funding levels of those with an over-reliance on equities suffered more than those that had diversified into other asset classes.

“Hence, the benefits of diversification were brought to the forefront of institutional investor considerations and, as a result, the demand for alternative investments increased significantly.

“Investors are also aware that they need to invest in higher-risk and potentially higher-returning asset classes to improve their funding levels. However, following the equity market crash, pension funds wanted to shift away from their heavy reliance on the developed global equity markets. Private equity was an obvious candidate for investment given the risk/return profile of this asset class.”

Capital Dynamic’s director John Gripton points out the importance of choosing a manager when entering the private equity arena, as it is extremely difficult for trustees to manage the investment themselves.

Gripton says: “There are some very large pension funds that have a terrific in-house capability, but private equity is extremely labour-intensive.

“Some of the very large groups of managers have a huge team of people – 60 or 70 investment professionals – and they only complete four or five deals a year. The majority of pension funds do not have a team of that size and would select either a manager to co-invest alongside or would invest through a group such as ourselves.”

As with any asset class there are pros and cons associated with investing. For private equity, the biggest draw card is the increased diversification, which minimises overall portfolio risk, and the increased returns that can be gained over the long term.

Collier argues when traditional assets are not performing, the benefits offered by private equity are particularly valuable in terms of enhanced return potential and diversification of overall equity exposure.

She says: “Investors in private equity influence their potential returns through the decisions they take at two key levels: asset allocation and selection of private equity fund managers.
“Given the wide dispersion in private equity returns compared with other asset classes, selectivity is critical to achieving outperformance, as is access, with demand for top-tier managers substantially exceeding capacity – strong arguments for implementing a private equity programme using the fund-of-funds route.”
Gower agrees the returns available from private equity are very attractive to pension funds.
He explains: “In terms of long-term returns, private equity has generally outperformed public markets and we believe that the asset class as a whole continues to have the potential to do so in the future.
“Private equity returns are absolute, in that they do not follow a benchmark or an index. Therefore, a private equity holding in a quality company should continue to increase relative to its current value, rather than rising or falling in line with broad market indices.
“Typically, the strategy of private equity firms is to implement a long-term corporate strategy, and this is very much in keeping with the long-term investment horizon of some institutional investors, such as pension funds.”
Gripton agrees and says: “Private equity as an asset class has provided very solid returns and outperformance of the quoted equity markets now for many years. On average, the outperformance is about 3pc per annum, and if you select the better managers then you can get that up to roughly 6pc per annum.”
The other big attraction of private equity is the diversification it can bring to an investment portfolio.
Gower says: “From the perspective of diver-sification, private equity has a low correlation with the traditional asset classes of equities and bonds, and, as such, introduces real diversification benefits when included in an institutional portfolio.”
Franklin Templeton Institutional’s managing director and head of global real estate for fiduciary global advisors Jack Foster explains further.
He says: “Private equity allows you to invest across a whole spectrum of different types of investment; you can do everything from venture funds, which are start up companies to real estate, and then you can do distressed debt in a private equity model as well. So, you get into different asset classes, but you generally get these higher returns and a high alignment of interest and alpha and uncorrelation.”
Illiquidity is often cited as being a drawback for private equity investors, but it need not be.
Collier explains: “In fact, for investors with a long-term horizon, illiquidity is of limited relevance in terms of year-to-year cash flows. Investors in a position to meet their short-term liabilities may be in a position to arbitrage market desire for liquidity and capture the illiquidity premium.”
Gripton agrees, and says: “Because of the illiquidity you are getting premium on this particular part of the asset class and therefore it will actually give you the outperformance. So, although you have the illiquidity, given a pension fund’s position – as long-term investors looking at performance in terms of decades – that premium on the liquidity is extremely important.”
Gower says an additional problem is the potential difficulties in accessing private equity for the first time, causing it to be an expensive way of gaining diversification.
He explains: “Due to the long-term nature of private equity, and especially with regard to commitment periods that are commonplace in private equity funds, there is no natural liquidity in the short or medium term.
“In addition, while access to high-quality private equity is difficult at the best of times, as a private client or a small institution it has been almost impossible to gain access to the asset class with high minimum entry levels. As a result, investing in private equity to gain advantage of its diversification benefits is very expensive.”
Foster says a major issue with private equity is to do with its very nature. As it centres on investing in private companies, there are some problems with transparency, an issue pension funds can find difficult to deal with.
He says: “It is an asset class that is difficult to track in terms of performance. So if you are a pension fund manager, how you are performing relative to any benchmark is harder to assess. A general benchmark for private equity – and in particular hedge funds – often tends to have a bias, which doesn’t show the whole universe, as poor-performing private equity groups will drop out and not report.”
Gower agrees there are issues with transparency within the industry.
He says: “The opaque nature of the market and the limited, irregularly reported information made available to investors is an issue within private equity. This makes the process of investment and the valuation of assets both difficult and imprecise. In addition, while investors need to “commit” funds to private equity partnerships, it invariably takes time for the assets to be invested and for investment to provide returns after initial losses.”

Accessibility for smaller schemes
Trustees may have decided a pension scheme requires exposure to private equity. However, whether it is in position to fully access the asset class is another matter.
Private equity investors tend to be large schemes that have the expertise and the required capital to get into the asset class, something smaller schemes may be lacking. There are an increasing number of opportunities emerging for the latter, although there are still obstacles in the way.
Gower explains: “While all pension funds would like to have exposure to the best private equity funds, selecting the ‘best funds’ over such a long investment horizon can be challenging [and possibly also virtually impossible]. As such, it may be more appropriate for them to try to ensure as far as possible that they avoid the worst performing funds.
“The main reason small funds have not, to date, gained exposure to this asset class is due to the availability of suitable funds and the minimum entry issues, rather than not being able to gain access to the best funds.”
Gripton agrees it can be difficult for newcomers to gain access to this attractive asset class, but it is not impossible.
He explains: “Smaller schemes are getting their access now through asset managers such as Capital Dynamic. We have been in the market for a long time and we have worked with many of these managers for 18 or 19 years. Therefore, through our fund of funds product we can provide that access for the smaller pension fund investor.”
Yet, Standard Life Investment’s chief investment officer of private equity Peter McKeller suggests investors can have difficulty selecting the best funds to invest in.
McKeller says: “As the asset class has matured I would argue that there has been a greater transparency in terms of return data, and it has been easier to assess who is good and who is not. That puts access at a premium, as is the ability to select.
“So, if you were coming to the asset class for the first time and did not have the experience or the relationships behind you, you would find it very difficult to select and access the very best funds.”
Collier agrees access can be difficult for smaller schemes, although solutions are being developed.
She says: “It is certainly challenging for smaller schemes to develop an appropriately diversified private equity portfolio by making their own direct investments into funds, both because of access issues and minimum commitment sizes, and because many smaller schemes do not have the requisite in-house resources to handle what is a time-intensive and specialist due diligence process.
“Funds of funds provide a solution for such groups and we expect to see more smaller investors seeking exposure to private equity.”
Collier makes the point that there are massive incentives for the private equity industry to make investments more accessible. The drive to make private equity investments available to defined contribution scheme members and the retail investment market will no doubt have a cumulatively beneficial effect on the accessibility of private equity as far as smaller DB schemes are concerned.
Collier continues: “Accommodating DC plans and, increasingly, retail investors, is recognised as one of the key challenges for the private equity industry in the future.
“This is one factor underlying the recent increasing interest in listed private equity vehicles.”
While there seems to be a growing interest from smaller schemes, not many are actively investing in it at this stage. This, of course, may be down to its inaccessibility.
McKeller says: “Clearly there comes a point where schemes may be too small to be able to access the asset class in a decent way to give it appropriate scale in private equity, and equally you have obviously got to look at the whole asset and liability mix within a particular firm and the duration of the liabilities in terms of how mature a scheme is.”
Gower agrees it can be difficult for small pension schemes to enter the market, which may be putting some of them off the asset class altogether; but, he adds, there are options such schemes could consider.
He says: “One specific option for pension schemes is to access private equity via a limited partnership closed-ended fund [investment trusts] that are available in the market. However, there are possible issues with this because their shares can trade at a discount or premium to net asset value.
“Recently there has been an increase in the availability of ‘diversified growth’ options available for small and mid-sized pension schemes. These are often pooled investment vehicles that in turn have an exposure to a wide range of underlying asset classes.
The use of private equity in these products is now commonplace and, as a result, this also offers smaller pension schemes the opportunity to invest in this asset class.”
There have been a number of reports in the national media recently about pension schemes investing directly in private equity, rather than through a third party, with a view to saving money on fees. However, Gower says it is unlikely any but the very largest schemes will consider this route a serious investment option.

He says: “Apart from the largest pension schemes, an allocation to private equity is made to take advantage of diversification benefits of this asset class. Hence, it seems unlikely that all but the very largest global pension schemes will take this investment a step further and invest directly into specific private equity deals.

“In terms of fees, it is not clear as to whether investing in a broad range of private equity deals directly will actually cut costs relative to some of the funds available to pension schemes, as the infrastructure and resources required to invest and manage direct equity investment are large.”

McKeller also agrees this is not an option for most schemes.

He says: “Although more pension fund money is coming into the asset class, it either goes through the fund of funds route or it is going into direct funds.

“It is not going into direct deals per se and I would find it very strange indeed if a pension fund was investing in individual deals.”

The wider drive for alternative assets
Private Equity is categorised as an alternative investment by pension funds, alongside the likes of hedge funds and property. Pension funds have increased their allocation to alternatives over the past 10 years because of strong returns, greater awareness and broader availability.

A turning point was the Myners report in 2001, highlighting the potential of alternative assets.

Gower says: “Before then, property was by and large the only alternative investment exposure a pension scheme had. However, since 2001 pension funds have embraced the idea of investment into alternatives. It looks like this is an area where growth will continue, alongside hedge funds, commodities and even currency.”

Some are beginning to question the appropriateness of labelling private equity as “alternative”.

Collier says: “Real estate, hedge funds and private equity each present their own challenges to investors, but all three assets have continued to move into mainstream acceptance, to the extent that the ‘alternatives’ label seems increasingly inappropriate.

“The findings of the Russell 2005-06 alternative investing survey showed anticipated returns from private equity were greater than 10pc across all regions, whereas, with the exception of Australia, all regions expected hedge fund and real estate returns to be in the 5pc to mid-8pc range.

“At the time that survey was carried out, usage of hedge funds was increasing dramatically across all regions. However, that trend does not appear to have developed at the expense of private equity, as the expectation of increased commitments to private equity in the same survey show.”

Gripton does not think private equity is being treated as an alternative; he thinks it is increasingly being dealt with simply as a variety of equity.

He says: “Many pension funds just switch between the public markets and the private markets, so I think we need to bear in mind it really is part of their overall equity portfolio.

“There are alternative assets and some groups do treat it as an alternative but I think the really sophisticated ones look at it differently. As an asset class, it is ideal for pension funds because they can take a long-term view and they don’t necessarily need the short-term liquidity you would get from hedge funds, where you can give notice and come out after a short period of time.”

Private equity will undoubtedly be seen as an alternative investment by schemes for some time, and it has a number of other asset classes with which to compete as schemes continue to strive for diversification.

What is certain is that, as the industry continues to develop with a view to increasing accessibility – not just for smaller DB schemes but for DC members and retail investors as well – private equity has much potential to become more of a mainstream asset class.

Foster says: “Clearly the diversification and correlation issues of private equity – given these are illiquid investments with difficult challenges around benchmarks – make these investments look like alternatives.

“When there are only two or three private equity funds in the world, not every pension fund is going to invest in it. Now there are hundreds of private equity funds and there is much more choice. And choice is very important.”