Private equity investments involve acquiring equity interests in non-publicly traded companies or real estate assets, offering pension managers the potential for higher returns and greater diversification due to lower correlation and volatility to traditional public market investments such as stocks and bonds. This makes private equity an attractive option for investors with long time horizons looking to optimize and close funding gaps in pension programs. 

History and evolution of Private Equity in public pension portfolios

As the world has progressed, our quality of life has improved, and as a result, life expectancies have increased. While this is great news for humanity, it does pose some challenges for pension managers. With plan members living longer, plan sponsors face increased obligations in terms of projected benefits.

To compound the problem, natality rates have been dropping in developed countries, which means fewer people are entering the workforce to contribute to pensions. As the average population gets older and enters retirement, the burden on pensions increases, as contribution projections drop.

To make matters worse, until very recently, interest rates had been dropping steadily for the past 40 years. This decrease in expected future returns has forced pension managers to seek out alternative investments, including private equity, to meet their higher projected liabilities.

Take a look at the chart below, which shows the Yale Endowment's asset allocation over time. While there are differences between Endowments and Pensions, both invest with the aim of funding future liabilities, which makes them somewhat comparable. It's clear that there has been a significant shift in the way the endowment has invested. Back in the 1980s, over 90% of the portfolio was allocated to traditional asset classes like stocks and bonds. But fast forward to 2020, and you'll see that the percentage has dropped to just 30%. This is a massive change, and it highlights the growing trend of diversifying investments beyond traditional asset classes.

[Asset mix evolution of the Yale Endowment over the past 38 years]

Currently, the biggest investors in Private Equity and Alternative Assets in general are public pensions followed by Endowments and Foundations. As one can see in the image below OTTP and OMERS hold over 60% of their assets in Alternative Assets. 

[Alternative asset allocation as a function of investor sophistication]

Now you may be wondering how Private Equity has performed over time relative to stocks.

For the most part, private equity has outperformed stocks and bonds. For example, for the 10 years ending in December 2019, annualized private equity returns measured by different benchmarks ranged from 13.8% to 16.5% with a median of 15.2%. This median was 1.7% higher than the S&P 500 Total Return Index for the same 10-year period. This supports the idea that private companies offer enhanced returns due to the illiquidity risk premium embedded in them. 

What about volatility?

We all know that the stock market can be a bit of a rollercoaster ride, with prices swinging up and down daily. But when it comes to private equity, things are a little different. Private equity investments are generally less volatile than public market securities, like stocks and bonds. However, some experts argue that this comparison isn't entirely fair. They say that since stocks are traded every day and appraisals on private equity are only done monthly or quarterly, the volatility of private markets is smoothed out and understated. We see where they're coming from, but we also think that public markets tend to overstate volatility during a period of market stress. Take CAPREIT for example. During the recent bear market that started in 2022, their stock dropped over 30%. But management realized that the market was undervaluing their assets, so they started selling some of them off in the private market and buying up their own units in the public market to capture the difference in pricing.

If the market was accurately pricing volatility and value, this wouldn't be possible. Of course, this is just one example and doesn't represent all private equity assets. But we believe that the true volatility lies somewhere in between reported public and private market volatility.

As you can see, private equity presents several potential benefits for pension managers. However, it's also important for pension managers to be aware of the risks involved with this asset class. These risks include:

1. Illiquidity: Private equity investments can be challenging to sell, particularly during times of market stress. This can create liquidity risks for pension plans, especially those with defined payouts that need to make distributions in the near term.
2. Rebalancing risks: Due to the illiquidity of private equity, maintaining the target asset allocation can be difficult. Pension managers need to make assumptions about expected returns and capital calls to maintain the right allocation mix. While there may be periods of drift, this is a risk that must be accepted when investing in this asset class.
3. Timely and accurate valuations: In illiquid markets, valuations can become stale and may not accurately reflect the true value of the transaction. Additionally, valuations may be model driven and dependent on assumptions which can increase the risk of mispricing. To manage these risks, thorough due diligence in the valuation process is essential when evaluating a private equity manager.
4. High investment costs: Private equity is an active strategy with higher management fees than traditional assets. However, historical returns have been higher even after taking into account these higher costs.

Public pensions and large endowments and foundations have been the primary beneficiaries of private equity investments, owing to their sizable assets under management (AUM) often in the hundreds of billions. With ample resources, they have built substantial positions across various strategies and managers. Unfortunately, smaller pensions serving smaller firms have not been able to invest significantly in private equity due to their limited scale. Many strategies require a minimum investment of $1M-$25M, making it more challenging for smaller pensions to achieve adequate exposure to the asset class without overconcentrating their portfolio. For instance, a $30M pension with a 10% target allocation to private equity can only invest in 1 to 3 managers, resulting in a lack of exposure to private equity. As a result, smaller pensions may be at a disadvantage compared to their larger public pension counterparts. Last year, alternative assets, including private equity, retained their value far better than stocks and bonds. As a result, public pensions like the Canadian Pension Plan achieved positive returns, while smaller pensions reported significant losses.

What we see going forward given the current market environment

The current market environment is somewhat challenging for every asset class. Since the beginning of 2022 central banks around the world have been raising rates to combat inflation increasing real rates. As such, growthy parts of the market have been hit considerably. Whereas value plays with good cashflows and strong balance sheets have been performing well compared to the overall market.

To have a view on any asset, you must have an opinion on inflation first. Currently, two camps exist. The first believes that inflation will decrease rapidly, and we will return to the deflationary period pre-pandemic. This argument stems from our current demographic situation, which show that as people get older, they tend to spend less. Additionally, the fast advancement of technology replaces jobs and increases productivity putting downward pressure on inflation. The other camp believes that inflation is here to stay due to the structural shortage of workers due to the boomer generation retiring, which will keep wage pressures high, thereby pushing inflation upward. Furthermore, deglobalization due to geopolitical conflicts poses inflationary pressures as supply chains need to reallocate to countries where labor is more expensive.

If you belong to the first camp, you will want to stay invested in growth sectors, particularly in early-stage venture capital, preferably in technology, where cash flows are in the distant future. Leverage buy-outs may also work due to the low cost of capital we would experience in a deflationary environment.

However, if you believe that we are entering a structural inflationary environment, it would be best to invest in private equity real estate, specifically multifamily and storage. As tenants move, rents reprice higher, increasing the property's value. Additionally, it would be wise to invest in late-stage private equity deals with projects or companies that have strong fundamentals and balance sheets.

We also believe that this asset class will become more prevalent in smaller pensions as more financial products are created with the purpose of filling the gap between smaller pensions and alternative assets leveling the ground between the biggest pensions in the world and the smallest ones that have trouble accessing the asset class due to the size constraints. Here at MacNicol & Associates we are actively helping pensions bridge this gap.  

Sources:

https://reason.org/wp-content/uploads/examining-private-equity-public-pension-investments.pdf