Harry Campbell
Private equity and public pensions are one of Wall Street’s most peculiar love affairs. Recently, the two have tried to become even closer. But don’t get mushy — this relationship is about money, not romance.
Public pensions pay billions in fees to private equity. The question is whether it is worth it.
Private equity’s first date with public pensions was in 1981, when the Oregon Investment Council, the manager of Oregon’s pension fund, invested along with Kohlberg Kravis Roberts Company to buy the retailer Fred Meyer.
Since then, the two have been inseparable, and pension funds have at times made up more than 50 percent of private equity’s financing. It’s an odd pairing: the millions of working-class Americans who rely on public pensions have invested billions with the private equity industry, which in exchange has made billions for these pension funds.
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The titans of private equity, meanwhile, have become rich off public pensions. A New York Times study last year found that the 10 largest public pension funds had paid private equity $17 billion in fees from 2000 to 2010. Last year, the Washington State Investment Board, the manager of the state’s pension funds, paid $144.8 million in fees to private equity firms to manage $13.5 billion.
The private equity firms know they have a good thing going. A few years ago, a senior adviser to the Blackstone Group called state pension benefits “too generous.” At least one pension fund subsequently refused to deal with Blackstone, most likely pushing the private equity firm to issue a remarkable statement that the firm opposed “scapegoating” of public employees and that it believed “a pension is a promise” that should be honored.
Some pension funds are looking to get even tighter with private equity.
The Teacher Retirement System of Texas, which manages about $107 billion on behalf of Texas teachers, announced in November that K.K.R. and Apollo Global Management would manage $6 billion of its money. It will be invested not only in private equity but also in other asset classes managed by the two firms, including debt.
Just last week, the New Jersey Division of Investment, the manager of New Jersey’s $66 billion public pension fund, agreed to provide Blackstone with $1.8 billion to manage. Blackstone will also invest the money in private equity as well as other investments.
These big commitments come as big private equity firms are busily converting themselves into full-service asset managers.
At the same time, pension plans everywhere are also desperate for yield. Pension plans are reportedly underfinanced by anywhere from $700 billion to as much as $4 trillion, depending on the calculations. Poor returns over the last few years have not helped. Over the last five years, the average state and local pension fund has returned 4.7 percent, according to Callan Associates.
Pension plans hope to make up these lost years and reach performance targets that in some cases are still set at a hopeful 7 to 8 percent a year. Private equity has traditionally been a high-performing asset class, and shifting more assets into this and other alternative investments like hedge funds is seen as a possible solution. Wilshire Associates recently found that the average pension fund had increased its allocation to private equity to 8.8 percent in 2010 from 3 percent in 2000.
Even with new money coming in, private equity firms have been so eager to raise money in the last few years that at times they have resorted to the equivalent of retailers’ half-off sales. Typically, investors pay private equity firms a yearly administrative fee that is 2 percent of total investments. The private equity firm also gets 20 percent of any profits earned. Some firms like K.K.R. received the 20 percent of profits from the first dollar in returns, but most private equity firms typically must first reach a hurdle of 8 percent returns.
Some private equity firms have been lowering the 2 percent fee, and even K.K.R. has reportedly agreed to a threshold before it takes 20 percent of the profit.
Both the New Jersey and Texas retirement plans were said to have been offered these better terms before investing their money.
The question is whether even this is too much for public pension plans.
An alternative to private equity comes from the Ontario Teachers Pension Plan. This Toronto-based pension fund, which has more than $100 billion in assets, has adopted a do-it-yourself approach with the $12 billion it has invested in private equity.
The Canadian fund has hired its own team that arranges private equity transactions (though they also at times invest directly in a private equity firm’s funds). The pension plan has bought the Toronto Maple Leafs and Raptors sports teams, and just last week was part of a group paying $1.3 billion to buy Blue Coat Systems, an enterprise software company. The pension fund has outearned many of the private equity firms, earning 18.5 percent on its private equity investments through the end of last year from its beginning in 1990.
In comparison, the California Public Employees’ Retirement System, known as Calpers, says that it has earned a return of 11.1 percent on its alternative investment program since its inception, also in 1990. The Texas Retirement Fund, meanwhile, has had an annualized return of 13.1 percent in the last 10 years, while Preqin reports that the average pension plan earned just 7.2 percent on its private equity investments in the last 10 years.
The Ontario teachers’ fund strategy of direct investing eliminates the fees paid to private equity. The fund also doesn’t have to deal with placement agents who get a commission from private equity firms for selling pension fund investments to them.
The direct investment approach, however, is not for every fund. It requires that the fund build its own team and take the risk of failure. Managers may prefer to blame the private equity firm for poor results rather than themselves.
Setting up an independent investing team is only for the largest pension funds. For many smaller pension plans that can’t afford the losses or their own investing operation, private equity is a boon.
The answer is likely to be a combination of the Ontario model and the Texas/New Jersey route. The largest funds may want to explore setting out on their own. Smaller funds may wish to bargain hard with private equity to obtain lower fees.
In the mix, pension funds need to be aware that while private equity firms can provide valuable services, that comes at a cost to the funds’ beneficiaries.
Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.
Article source: http://dealbook.nytimes.com/2011/12/13/wall-st-s-odd-couple-and-their-quest-to-unlock-riches/?partner=rss&emc=rss
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