Sunday, January 30, 2011

Private Equity Rewards Pensions?

Ellen Kelleher of the FT reports, Private equity rewards pensions:
The private equity holdings of the world’s largest public-sector pension funds outperformed most other asset classes in the short and long term, new research suggests.

The 20 largest public pension funds now have an estimated $224bn allocated to private equity deals – or 5.5 per cent of their capital on average.

Their investment have provided strong returns, according to a study by Preqin, an independent research house that focuses on alternative assets.

The study of the financial statements of more than 150 public pension funds from North America, Europe and the UK suggests the returns on their private equity investments and also their fixed income holdings in many cases, outshone hedge funds, real estate and listed equities.

As of the second quarter of 2010, private equity and fixed income were the only investment types to generate positive median returns across one, three, five and 10-year periods; the other asset classes fell into the red for at least one of the periods, the study shows.

All asset classes show positive returns across five and 10 years, but only fixed income and private equity showed positive returns across the three-year period, reporting respective gains of 7.6 per cent and 0.6 per cent.

“Private equity investments provide diversity within the pension funds’ investment portfolios, and have the potential to yield high returns,” said Tim Friedman, head of communications at Preqin.

As overall mergers and acquisitions activity starts to rebound this year, bankers expect it to throw up opportunities for private equity groups to team up with big corporate groups, either by financing bids or buying non-core subsidiaries.

A return in force to dealmaking in Europe last year by private equity firms came in spite of continued tight supply of finance.

The value of company buy-outs almost trebled in Europe from €18.3bn ($25bn) in 2009 to €49bn last year.

I take this research from Prequin with a grain of salt. Sure, private equity did perform well over the last 10 years but does this automatically imply that it will continue to outperform over the next 10 years? I know public pension funds like OMERS are aggressively moving into private markets, and while it might make sense for them because they have the internal expertise to do so, it certainly doesn't make sense for every pension fund.

A few days ago, I wrote on Carlyle's acquisition of AlpInvest, a European private equity fund of funds owned by Dutch pension funds APG and PGGM. A senior pension fund manager shared these thoughts with me on this deal:

A scenario:

AlpInvest will enable Carlyle to go public, and thereafter I bet will merge with Blackstone or some such, creating a mega private equity/hedge fund firm.

The private equity asset class will roar ahead unabated based on the publicity and related hopes and dreams of institutions, and all this will come to a reckoning in 2013/14 or so (when the wall of debt refinancing comes home to roost). Then the slow, grinding diminution of an overdone industry will unfold for the decade thereafter. Handfulls of firms and institutions will end up with positive IRR for the full length of their programs.

Mercer has already promoted PE going forward as having expected returns less than public markets. They are not wrong.

I also worry that PE returns will disappoint public and private pension funds in the next decade. There is a tsunami of liquidity flowing into private markets as every single consultant is touting the "benefits of private equity" (and other private markets) without understanding the nature of the asset class and how its performance is linked to that of public markets. Moreover, studies have shown that performance persistence of private equity is concentrated in the top funds and that the "illiquidity premium" doesn't exist if you invest in average funds.

The question that all investors should think hard about is will private equity continue to outperform public markets and other asset classes in the future? If so, in which countries and in which sectors? Do they have internal expertise to do direct deals and co-investments? If not, then why bother tying up capital in an illiquid asset class which might very well underperform public markets?

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