Thursday, February 9, 2012

Pension Funds Queasy Over Private Equity?

Cristina Alesci and Devin Banerjee of Bloomberg Businessweek report, Pension Funds Get Queasy over Private Equity:

Mitt Romney’s campaign for the Republican Presidential nomination may be creating funding headaches for his former colleagues in the private equity industry. Romney’s opponents have characterized Bain Capital—the firm he helped found in 1984 and left in 1999—and other buyout managers as corporate looters who enrich themselves at the expense of ordinary workers. The issue is likely to remain in the news should Romney win his party’s nomination and face President Obama in the general election.

With public scrutiny focused on private equity funds, pension funds are more reluctant to invest and may ask for more details on job creation and push for lower fees, according to officials and trustees at public pensions. “Pension funds have boards. They don’t want to be giving money to an industry that has a taint,” says Tony James, president of Blackstone Group, the world’s largest private equity firm. “Similarly, boards of directors don’t want to sell their company to organizations they don’t view as respectable. So it could be very damaging for the industry.”

The debate comes as the industry is competing for a shrinking pool of investor dollars. Fundraising has fallen off sharply since the onset of the global financial crisis, staying below $100 million each quarter, according to London-based researcher Preqin. In the second quarter of 2007, at the peak of the leveraged buyout boom, private equity firms raised almost $214 billion. In the fourth quarter of 2011, they raised $52.4 billion.

Public and private pension funds in the U.S. provide 42 percent of the capital for all private equity investments, according to the Private Equity Growth Capital Council in Washington. Public employee pension funds, which must answer to ordinary workers, are sensitive to protracted debates about managers’ compensation and whether buyouts create value and jobs, says one official who asked not to be named because he wasn’t authorized to speak on the topic.

“The political attacks against Romney and Bain will definitely come up when firms pitch us their new funds,” says William R. Atwood, executive director of the Illinois State Board of Investment, which oversees $10.4 billion in pension funds. “You’d be crazy not to bring it up.” The Illinois pension board had $621.3 million, or 6 percent of its assets, in private equity as of Dec. 31, according to its website.

Bad publicity has hurt private equity firms in the past. Last year, Blackstone lost out on a deal to manage hedge fund investments for New York City’s public pension funds after the company’s chief strategist suggested retiree benefits were too generous.

Bain tends to be less reliant on pension funds than its rivals. When Romney set out to raise Bain’s first fund in 1984, he steered clear of pension funds, pursuing high-net-worth individuals who contributed about $37 million, according to a person who worked with Romney at the time. Kohlberg Kravis Roberts’s co-founders, by contrast, received early capital from Oregon’s and Washington’s pensions, with the latter contributing $12 million to KKR’s first fund in 1982.

The success of Bain’s first fund, which generated a 61 percent average annual return, according to marketing documents from 2004 obtained by Bloomberg, allowed Bain to charge a premium for its investment services. Bain collects 30 percent of the profit on its investments, the highest in the industry. Pensions historically have been less willing to pay the higher performance fees. In a recent fund, Bain relied on pensions for about 9 percent of client assets. Alex Stanton, a spokesman for Bain, declined to comment.

One Bain executive expects the storm to blow over. “Our limited partners have been with us for 28 years, many of them,” Bain Managing Director Stephen Pagliuca said in an interview at the World Economic Forum in Davos on Jan. 27. “We just keep our heads down and try to build value.” Pagliuca also said that pensions will come to rely more on private equity to meet their growing obligations to workers because traditional assets like stocks and bonds won’t return enough.

Still, with Romney’s candidacy keeping the spotlight on the industry, Atwood of the Illinois State Board of Investment says there’s bound to be an impact. “We all know that private equity managers make a lot of money, and we know how they do their business,” he says. “But when it’s on the front page, it causes us to think twice when making investment decisions. Private equity is more lucrative when it’s kept quiet.”

The bottom line: Pension funds, which provide 42 percent of the private equity industry’s capital, may pull back amid criticism of Romney and Bain.

Will pension funds pull back from private equity? Absolutely not. But they are taking more concentrated bets with fewer GPs. Yesterday, I wrote about CalSTRS going the Texas Teachers' route, considering making large separate-account commitments to private equity firms.

This morning I had a chance to speak with Neil Petroff, CIO of the Ontario Teachers' Pension Plan (OTPP). Neil is extremely sharp and knows his stuff in both public and private markets as well as hedge funds. Bob Bertram, his predecessor, was equally sharp. Great pension plans have smart CIOs allocating risk across all investment portfolios.

Anyways, we talked a lot about private equity. Neil told me these separate accounts in PE are the same as the ones used for hedge funds. Ontario Teachers' doesn't use them because even though they're less expensive than paying the traditional 2 & 20, they still cost 1 &10. OTPP prefers investing directly into private equity or co-investing, paying no fees.

He repeated what Jim Leech said at Davos, namely, Ontario Teachers' does do a lot of direct deals, getting into auctions bidding on deals. But he also told me they do not compete with the brand name PE funds, but will co-invest alongside them on deals, just like other large Canadian public pension funds. The key point is that they do not pay 2 & 20 or any fees on directs and co-investments, their teachers get that money.

We talked a lot about the private equity model and how pensions are better suited than PE funds to do private market deals that require a very long time horizon. Unlike PE funds that lever up and try sell a company after 4 or 5 years to realize gains and move on to their next fund, at Ontario Teachers' they have some direct PE investments that go back 18 years. And unlike PE funds, they spend most of their time on deals, not marketing.

At one point, I asked him about industry trends and how all these public pension funds moving into private equity will change the landscape. "It will increase competition and increase multiples". In other words, as all this pension money flows into private equity, it will decrease the expected return of the asset class.

Then we talked about CalTRS getting fully funded in 52 years and ATP being one of the best pension/ hedge funds in the world. Neil told me that U.S. pension funds use their expected investment return to discount their liabilities. So, let's say CalSTRS lowers their expected investment return from 7.75% to 7.5%, it will still be 200 basis points above the discount rate Ontario Teachers' uses.

"If U.S. pension funds used our discount rate, they'd be insolvent." To understand why, for every 100 basis decline in real rates, the present value of future liabilities goes up by $25 billion. Neil added: "In order to achieve their investment target, U.S. pension funds are taking more risk in private markets."

As for ATP, Neil told me their liabilities are nominal, not inflation-indexed. This means they bought bonds to match their liabilities -- and long bonds delivered outstanding double digit returns in 2011 -- and since they're fully funded, they can take more risk than OTPP or other pension plans that have a deficit. The same goes for Healthcare of Ontario Pension Plan (HOOPP), which he expects will be among the top-performing large Canadian DB plans in 2011.

On hedge funds, he told me it is a question of allocating risk internally and externally. They do a lot of relative value strategies internally but also allocate to external managers who have the skill set to deliver alpha in strategies that are not easily replicated internally. Ron Mock, the guy running hedge funds and bonds at Teachers', knows what he is doing. He told me something a long time ago that stuck with me ever since: "Beta is cheap; true alpha is worth paying for."

Institutional investors piling into Malakia Capital Management should think carefully about that last statement. Ron and Neil know all about the nonsense in the hedge fund industry. I'll write some more on hedge funds in my next comment. Will end by thanking Neil Petroff for taking some time to chat with me this morning.

Below, Scott Sperling, THL Partners, explains why he is increasingly optimistic about investing in North American companies and offers his view on private equity now.

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