Friday, September 7, 2012

Big Buyout Funds a Drag on Pension Funds?

Michael Corkery and Greg Zuckerman of the WSJ report, Big Firms a Drag on Pension Funds:
Several years of subpar results from the private-equity industry's biggest players are testing the patience of some of their most-loyal investors: the public-employee pension funds that have come to count on these buyout firms for healthy returns.

A new report by a consultant to the California State Teachers' Retirement System, or Calstrs, shows that returns from large U.S. buyout funds are lagging behind many of the pension's internal benchmarks.

The report by Pension Consulting Alliance, to be presented Friday to the investment committee of the teachers' pension board, cites Calstrs's "significant exposure to the relatively weak performance of the mega buyout segment."

Pension funds have been looking hard lately at all of their investments as they try to get the biggest bang for their buck in order to meet their huge obligations in a market where interest rates are low and returns on many types of holdings have been paltry.
Against that backdrop, returns of the largest buyout funds have been slipping. Funds launched in 2006 that manage $3.5 billion or more are up 4.1%, compared with gains of 14.1% for funds managing less than $300 million and a 9.7% gain for those managing $1 billion to $3.5 billion, according to consulting firm Cambridge Associates.

Many pension funds are sticking with their partners in the belief that the returns will eventually improve with time. And, in general, pension funds have been steadily increasing their allocations to private equity.

According to Wilshire Trust Universe Comparison Service, among pensions with assets greater than $5 billion, the average allocation to private equity was 13% as of June 30, up from 9.5% a year earlier.

But some funds are demanding lower management fees from the private-equity firms.
And the State of Wisconsin Investment Board has its own issues with certain large firms. The board is taking the unusual step of selling a block of its investments with large private-equity shops.

While the pension officials have declined to reveal the reasons for the sale, a consultant's report suggests the decision was linked to some "mega buyout" firms' decisions to sell all or part of themselves to the public or other investors.

Private-equity firms of all sizes managed to exceed stock-market returns over the most recent five-year and 10-year periods, but some pension managers say large buyout strategies haven't lived up to expectations.
"Private equity is perceived as an absolute return strategy,'' says Luba Nikulina, head of private markets at Towers Watson, a consultant to pensions and other large investors. "Investors are taking more risks and using more leverage so they expect returns in the midteens, not in the single digits."
Calstrs's private-equity investments underperformed the pension fund's benchmarks on a one-, three- and five-year basis, though they beat it over a 10-year period.
Many of Calstrs's private-equity investments were made between 2005 and 2008 at a time when private-equity funds borrowed billions to buy companies at high prices. Some of those deals have not panned out.
A Calstrs spokesman said private equity remains one of the pension fund's best-performing assets, citing a 14% rate of return since the pension began investing in private equity in 1988. The spokesman said it "was too early to tell" whether the returns of the large buyout firms would prompt Calstrs to change its investments.

The pension's largest buyout investments are with Blackstone Group LLP and TPG Capital, totaling $2.8 billion and $2.2 billion, respectively. Blackstone and TPG declined to comment.
Wisconsin has seen enough. The investment board overseeing the state's pension plans is selling off about $1 billion of commitments to KKR, Carlyle Group, Blackstone and other large firms. KKR and Carlyle declined to comment.

Wisconsin did retain some investments with Blackstone, a person familiar with the investments said.
An Aug. 15 report by private-equity consultant StepStone Group LLC suggested that the interests of some large firms are less aligned with their limited partners because of recent initiatives such as "asset aggregation and going public or selling stakes to third parties."

Spokeswomen for the Wisconsin investment board and StepStone declined to comment.

Some of the large buyout firms that are gaining new commitments are offering new incentives. The big firms have started providing services to pensions such as "strategic partnerships" in which the private-equity firms provide wide-ranging investment advice and opportunities.

The Teachers Retirement System of Texas committed about $3 billion each to KKR and Apollo Global Management last November.

As part of these partnerships, the pension fund pays lower fees in return for making such a large investment.

Still, the allure of the big-name private-equity firms remains strong.

"You are never going to get fired for going with Blackstone,'' says Michael Schlachter, a managing director at consultant Wilshire Associates. "There is less chance of being embarrassed by a household name."
Exactly, you're not going to get fired for going with Blackstone or other brand name funds but if they're not performing, you have to send them a message, which is what Wisconsin and others are doing.

I've already discussed the changing of private equity's old guard. Think it is worth sharing again comments from an expert in the field:
It's not alignment of interest issues driving this, it's lack of performance, and/or as likely expected portfolio problems during the immense refinancing to come in 2013 to 2015. The great myth is that these name brands have delivered, in fact most of their performance is highly transient and cyclical, and based on the logarithmic growth in the industry performance remains mostly reliant on the valuation of unrealized portfolios of huge scale.

If investors focused on life IRR net of fees and F/X costs the picture would be more straightforward, not necessarily bad but just more obvious as to the risks and full cycle reality. Also, private equity programs need to be measured with the portion of life IRR identifying realized vs. unrealized returns. It's not hard to do this. Valuation is imprecise, and that's ok, just don't declare victory on unrealized performance.

Low transparency and annual or even shorter term score cards for long term investors has led to epic capital market distortions, the outcome simply favouring the short term trading model of investing, and current short term yield at the expense of capital preservation - which approaches may indeed have huge investing merit for the times, so its not really bad for investors, but it is bad for companies and economies which have long term needs that are not being consistently served, especially smaller companies.

It's also usually very costly to vend to the secondaries markets, institutions who are reversing decisions in illiquids are not long term investing, and probably washing out much of their historical net life IRR with these sales. Irresponsible or brave and wise decisions? Depends on the philosophy driving the decisions.
Private equity as an activity remains viable, but only at a regional or specialized boutique scale, or if at larger scale in highly flexible and/or low transaction volume mandates (which would not fit into typical allocator benchmark frameworks and/or diversification preferences). This is how the industry was born, and original track records of appeal were created.

The idea of writing large cheques to fewer firms is a step in the right direction but in effect contains/sustains the problem, and is not the solution. It's simply hard to do private equity well, at any scale and especially at large scale, and requires sustained resources and high efforts. Large cheques to large firms appear to be decisions of expedience and convenience, rarely the qualities behind good investing decisions.

Large private equity funds and firms are in effect awkward conglomerates without synergies among holdings, and no liquidity and huge frictional costs associated with buy and sell/IPO of holdings. Remember what happened to the 1960's conglomerates? Bad business model.

The good news is the industry will fade and right size (just as large scale venture investing died slowly over a long time) along with the timeline of the larger than life personalities behind it, hopefully some younger and/or less fashionable minded people will create new and flexible boutiques under the radar and allow for transformation to a more useful scale and style of investing.

The private equity renaissance will be quietly supported by high net worth people, and smaller institutions with open minded ways of solving for the timeless investment conundrum. And, some secondaries investors will do really well, if the underlying franchises can transform/survive, or at least liquidate with necessary patience.
When you read this, you have to wonder about what JP Morgan and others are smoking when they claim the new asset allocation tipping point will see pensions shifting 25% of their assets into alternatives.

If that happens, it will dilute returns even further, placing more pressure on US public pensions struggling with high fees, low profits. As the article states, some pensions are moving into "strategic partnerships" to lower fees but this just seems like another way for big funds to attract more capital with no guarantees that they'll deliver the targeted returns.

One positive development for private equity and markets in general is that risk appetite is coming back as global central banks signal they're ready to do whatever it takes to shore up confidence and boost growth.

Go back to read my recent comment on bringing back the risk. We shall see how markets react to this morning's tepid jobs report and if Germany's Constitutional Court will approve the ESM on September 12, but my hunch is that we're in for a melt-up in risk assets.

Again, I am bullish US financials, energy, tech and think now is the time to be loading up on out of favor cyclical sectors like steel, copper, coal and anything else that got destroyed as investors feared the end of the world as we know it.

Below, Bloomberg's Sara Eisen displays the level of global GDP vs. payroll to population, showing that only 27 percent of all adults globally are employed full-time. She speaks on Bloomberg Television's "Bloomberg Surveillance." Obviously, the US and the world need more full-time jobs with decent wages and benefits. Let's hope better days lie ahead.

Also, Tom Steyer addresses the 2012 Democratic National Convention. The billionaire founder of Farallon Capital Management led a campaign that defeated a California ballot measure backed by the Koch brothers and the oil industry that would have gutted the state’s landmark global warming law. Is he getting ready to run for public office? I hope so.