Monday, October 21, 2013

Fresh Signs of a Private Equity Bubble?

Joe Morris of the Financial Times reports, Private equity tries to crack $5.3tn US pension market:
Pantheon Ventures is bidding to become the first private equity manager to crack the US’s vast defined contribution pension market.

A growing number of private equity firms have been sizing up the retirement plans, which sit on $5.3tn in assets. Though traditional corporate pensions have long dedicated portions of their portfolios to private equity, and the asset class ranks as a top performer for the plans, it remains conspicuously absent on 401(k) and other defined contribution platforms.

“No real progress has been made in terms of attracting clients, but we have certainly seen a lot of interest from private equity managers in the DC space,” says Nathan Voris, large market practice leader at Morningstar, the data provider.

Mr Voris says most private equity aspirants, which are thought to include KKR and Carlyle Group, are still studying the market, but last month Pantheon began pitching plan sponsors a private equity fund of funds.

None has signed up yet, mainly because no one else has signed up yet, says Kevin Albert, partner and global head of business development at Pantheon.

“Nobody’s done this before,” Mr Albert says. “Do I want to be first? That’s the issue.”

The fund of funds is designed as an investment sleeve of custom target-date funds, providing private equity exposure of 3-5 per cent for conservative allocation funds and 8 per cent for more aggressive, longer-dated funds.

Plan sponsors’ primary concerns have centred on liquidity and asset valuation, as defined contribution plans typically provide daily liquidity and daily valuations, Mr Albert says. Pantheon addresses liquidity by investing 30 per cent of the portfolio in a liquid exchange traded fund correlated to private equity, while a proprietary valuation process supplements underlying funds’ quarterly valuations with daily estimates.

Prospective clients are plan sponsors with a minimum of about $100m in assets, and that build their own target date funds, but eventually Pantheon intends to pitch to off-the-shelf fund providers, Mr Albert says.

Mr Voris agrees that liquidity and daily valuation are two of three obstacles for private equity managers. The third is cost. Indeed, defined contribution plan managers are under increasing pressure to reduce investment fees following bolstered fee disclosure requirements and a spate of lawsuits alleging excessive charges.

The Pantheon fund of funds will charge 70 basis points per year, compared with 63bp for the typical equity mutual fund in 401(k)s, according to the most recent data from the Investment Company Institute.

Pantheon seeks to justify the fees with performance, targeting returns of 2 per cent to 3.5 per cent in excess of the S&P 500, net of fees, expenses and the fund of funds’ liquidity portion.

Such returns do not sound unreasonable to prospective clients with any history of private equity investing in traditional, defined benefit pensions, Mr Albert says.

“Many of the people we’re meeting have DB plans that are typically frozen, where they have done private equity investments for many years,” he says. “This has been the best performing asset class in most cases for 30 years.”
There is no doubt that private equity has been one of the best performing asset classes but I caution readers, there is a wide dispersion of returns among funds and top quartile funds typically outperform over long periods, so take past performance with a shaker of salt. If investors weren't in the right funds, they grossly underperformed the S&P 500.

And while I welcome Pantheon's shift into the defined-contribution space, I have my reservations too. Pantheon is one of the better private equity funds of funds and the fees they are charging are reasonable but at the end of the day, private equity is better suited for large defined-benefit plans which invest directly in funds and co-invest alongside them on bigger deals. In other words, even if private equity makes inroads into defined-contribution plans, well-governed defined-benefit plans will still outperform DC plans.

Retail investors wanting a piece of the action in private equity should consider investing in the public shares of the Blackstone Group (BX), Kohlberg Kravis Roberts & Co.(KKR), the Carlyle Group (CG) and Apollo Global Management (APO). It's obviously not the same as investing in their private equity funds but as long as their underlying business is growing, their shares will keep rising (and they pay nice dividends too).

Institutional investors are also refocusing their attention on private equity. Ayesha Javed of Dow Jones Financial News reports, Pension schemes rebalance their portfolios:
During the financial crisis, private equity fundraising suffered because of the so-called denominator effect, where pension funds’ allocations to the industry were sharply reduced because the overall value of their assets had fallen due to plummeting public equities markets. Now, with equities on the rise, the opposite seems to be true.

The denominator effect, which happened because pension schemes typically attempt to keep the percentage of their assets in private equity constant even though the value of their assets changes, has been likened to a pendulum by some industry executives.

Kishore Kansal, head of Tullett Prebon Private Equity Risk Solutions, said: “Following the financial crisis, there is a bit of a love-hate relationship between pension funds and the private equity asset class.

“In the aftermath of the crisis, many pension funds found themselves the victims of the denominator effect. But now that stock market valuations have gone up, the denominator effect has become less of an issue.”

Global allocations to private equity by privately run pension funds fell from $219.7 billion at the start of 2009 to $148.6 billion a year later, according to data provider Preqin. But since then they have gradually risen and currently stand at $235.2 billion. This has reflected the wider equities markets, which fell sharply in 2008 only to gradually reach record highs this year.

Public pension funds did not experience the same drop in 2009 but have gradually grown their allocations and now stand at $487.1 billion.

But investors’ allocations in percentage terms have remained relatively constant over the period.
Globally, pension funds’ allocations to private equity fell from an average of 5.52% of their total assets under management in 2005 to 4.58% in 2007, according to Preqin. Average allocations as a percentage of total AUM rose to 5.04% in 2008 and 5.85% in 2009 before gradually tailing off to 5.34% by 2011. Last year allocations were back up at 5.81% and they stand at 5.69% so far this year.

In Europe, pension funds allocated 4.29% of their assets under management in 2008, rising to 5.09% in 2009 before dropping to 4.14% in both 2010 and 2011. But that grew to 4.52% in 2012, and currently stands at 4.42%, according to Preqin.

Some of the largest European pension funds that invest in private equity include Dutch pension funds APG and PGGM. The two schemes are rebuilding their capacity to invest in the asset class after selling their joint fund of funds business, AlpInvest Partners, to Carlyle Group in 2011. APG’s private equity assets under management have risen from €15.1 billion in 2011 to €16.8 billion currently, while PGGM has €8.4 billion of private equity assets under management, compared with €7.5 billion last year, according to Preqin data.

Antoine Dréan, founder and chairman of private equity advisory firm Triago, said that as well as the reverse in the denominator effect, investors such as pension funds were also again seeing distributions – returns from private equity funds to their investors – from their investments. He said: “There have been a lot of distributions [to investors] through [dividend] recaps due to good debt market conditions, and from secondary buyouts, which has put more money back into the game.”

He added that improved public equity market performance also meant that private equity fund managers, or general partners, were benefiting from the added exit option of an initial public offering.

Pension funds also face the need for higher returns as the yields on government bonds, or gilts, are not high enough to achieve the returns they require on their current time scale, according to Kansal.

He added that pension funds were being driven to invest in alternative assets by their need to make “outsized returns”, which they were actively seeking and could not achieve from investing in gilts. He said: “Many pension funds are facing a global macroeconomic problem: yield is low. Pension funds are asking themselves: where do I make returns to match my liabilities?”

Dréan said private equity investors, or limited partners, were also changing their attitudes towards the asset class, and were more upbeat about it. He said: “Many [investors] believe that 2014 to 2015 and beyond will be good for private equity funds. There will be less silly money – money that is not disciplined and that would be put to work just because they [firms] want to [spend it].”

He said there was a perception that the economy was improving, particularly in the US: “There is a confidence level which is more quantitative than qualitative.”

Mark Calnan, global head of private equity at Towers Watson, said pension fund allocations to the asset class were in flux and that this was something that the industry was still getting comfortable with. He added: “Pension funds need to take a longer-term perspective and recognise that the pendulum shifts and that sometimes they will be more allocated and sometimes they will be less allocated.”
Investors need to look at where private equity funds are generating their returns. Ayesha Javed also wrote a blog comment for the Wall Street Journal's Private Equity Beat stating that dividend recaps in Europe recently topped $8 billion:
The controversial practice of private equity firms using dividend recapitalizations to take payouts from their European portfolio companies is at the highest level since the onset of the financial crisis, according to Dealogic figures.

In the first three quarters of this year there have been $8.2 billion worth of dividend recapitalizations for 20 private equity-backed deals in Europe, the highest level since the same period in 2007, when $38 billion worth of recaps were done for 36 deals.
I've covered the controversial practice of dividend recaps in private equity. I'm cautious on private equity knowing that in this environment, the pressure is on funds to find good deals.

And I get nervous when I read that Japan's GPIF is making moves into private equity:
Japan's Government Pension Investment Fund (GPIF) is making initial moves toward investing in private equity, sources say, a potentially big step in the world's biggest public pension fund's strategy of shifting some of its $1.2 trillion in assets towards riskier investments.

GPIF has hired a veteran private-equity manager from Sony Life Insurance Co and moved several internal staff into its investment group to focus on private equity, people familiar with the process told Reuters on Friday.

Putting even a sliver of Japan's $2 trillion public funds into private equity - typically nimble private companies that invest in promising startups and turnarounds - would be a notable advance in Prime Minister Shinzo Abe's push for higher returns from public funds and greater risk-taking in the economy at large.

GPIF posted record annual investment gains of 11.2 trillion yen ($114.56 billion) in the fiscal year through March but in recent years it has underperformed major foreign public pension funds that are more heavily weighted towards stocks and other risk assets.
According to the article, it's not clear when GPIF might begin investing in private equity:
Such investment may be included in a medium-term strategy plan expected to be hammered out in the fiscal year from April 2014 for implementation the following year, a source said.

Investment strategy may depend on a November report by an Abe-appointed panel examining public funds' investments. The seven-member panel is looking into improving governance of public funds and beefing up returns on investments by raising exposure to equities and foreign assets.

The panel said in September that public funds, including GPIF, should alter their emphasis on Japanese government bonds and diversify to investments including infrastructure and private equity.

GPIF started looking into alternative assets in November of last year, when it selected four companies to conduct feasibility studies for possible future investments in assets including private equity and infrastructure.
As I recently stated, I'm not sure GPIF is ready for Abenomics. Moving into private equity requires a lot of preparation, the right approach, the right team and the right governance. Noriko Hayashi who joined GPIF to focus on potential investments in private equity should talk to Mark Wiseman at CPPIB and Derek Murphy at PSP Investments. The biggest risk I worry about for GPIF is vintage year risk because now isn't the best time to invest in private equity.

And I leave you with this thought. Laura Kreutzer reports the Yale University endowment is lowering the percentage of assets dedicated to private-equity investments for the first time since 2005:

The New Haven, Conn., college’s endowment totaled $20.8 billion as of June 30 and is closely watched for changes in its holdings of stocks, bonds, hedge funds, private equity and other investments. Yale Investments Office, which manages the endowment, said last month that it cut the endowment’s target exposure to private equity to 31% of assets for the fiscal year that began July 1.

Yale Investments Office also reduced its targets for real estate, while increasing allocation targets for hedge funds, foreign equities and natural resources.

The private-equity target was 35% in fiscal 2012. As of June 30, 2012, private equity represented 35.3% of the university’s $19.3 billion of endowment assets, according to the latest detailed data available.

Yale Investments Office declined to comment on the moves through a spokesman.

Yale’s private-equity portfolio has generated a 14.4% annualized return in the past decade, ranking it as one of the endowment’s best investments, according to a preliminary report issued in September. Natural resources and real-estate portfolios, both largely made up of assets that like private equity are harder to sell, had annual returns of 15.6% and 7.2%, respectively.

Chris Douvos, a former portfolio manager at the Princeton University endowment who now is managing director at private-equity fund manager Venture Investment Associates in Peapack, N.J., said it is unlikely Yale’s lower private-equity target reflects a broad view of private equity as an investment.

“It’s extremely likely that Yale’s [target] reduction is … more of a micro-commentary on the managers out there,” he said.

The 31% target would keep private equity as the largest asset class in the Yale endowment’s portfolio—and one of the biggest in the U.S. University endowments with more than $1 billion in assets had an average private-equity allocation of 26% last year, according to a survey by the National Association of College and University Business Officers and Commonfund Institute.

Many university endowment managers have closely followed the “Yale model” of asset allocation, pioneered by Yale Chief Investment Officer David Swensen. The strategy called for higher allocations to alternative asset classes, such as private equity, real estate and natural resources.

The financial crisis and economic downturn raised questions about the strategy, especially at schools with fewer assets. Endowments at Harvard University and other colleges that increased exposure to such investments were hurt by steep declines in the value of their portfolios.

Yale’s endowment lost almost a quarter of its value in the year ended June 30, 2009. The university has since boosted its cash reserves, and the value of the portfolio has increased in subsequent years, including a 12.5% return for the year ended June 30.

Many endowments have “realized that putting a preponderance of the portfolio in illiquid … strategies may be too aggressive for them,” Mr. Douvos said.
We can debate the meaning of the Yale endowment's latest private equity moves but I agree with Douvos, it's probably more micro than macro related as it's hard to find good PE managers in this environment. And he's right, many endowments are much more cognizant of the risks of putting a preponderance of their portfolio in illiquid strategies. Public pensions seem unfazed, taking on more illiquidity risk.

Does this mean that it's time to ditch the Yale endowment model? Not necessarily. Pensions have a much longer investment horizon than endowments so they can take on more illiquidity risk, especially if they're not underfunded or have the benefit of net liquidity flows for many more years (like CPPIB and PSP Investments).

But most pensions praying for an alternatives miracle are in for a nasty surprise. Unlike CPPIB, PSP Investments and others who form Canada's top ten, their governance model is all wrong and so is their approach into alternative investments. They will get socked with high fees and receive mediocre performance in return. And even Canadian funds flying solo will have a hard time generating the deal flow of past years.

One thing is for sure, as more money piles into private equity, real estate, and infrastructure, the prospective returns will be diluted for all investors. Are we in the midst of a global private equity bubble? You better believe it but we're still in the early innings of a long alternatives bubble inflated by global pensions.

Below, KKR & Co. agreed to buy a 10 percent stake in appliance maker Qingdao Haier Co. for 3.38 billion yuan ($552 million), the New York-based private-equity firm’s biggest investment in China. Angie Lau reports on Bloomberg Television's "First Up." Looks like KKR is taking the lead in Asia.

And Apollo Global Management LLC, the private-equity firm run by Leon Black, is considering seeking approval to raise the limit on its next flagship fund after investors expressed interest in putting in as much as $20 billion, according to two people with knowledge of the matter. Bloomberg's Devin Banerjee reports on Bloomberg Television's "Money Moves."

Finally, Bloomberg’s Emily Chang reports on private equity firm Cerberus being in the early stages of considering an offer to acquire all of BlackBerry. She speaks on Bloomberg Television's "Bloomberg West." Cerberus might be able to pull off a major turnaround but looks like shareholders got another Rim job.