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Private equity as an asset class for pensions Back  
In 2005 the National Pension Reserve Fund made its first allocation to private equity. Paul Droop examines the options for pension funds who are interested in allocating to this asset class, and says that those prepared to accept the uncertain cashflows will potentially be rewarded with enhanced diversification and a wider source of potential returns, both of which are increasingly important.
Private equity has become more widely discussed over the last few years as a potential new asset class for pension funds, due to its potential as an alternative to traditional equity and bond investments. In fact, as its name implies, private equity is a form of equity investment. However, whereas listed equity investment involves gaining ownership of a company that is generally reasonably well established through purchase of shares quoted on a public stock exchange, private equity investment involves taking a direct stake in businesses that are not yet quoted.
Paul Droop

The most commonly known form of private equity is venture capital, which focuses on emerging and embryonic companies, and is hence often regarded as the highest risk type of private equity. The objective is to take a strategic holding in the business at an early stage of its development, actively contribute to the management of the business, and then to realise the investment, hopefully multiplied many times, generally through an IPO. Other forms of private equity include:

Management buyouts: This involves providing the capital to purchase a major interest in a company in order to gain management control of the company with the objective of eventually transferring ownership through an IPO.

Distressed securities: Purchase of a controlling interest of a bankrupt company’s debt or equity in order to control the fate of the organisation.

Mezzanine financing: Use of preferred shares or subordinated debt to refinance a takeover target.
The obvious attraction of private equity investing is performance, which has the potential to be considerable. Firstly, private equity investments are generally targeted at relatively small and rapidly growing companies, often based upon new and inventive ideas that can offer strong returns. Secondly, investors need to be compensated for the additional risks that they are taking. For both these reasons we would expect private equity to deliver long-term returns significantly above those for quoted equity.

A few points though need to be noted with regard to returns. In practice, a private equity manager will take a cash sum and ‘draw down’ the funds as appropriate opportunities become available, unlike list equities, where most funds can usually be invested immediately. This leaves a potential cash drag on returns for a private equity investor. Secondly, the universe of private equity managers has, in the past, been comprised by a large number of managers who have under-performed the average, offset by a much small number of managers who have provided very strong returns. The means that manager selection is particularly crucial in the area of private equity, a problem compounded by the fact that an increasing number of the best managers are closing for new business.

Other attractive features of private equity are its power of diversification and the opportunity to find some diversity in fund returns. Since private equity is directed at companies that are not quoted, its returns are not so highly correlated with those of major stock markets. However, it should be noted that, since an IPO is the most common exit strategy for many private equity investments, there is still considerable reliance on the state of stock markets at the time of realising the investment.

Diversity means finding alternative sources of returns to the equity risk premium upon which pension funds are still so heavily reliant. In the case of private equity much of the return on offer accrues for the liquidity investors are providing to the market, something that isn’t a feature of quoted markets.

The potential rewards in private equity are significant, but the disadvantages and challenges of private equity investing should not be ignored. In the first instance, considerable commitment of time and expertise from pension fund trustee’s or an investment committee is required to select and monitor private equity investments. One of the key reasons for this is because private equity managers tend to specialise in very specific areas in terms of deal size and geographic region. So to build a truly diversified portfolio requires many more managers than the two or three that are required in the quoted market. Funds must therefore spend three to four times as much time and effort monitoring private equity as they do on the portfolio’s other assets.

This clearly means that the level of time, effort, and indeed specialist knowledge required is disproportionate to the sums of money involved. However, it may well be worthwhile considering the added value, both in terms of additional return and potential risk reduction at the total fund level.

Other challenges that arise with private equity investment include:

Illiquidity: The long-term nature of private equity investment (typically 5-10years) means that liquidity can be virtually non-existent. Early withdrawal from a private equity investment is likely to result in substantial costs.

Understatement of volatility: Without a consistent stream of traded prices from a portfolio of listed investments, the volatility of private equity can be significantly understated.

Legal Agreements: Contractual arrangements for private equity investments are very different from traditional investment management agreements (e.g. partnerships).

Cashflows: It can take years to fully invest an allocation to private equity, depending on the availability of investment opportunities. Similarly, the timing of proceeds from private equity investments is difficult to predict and control.

Fees: Fees for private equity investments are significantly higher than fees for traditional fund management services.

Funds can go down three different routes when considering dedicated private equity investing. They can elect to do it in-house, invest in private equity via a fund of funds, or use an external advisor.

Building up the highly skilled in-house team needed to specialise in private equity manager selection and portfolio construction is not an option for most funds.

Funds of funds offer a more practical option for most funds that have limited time and resources. The approach adopted by fund of funds managers is to build a portfolio of private equity investments. There is a wide range of highly skilled and well-resourced organisations able to provide this service. These differ in size and ability, as in any other asset class, and the level of tailoring and specialisation they allow through focused funds varies enormously. Some even build bespoke portfolios for larger clients.

Funds that want to maintain a high level of control, and tailor the private equity portfolio to fit their overall strategy, may opt to use a specialist private equity advisor to help in constructing a portfolio of private equity funds. Following this approach, the level of involvement of the advisor varies from providing appropriate long lists to full discretionary management within set parameters. The level of time and expertise required of the fund Trustees decreases as the level of delegation to the advisor increases. For most funds, however, the fund of fund routes would be a more practical approach.

However, none of these approaches totally overcomes the complications involved in private equity investing. In addition, many fund sponsors are uncomfortable with the idea of their managers returning money (lack of opportunities or realisation of an investment) and telling them when to send more (new opportunity). This is a philosophical as well as a practical issue. The idea that the sole manager responsible for investment in an asset class should also determine the level of funds committed, as well as the timing of any investments, naturally raises some eyebrows.

Private equity investment is likely to remain outside of the investment strategy for many pension funds where trustees or investment committees lack the time, expertise or money to allocate to this particular specialist area. However, funds that do want to invest in private equity can follow a number of different routes. Those plans that are prepared to accept the uncertain cashflows will potentially be rewarded with enhanced diversification and a wider source of potential returns, both of which are increasingly important.

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