Top 200 pension funds still carrying torch for alternatives

Private equity, real estate asset classes show double-digit increases in 2011

020612 nesbitt
Easing: Stephen L. Nesbitt said investors were less skittish over alternatives in 2011.

Updated with correction

U.S. pension fund investors' love affair with alternatives is still alive, with investments in everything from private equity to real estate skyrocketing, Pensions & Investments' annual survey of the 200 largest retirement plans shows.

In the 12 months ended Sept 30, investments by defined benefit plans among P&I's Top 200 grew by double digits across all of the alternative asset classes, compared to the year-earlier survey:

  • Real estate equity rose 26% to $212 billion.
  • Private equity grew 16% to $313 billion.
  • Venture capital was up 26%, $34.8 billion.
  • Buyouts increased by 15%, to $71.4 billion.
  • Commodities climbed 13%, $20.6 billion.
  • Infrastructure accelerated 25% to $6.4 billion.

Hedge funds, while still popular, exhibited the slowest growth — up 2% to $111.9 billion. Returns cut into hedge fund growth. For the 12 months ended Sept. 30, the HFRI Fund Weighted Composite index return was -0.99%.

That was not the case with other alternatives asset classes. In the 12 months ended Sept. 30, the NCREIF Property index returned 16.1%; the Cambridge Associates LLC U.S. Venture Capital index, 20.9%; Cambridge's U.S. Private Equity index, 13.8%; and Cambridge Associates' U.S. Buyout index, rose 13.41%. The Dow Jones-UBS Commodity index was flat.

Adjusted for index gains, the increases in most alternatives assets are still notable: real estate grew 8.9%; venture capital, 4%; and hedge funds, 3%. Private equity inched up nearly 2% and buyouts, 1.3%. (There is not a widely adopted infrastructure benchmark.)

Those numbers — especially compared to the returns for more traditional asset classes — are holding investors' interest: Equity and fixed-income returns for the same period did not even come close. The Russell 3000 stock index returned 0.54% and the MSCI Europe Australasia Far East index, -8.87%; while the Barclays Capital Aggregate bond index returned 5.26% and the Citigroup World Government bond index (unhedged), 4.61%.

Pent-up demand

There was pent-up demand for alternative investments, said Stephen L. Nesbitt, CEO of alternative investment consulting firm Cliffwater LLC, Marina del Rey, Calif.

“In 2008, 2009 and 2010 — particularly in 2009 — everybody was looking into the headlights and everybody was risk averse,” Mr. Nesbitt said. “Last year, people were comfortable enough that they had liquidity and could start taking risk.”

The stock market rebound is allowing investors to make the alternative investments they would have made in 2009 and 2010, he said. When the stock market is down, the so-called “denominator effect” takes over. The decline in a pension fund's total assets causes target allocations to illiquid alternative investments to rise to or above their targets. That, in turn, curtails pension funds' ability to make additional commitments to alternative investments, he explained.

In September, the $149.7 billion Florida State Board of Administration, Tallahassee, launched a search for managers to run up to $6 billion in private equity, hedge funds, real estate, commodities and infrastructure. As part of adopting a new asset allocation last April, the Illinois Teachers' Retirement System, Springfield, raised alternative investments by an aggregate five percentage points. This included bumping up the $37.8 billion fund's target allocations for private equity to 12% from 10%, and hedge funds to 8% from 5%, of total plan assets.

But these boosts don't necessarily mean that investors are making tons of new commitments to each of the alternative asset classes, experts said.

Real estate funds, for example, had a particularly lousy fundraising year in 2011. There are plenty of funds on the market, but investors are committing to only a small fraction of them, placement agents note. Although most pension funds invest in real estate through funds, some of the very largest were beginning to invest more capital through separate accounts, joint ventures and direct transactions in 2011.

These same experts attribute the increases in real estate assets under management to a combination of rising property values and a greater number of real estate fund managers calling for capital from investors' commitments.

“There were a lot of capital calls last year,” said Nancy Lashine, co-founder and managing partner of New York-based placement agent Park Madison Partners LLC.

“We were not active in 2009 and 2010. We and other (real estate managers) were looking for greater liquidity and depth in the market” before making any moves said Daniel Plumlee, chief investment officer of L&B Realty Advisors LLP, Dallas. “Liquidity and depth began to return in a meaningful way last year.”

Increased allocations

Some investors increased their modest real estate allocations, while others filled out their allocations last year, said Andy Smith, managing partner and CEO of L&B Realty Advisors.

A number of funds raised in 2007 and 2008 were coming to the end of their three-year investment periods last year, Ms. Lashine said.

“There was a lot of money committed that had not been invested,” she said.

These calls for the cash represented by fund commitments caused real estate assets under management to increase at pension funds because many U.S. pension funds account for real estate fund commitments when they are called, rather than when the commitments are made, Ms. Lashine said.

Real estate managers got tired of waiting for a buying opportunity from distressed property owners following the 2008 economic meltdown, said Kevin White, director of business development at Virtus Real Estate Capital LLC, an Austin, Texas-based real estate fund manager.

“Everyone expected a big, epic rash where borrowers threw their keys at the banks and there was blood on the street,” Mr. White said. “People are more confident in the overall economic conditions and that incidences of the throwing of the keys are fewer and far between.”

Virtus closed its fourth self-storage fund with $100 million in September.

It took a critical mass of both deals and investor interest in a fund's particular investment strategy to bring enough capital to close a fund last year, said Justin Metz, managing principal of Related Fund Management LLC, a subsidiary of the Related Cos., New York.

When Related closed its $825 million Related Real Estate Recovery Fund on Jan. 25 — its first distressed fund — it already had invested 25% of the fund's capital.

“We built more and more momentum the more (fund) closings we had,” Mr. Metz said.

While investors' passion for private equity is evident from the 16% hike in P&I's numbers, the love does not extend to all sectors. Pension fund executives are still not that crazy about big buyout funds, while some of the hottest private equity funds last year were sector funds.

“There continues to be a rebalancing across buyout strategies. Specifically, investors are shying away from mega buyouts in favor of small/middle market buyouts U.S. pension funds ... and often prefer more specialized sector-focused funds,” said Jay Rose, partner in the San Diego office of private equity consulting firm StepStone Group. “Some of the best sector-focused managers raised funds in 2011,” he added.

Megabuyout funds returned 12.5% for the year ended Sept. 30, compared with the return of all U.S. buyouts of 13.41% for the same time period, according to data provided by Cambridge Associates.

Small-cap buyout funds, those with $300 million or less, had the best performance among buyouts fund — 18.03% — for the 12 months.

Parag Saxena, founder and CEO of New Silk Route Growth Capital, Mumbai, which invests in private equity in India, said the economic and growth challenges facing the U.S. and Europe are forcing U.S. pension plans to look at the emerging markets.

Main attraction

Fund managers and consultants say the main attraction of alternatives overall are returns. Pension funds are suffering from a double whammy of being underfunded and having difficulty finding investments that will give them enough profit so they can hit their funds' total return goals. Managers with good track records and alternative investments that can generate income were better able to attract capital.

“Plan sponsors are continuing to invest capital in hedge funds and private equity funds because they recognize the benefits of lower volatility and higher risk-adjusted returns in addition to the diversification benefits,” said Sam Gallo, managing director, of PwC Financial Services, New York.

Despite the poor returns they experienced during the survey period compared with other alternatives, hedge funds remained a popular way of putting money to work for defined benefit plans in P&I's Top 200.

“From a risk-return point of view, investors thought hedge funds might be a diversifier” against the equities and fixed income in their portfolios, noted Cliffwater's Mr. Nesbitt.

A number of investors in the P&I 200 added or boosted hedge funds allocations or made new hedge fund investments last year.

Several — including the $69.9 billion defined benefit plan of the Ohio Public Employees Retirement System, Columbus — began investing directly in hedge funds, rather than through funds of funds.

But others opted for the funds-of-funds route.

For instance, in August, the $13.4 billion Kentucky Retirement Systems, Frankfort, invested a total of $1.2 billion with three hedge fund-of-funds managers as part of its new 10% allocation in an absolute-return asset class.

Investors are starting to model their hedge fund portfolios as they do their private equity portfolios, Mr. Nesbitt noted.

The lion's share of hedge fund investments by defined benefit funds among the Top 200 continues to be in direct investments — accounting for 70% of the total hedge fund assets reported.

Six of the top 10 investors reporting hedge funds assets only listed direct investments — including the top-ranked $47.4 billion Pennsylvania Public School Employees' Retirement System, Harrisburg. PPSERS had its entire $5.6 billion hedge fund portfolio invested in direct hedge funds.

The $48 billion Massachusetts Pension Reserves Investment Management Board, Boston — ranked 10th — is the only fund in the top 10 that has its entire $3.6 billion hedge fund portfolio invested in hedge funds of funds.

However, in October — after P&I's survey period closed — MassPRIM created a “pilot” direct hedge fund program, investing an initial allocation of $280 million with 11 firms.