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Opportunities still exist, private equity investors and managers say

Private equity returns might be disappointing, but the asset class still provides a better opportunity than public stocks, observers say.

For example sector-focused funds in areas including health care, consumer, financial services and energy have the potential of outperforming the median, said Andrea Auerbach, managing director, head of global private investment research of Cambridge Associates LLC in the Menlo Park, Calif., office.

A recent Cambridge study revealed that health-care-focused private equity firms with fund vintage years of 2001 to 2010 provided a 25.1% gross internal rate of return, outperforming the 17.3% return for generalists' health-care private equity investments for the same period.

Private equity managers can make significant changes at smaller companies that there is no room to make in larger companies that might already have market dominance, Ms. Auerbach said.

“If you get access to 780 additional basis points, maybe you should take a look,” Ms. Auerbach said.

Managers say they provide investors needed returns they cannot get from their stock and bond portfolios.

“The biggest advantage we have is the presence of control. We have the ability to make companies better,” said Vik Sawhney, New York-based senior managing director and chief operating officer of the Blackstone Group's private equity business.

Investors remain committed to private equity but they are moderating their strategies in expectation that it will be much harder to squeeze out excess returns.

Bob Jacksha, chief investment officer for the $11.7 billion New Mexico Educational Retirement Board, Santa Fe, noted that private equity was the pension fund's best performing asset class for the three- and five-year periods ended Dec. 31.

“Thus, we think PE is worth the effort,” Mr. Jacksha said in an email. “The question is: Will it be worth it in the future with more and more institutional money going into the market? We think so, if one takes a careful, selective approach to the asset class.”

New Mexico Public Employees Retirement Association, also in Santa Fe, decided to take a new approach to its private equity portfolio as part of adopting a new asset allocation in May. Fund officials took out credit and debt strategies from the private equity portfolio and made private equity part of its global equity portfolio. This way pension officials evaluate private equity against all other types of equity — stocks, low volatility and hedged, explained Jonathan Grabel, chief investment officer for the $14.2 billion pension fund in an interview.

Separating private equity from other forms of equity allows private equity managers and investors to “too readily excuse performance and justify extraordinary fees,” he wrote in a “Viewpoint” posted on the pension fund's website in May.

What's more, pension officials no longer make manager selection the key factor in building the private equity portfolio because it leads some investors to expect the unachievable goal of always winding up with a top-quartile manager.

“The math simply cannot work,” he wrote.

Instead, pension officials are taking a strategic approach to private equity. They are using private equity to fill in exposure gaps in the entire global equity portfolio such as the emerging markets, health-care and consumer sectors, he said in the interview. In coming months, pension officials may consider a mandate focusing on private equity firms raising their first or second funds, he said.

“There's voracious demand for private equity as a magic elixir that can fix portfolios,” Mr. Grabel said. “It's not good enough to commit to just any fund and hope for returns.”