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The P&I 1000: ALTERNATIVES

Funds jittery over stock market put their faith in alternatives

Most asset classes see growth but distressed debt, REITs miss out

Lori Campana said more investors want value-added strategies.

Fears that the high-flying stock market will soon come down to earth has institutional investors looking to alternative investments as a prime source of portfolio return.

Most of the alternative asset classes represented in Pensions & Investments' annual survey of the largest U.S. retirement plans showed assets invested by defined benefit plans grew in the year ended Sept. 30. Among DB plans in the largest 200 retirement systems, private equity investments rose by 10.4%; real estate equity was up 6%; energy grew by 5.6%; and infrastructure was up 19.1%. This was a sharp contrast to the findings of the 2016 data, in which private equity and real estate equity assets had fallen.

However, there were a few exceptions to the general trend of increasing alternatives assets during the 2017 survey period. Distressed debt assets fell 7.4% and real estate investment trusts were down 2.6% for the top 200 plans. Both asset classes also had fallen in the year-earlier survey, slipping 0.3% and 0.8%, respectively, in the year ended Sept. 30, 2016.

Despite projections of lower returns in most alternative investment asset classes, investors are taking on more illiquidity because they don't think the public market outperformance is sustainable, said Sona Menon, Boston-based managing director and head of North American pensions for Cambridge Associates LLC.

"We have seen a trend toward growing allocations" to alternative investments, including private equity, venture capital, private credit, real estate, and oil and gas, Ms. Menon said. "First and foremost in the last few years, the public equity markets have done very, very well, much more than anyone had anticipated … and there is an acknowledgment that it's not sustainable."

Cambridge Associates executives are encouraging clients to determine how much illiquidity they can tolerate. Many investors are underallocated to alternative investments, especially because the high-performing stock market is skewing asset mixes, pushing down the percentage of alternative investments in portfolios, Ms. Menon said.

Across P&I's largest 200 plans, private equity accounted for 8% of the aggregate defined benefit allocation as of Sept. 30 from 8.2% as of Sept.30, 2016. Broken out by type of plan, private equity's average share of public pension plans' portfolios dipped to 8.8% as of Sept. 30 from 9% and among corporate plans, to 5.7% from 5.8%, P&I's survey data show.

Private equity assets of the top 200 defined benefit plans were up 10.4% to $331.7 billion. Three out of the four private equity sectors P&I tracks also showed gains — venture capital was up 8.8% to $35.9 billion, buyouts were up 13.3% to $189.9 billion and mezzanine was up 9.8% to $4.5 billion. Distressed debt dropped to $23.7 billion.

Positive index returns

Indexes during the period were in positive territory. The net return for Cambridge Associates' U.S. Private Equity index was 16.9% for the 12 months ended Sept. 30, and for the Cambridge U.S. Venture Capital it was 7.9%.

Even so, investors' alternative investment portfolios are poised to reap lower returns. "The big issue in 2017 was there was a ton of demand for private equity — from large sovereign wealth funds to retail," said Faraz Shooshani, managing director and senior private markets consultant in the San Francisco office of consulting firm Verus.

Investors had more money to spend. Investors received $92 billion more capital in the form of distributions from their private equity managers than they paid out in capital calls as of June 30, according to London-based alternative investment research firm Preqin. If the pace of distributions continued, it puts 2017 on pace to exceed net capital flows to investors of $159 billion in all of 2016, Preqin data showed.

"Given that, it's been a lot easier for managers of all stripes to raise money and it's been easier for first-time funds to raise money," Mr. Shooshani said.

At the same time, managers are paying higher prices and using a larger percentage of leverage, he said.

The California Public Employees' Retirement System, Sacramento, heads the list of defined benefit plans among the top 200 with ​ investments in private equity with $26.9 billion, up 4.9% for the year. CalPERS also leads the list once again in buyouts, with assets rising 13.1% to $17.2 billion. The giant fund is eighth on the mezzanine list at $163 million, level with the year-earlier survey, and ninth for venture capital with assets down 15.5% to $1.1 billion.

Of the five defined benefit plans reporting the most in private equity assets, all showed increases from the year-earlier survey, most in the double digits. Second-ranked Austin-based Teacher Retirement System of Texas' private equity portfolio rose 17% to $18.7 billion. The Washington State Investment Board, Olympia saw private equity grow 12.5% to $17.8 billion. California State Teachers' Retirement System, West Sacramento, was up 6% to $17.3 billion, and fifth-ranked Albany-based New York State Common Retirement Fund's private equity portfolio grew 11% to $15.8 billion.

CalPERS also was at the top of the list of defined benefit funds investing in real estate equity, with $32.3 billion as of Sept. 30, a gain of 8.8%. CalSTRS followed with assets rising 1% to $26 billion, and Texas Teachers was third with $17.6 billion, up 4.8%. The Washington State Investment Board was in fourth place with equity real estate up 21.2% to $14.7 billion, and New York Common Fund saw a 3.5% increase to $13.3 billion.

The NCREIF Property index was up 6.89% in the 12-month survey period, down from 9.2% in the previous year. The NCREIF Open-end Diversified Core Equity index returned 7.66%, down from 10.1%.

Timberland flat

Within equity real estate, timberland assets were flat at $10 billion for the year. By comparison, timberland assets had dropped 3.6% in the year-earlier time period. For the 12 months ended Sept. 30, the NCREIF Timberland Property index returned 3.28% , unchanged from the previous year.

Real estate continues to see capital inflows, said Lori Campana, Boston-based managing director and partner at placement agent Monument Group Inc. And while some investors see trouble spots on the horizon for U.S. private equity, they do not agree as to whether there is cause for concern.

"There are investors that are concerned with prices in the U.S. and are looking at Europe and Asia. There are others that like the stability of the U.S.," she said.

There is more capital being allocated to value-added strategies, but not all managers are getting capital commitments, she said. Investors are interested in skilled managers that know how to find value in properties rather relying on making money solely from the property appreciation, Ms. Campana added.

Assets invested in REITs among DB plans in the top 200 dropped 2.6% to $22.6 billion. Returns were positive, but still substantially lower than the previous year. For the 12 months ended Sept. 30, the FTSE Nareit All REIT index was up 3.62% on a total return basis, and the FTSE Nareit All Equity REITs index was up 2.57%. By comparison, the previous year the FTSE NAREIT All REITs index return was 20.6% and the FTSE NAREIT All Equity REITs index, 20.9%. All figures are gross returns.

Among defined contribution plans in the top 200, REIT assets fell nearly 28%, to $4.7 billion.