Denominator effect causes plans to rethink allocations

A major reason pension funds are rethinking their asset allocations is an increased exposure to private assets — due, largely, to the denominator effect.

Pension plans with private investments have seen that part of the portfolio "hold up pretty well vs. public equities and bonds that are down double digits this year," said Sona Menon, Boston-based head of North American pension practice at Cambridge Associates LLC. "This is a combination of what we call the denominator effect — because the broader portfolio has shrunk — (and) the numerator effect, because private assets have done well."

The MSCI ACWI index is down 17.5% for the year through Aug. 31. The 10-year Treasury yield is at 3.9%, compared with 1.5% at the end of last year, and U.K. 10-year government bonds surged to 4.5% on Sept. 27 before falling to 4.14% on Sept. 29.

On the other hand, private market asset returns — which sources said typically lag public markets by a quarter — are looking relatively good. In real estate, for example, the National Council of Real Estate Investment Fiduciaries Fund Index-Open-end Diversified Core Equity returned a net 4.5% in the second quarter, following 7.1% for the first quarter.

It's meant some pension funds that might have had a 10% target allocation to private markets may suddenly have found themselves with a 15% or even 20% exposure, just by doing nothing.

"The U.S. is probably the most exposed (to this increase in private markets allocation), partly because they've suffered the most from the denominator and numerator effect," said Peter Hobbs, London-based managing director, head of private markets at consultant bfinance U.K. Ltd. "Their private assets portfolios have gone up hugely, just because of what the markets have done."

For U.K. pension funds, there's an additional reason for increased exposures. "Many pension schemes have had to … sell off some of their liquid, return-seeking assets to top up LDI (liability-driven investment) programs and meet collateral requirements, just so they can maintain the same level of hedging," said Lok Ma, Reigate, England-based defined benefit solutions specialist at Willis Towers Watson PLC. With those portions of the portfolio getting smaller for U.K. pension funds, "illiquid, private market assets have become a substantially bigger part of the portfolio," Mr. Ma said.

Along with improved funding levels, it means pension fund executives and their consultants are thinking hard about how to manage their overweight positions to private assets.

Bfinance is currently surveying more than 450 investors to find out what they're doing about current challenges. So far, about half of them say they can "wait as long as it takes" on their private markets overexposure, Mr. Hobbs said. "The other half are going to see some pressure to rebalance if their private market portfolio valuations remain high relative to the strategic allocation — whether that's soon or in the next two to three quarters."

Some pension funds are managing the issue of needing to keep liquidity in portfolios while retaining private markets allocations. "We are seeing more attention to the pacing of investments — and understanding what investors are actually exposed to," Mr. Hobbs said. "Oftentimes you invest in these asset classes and your capital will be drawn over many quarters with the J-curve. Investors are now wanting to understand what that drawdown is going to look like … across their portfolio, and whether they're going to get spikes in demand for capital."

But a pension fund needing to sell out of private assets in order to move to a pension risk transfer and pass assets to an insurer — since illiquid assets will not, in general, be suitable for an insurer's asset pool — must exercise extra caution, sources said.

In these cases, executives might need to sell quickly in order to get to that buyout point as quickly as possible, before prices move. And it means taking a potentially huge haircut on the assets — maybe around 20%, sources said.

"For those situations, if the haircut is too big then selling in a hurry is counterintuitive," WTW's Mr. Ma warned. If the value of the sale is too low, the fund may actually be further away from the buyout point than thought, meaning they will then need to invest in more return-seeking assets and "build back up towards the premium," he said.

Thinking ahead and stress-testing the liquidity of the private markets allocations is now more important than ever. "You don't want to be selling private assets ahead of their natural maturity — in the majority of cases that will be expensive to do, complicated and time-consuming," said Elaine Torry, Glasgow, Scotland-based partner and co-head of DB investment at consultant Hymans Robertson LLP.

However, there are also potential opportunities for pension funds and other institutional investors with longer time horizons.

"There are other schemes, however, where that time horizon is still quite long," such as local government pension schemes in the U.K., which are still open to future accrual, said David Rae, London-based managing director and head of strategic client solutions at Russell Investments. "So actually, as much as there's a catalyst for some schemes to be looking to reduce private equity exposure," others are looking for attractive investments where they can pick up an illiquidity premium with good growth prospects, Mr. Rae said.

Whatever pension funds choose to do with their outsized private markets allocations, current events are serving as an "uncomfortable reminder that private markets are good but have three recurring challenges: the liquidity issue, that they're opaque and they're expensive. Times like these they all come home to bite," bfinance's Mr. Hobbs said. Until recent turmoil in public markets, those three challenges were able to be overlooked, "and the way investors have flocked to private markets and maybe not paid enough attention to the Achilles' heels of these asset classes" has also not been highlighted before.

They're also serving as a reminder to make those, potentially uncomfortable, asset allocation and haircut decisions now.

That's because, for some, it won't just be "a double whammy, but triple: You've got the rising cost of finance and rising debt; you've got investors being concerned about the asset class, being overweight and needing liquidity; and you've got the reduced income growth, rental growth and demand growth for the assets themselves," Mr. Hobbs warned. "It's a good time to think about different scenarios, take a view and maybe that 20% cut in the secondary market is worth taking rather than waiting until things are worse in six months' time."