SANTA MONICA, Calif. - Worried about the riskiness of some LBO partnerships, Wilshire Associates is soliciting private data from pension fund officers to help in building valid risk measures for LBOs.
Typically, pension fund officers bristle at investing in an asset classes without understanding the risks involved. But Wilshire consultants say that no commonly accepted measurements of risk now exist for leveraged buy-out partnerships. Missing are such basic tools as measuring the volatility of the investment and value added brought by managers.
Yet pension funds have invested an estimated $100 billion in such deals.
Using a synthetic LBO index - made up of indexes that replicate the financial structure of partnership investments - Wilshire officials intend to obtain standard deviation returns based on market values.
"We will have valid benchmarks to determine whether general partners are adding value for the level of risk they are incurring," said Hal Reynolds, vice president and principal at Wilshire.
But Wilshire needs detailed data on a significant number of partnerships before it can build a synthetic LBO index, and must persuade pension funds to part with the information.
Wilshire officials hope for 20% of available partnership data to get started.
Funds ready to help?
Some pension funds might be ready to help.
The growing worry about risks with LBOs also has prompted the Institutional Limited Partnership Association, an informal group of investment professionals including pension executives, to consider building an LBO partnership database. The database could lead to the use of more precise statistical risk measures for LBOs The exact nature of the potential measures wasn't available.
The association also would need data from fund members to establish the benchmark. It is considering the use of an independent organization to compile the data, but still the partnership data must be volunteered by pension officers.
ILPA members plan to address the subject of an LBO database and risk measures in September in New York.
Officials with the $118 billion California Public Employees' Retirement System, Sacramento, are holding serious discussions about the LBO benchmark with Wilshire.
But CalPERS has not given approval yet to let its data be used in Wilshire's planned Private Equity Cooperative. One concern of system officials is that enough data be collected to make the risk measures valid.
James Parker, chief investment officer for the $26 billion Washington State Investment Board, said he is interested in Wilshire's effort to build a benchmark and wants to hear more about it.
Both California Employees' and Washington State are Wilshire clients.
David Locke, senior investment officer for alternative investments at the $22 billion Los Angeles County Employees' Retirement Association, said he believes fund officials also might be interested in hearing Wilshire's proposal.
Mr. Locke, an ILPA member, said he is studying the ILPA benchmarking effort. He said the Institute for Fiduciary Education, Sacramento, is putting together a sample database for the ILPA.
One attraction for the ILPA database would be that members would be able to analyze the data any way they wanted, said Mr. Locke.
Big changes for general partners
If Wilshire succeeds in its new index, LBO general partners could find their world turned upside down. Wilshire intends not only to find out the risk-adjusted returns of the partnerships, but also how much skill the general partners are adding for their significant fees. It is possible some general partners who aren't getting much pension fund money now could be pension fund darlings tomorrow.
Currently, pension funds are using appraisal or intuitive-type approaches to measure risk of institutional private equity investments - an estimated two-thirds of which are LBOs. Wilshire officials believe this is no more effective than the old appraisal-based measures for real estate that led to billions of dollars in losses for funds.
Wilshire officials say at least one area where LBO partnerships are making investments, particularly deals sought by large partnerships, might be super-heated with investment demand.
Wilshire wants about 10 giant pension funds, for starters, to make their LBO investment data available to construct the index.
Stephen Nesbitt, senior vice president at Wilshire and head of its consulting division, said some funds are enthusiastic about the possibility of being able to more closely measure risk.
Other consultants are doubtful about the process.
To measure risk using standard deviation, consultants usually need transaction-based pricing of securities. But LBO securities aren't traded.
Wilshire officials say they can come up with a "re-engineer" methodology to get the business characteristics of underlying LBO investments, mirror the financial structure of the LBO fund and construct the LBO Index from public market benchmarks.
The desire of consultants to be able to measure risk of LBOs is understandable.
Worries of Wilshire officials include:
Some areas of LBO investment - larger deals sought by megapartnerships such as Kohlberg Kravis Roberts & Co. - are possibly overheated. (No one at KKR could be reached for comment.)
Non-U.S. LBO-style investments might be undervalued, but no modern portfolio theory-type measurements are available now to back up that supposition.
Some pension funds are overestimating the diversification factors LBOs bring to their allocation plan.
Because of the dramatic increase in leverage used by LBOs, some pension funds are increasing their equity exposure by 10% rather than the 5% increase in exposure they think they are getting.
Pension executives are being drawn into private equity because of high annualized returns, but the returns aren't risk adjusted. If some pension officers had been aware of the risk taken, they might have set a higher hurdle for acceptable investment returns, Wilshire officials believe.
LBO investing on the rise
Despite the lack of accurate risk measures common for public market investments now, pension fund LBO investment is rising.
Wilshire officials estimate two-thirds of pension funds' private equity allocations are in LBOs. And the average large pension fund investment in private equity has risen to a 3% allocation from virtually nothing 10 years ago, according to Wilshire.
Some pension funds have a private equity allocation of 15% of assets.
Pension funds, endowments and foundations invested an estimated record of $26 billion in LBOs in 1996, according to Wilshire Associates.
Jeff Reyes, managing director with Venture Economics Inc., a consulting firm that tracks private equity investments, estimates the amount invested in LBOs will be high again this year - about $18 billion to $20 billion.
Despite what Wilshire officials see as the need for new risk measures, Mr. Reyes said he doesn't think a benchmark for LBO risk similar to ones used in public markets using standard deviation can be established.
"There really isn't a benchmark of risk (for private equity). It's a non sequitur. There really isn't anything you can compare it against unless you are to take something arbitrarily like the S&P 500," he said.
One risk measure investors use in connection with LBOs is collateral risk -the risk of losing their principal investment, Mr. Reyes added.
Performance attribution eyed
However, Wilshire officials are looking for much more in risk measurement, including performance attribution.
Gary Robertson, a consultant with Wilshire competitor Callan Associates, San Francisco, said he favors better ways to measure the risk of LBOs. But he also expressed doubts about the ability to build "a better mousetrap" to rigorously measure risk of LBOs.
"An index in private equity is impossible - in the same nomenclature as stocks and bonds - because anyone can go out and replicate and buy that index . . . (but) in private equity you can't buy a representative sample of partnerships out there. It's impossible," Mr. Robertson said.
But Wilshire officials contend it can be done with a synthetic-like index.
Wilshire has outlined the methodology to create the risk measure in a paper called "Benchmarks for Private Market Investments." Simply, the plan calls for selecting an index of publicly traded stocks with business characteristics similar to buy-out funds. Then, Wilshire executives say, they will re-engineer the capital structure of the index using combinations of indexes to replicate the financial structure of the underlying companies in LBOs.
In the bust in the real estate office market, consultants got some of the blame for not warning pension funds in advance. If they can help it, Wilshire officials want to remove any potential surprises for pension officers in the LBO markets.