Hedge funds, distressed debt see bulk of sponsors’ increase

Alternative investments by pension funds increased 10.6% to $134.9 billion in the 12 months ended Sept. 30, with most of the money flowing to hedge funds and distressed debt, according to Pensions & Investments' annual survey of the nation's largest plan sponsors.

Investment in hedge funds rose 69% to $14.4 billion, with some $6.1 billion directly invested in hedge funds and another $8.3 billion in funds of funds.

In other alternative classes, the survey showed distressed debt investment grew by 55% to $5.9 billion; and other private equity rose 13%, to $82.4 billion.

The pension fund reporting the largest hedge-fund-of-funds investment was the Pennsylvania State Employees' Retirement System, with $3 billion. Tops in direct hedge fund investments were General Dynamics Corp., Falls Church, Va., with $2 billion, and General Electric Co., Fairfield, Conn., with $1.3 billion.

While not covered in the survey period, PennSERS' hedge-fund allocation grew even larger in late 2003. Trustees of the Harrisburg-based fund approved a new asset allocation in December, giving the fund a 20% exposure to absolute return strategies, up from 10%. Under that new target, its total allocation to absolute return strategies — invested through funds of funds — will be almost $5 billion.

The Pennsylvania School Employees' Retirement System, Harrisburg, reported the largest distressed debt investment, at $1.3 billion, followed by General Motors Corp., Detroit, with $658 million, and the Washington State Investment Board, Olympia, with $554 million.

Once again, the California Public Employees' Retirement System, Sacramento, has the largest venture capital investment, at $1.34 billion. The Sacramento-based California State Teachers' Retirement System's venture capital investment skyrocketed 84% to $996 million from $540 million, ranking it second, while Verizon Communications Inc.'s investment dropped 15% to $935 million from $1.1 billion. The overall venture capital investment reported by the top 200 funds fell nearly 14.7% to $16.3 billion, but the drop is mostly due to funds changing how they classify alternative assets, and that CalPERS' 2002 figure was incorrect.

The New York State Common Retirement Fund, Albany, again has the biggest investment in other private equity investments with $6.23 billion, up 6% from $5.87 billion a year earlier, followed by CalPERS, up 7.2% to $5.5 billion. The Lansing-based State of Michigan Retirement System's private equity investment rose 8% to $5.2 billion from $4.8 billion, and the Washington State board's private equity investment grew 8.2% to $4.3 billion.

Joe Dear, executive director of the Washington State board, which oversees $40 billion in retirement plan assets, said that while hedge funds have been the hot asset class, the board has no plans to invest in that area.

Presentations were made to the board in 2002, he said. "The board did not ask for a hedge fund program," Mr. Dear said.

The most significant change Washington board officials intend to make is to reduce the number of relationships and increase the assets managed by the remaining private equity managers, Mr. Dear said.

"It's not that we won't consider new relationships, but we will make a continuous effort to look at the performance of our 87 general partners and over time, reduce that number," Mr. Dear said. "It won't happen rapidly, but that's the goal."

While hedge funds were hot in 2003, other private equity investments are just starting to recover from a drop in commitments from pension funds, said Clinton P. Harris, founder and managing partner in Grove Street Advisors LLC, a Wellesley, Mass., private equity gatekeeper that manages a $500 million in three captive funds of funds for CalPERS.

"Commitments in 1999 and 2000 were sky-high and then dropped. So many of our funds reduced commitments," Mr. Harris said.

The pace of investment slowed dramatically in 2002 and 2003 compared with 2001 and 2000, and now commitments are growing again, he said.

For example, the venture capital industry was investing at the rate of $28 billion a quarter at the top of the tech bubble; at the bottom, in the third quarter of 2002, that figure dropped as low as $1.5 billion a quarter. Now it is up to $3.5 billion a quarter and is expected to continue at a pace of about $4 billion each quarter in 2004, according to estimates of the National Venture Capital Association, a Washington-based trade group representing venture capital and private equity organizations. However, the NVCA expects the returns for less than five years to remain poor in 2004, with longer-term performance outperforming most other asset classes.

"Venture capital is cyclical and we're probably close to the midpoint, with the low sometime in 2002," Mr. Harris said. "Buyout is growing and rebounding quite a bit, but it is harder to draw long-term trends."

"People did, in fact, increase their commitments to alternatives" in the year ended Sept. 30, said Allan Emkin, managing director of Pension Consulting Alliance, Los Angeles. "In the early part of the period, the assets did not get appreciated because they are not marked to market."

However, there is no universal alternative investment portfolio for large plan sponsors. "It has more to do with risk tolerance, expertise and what they are familiar with," Mr. Emkin said. "There is not one approach to private equity."

There was a period where distressed dominated, he said.

"Most clients are still participating in distressed. People are still going into distressed but a big chunk of the gains have already been attained," Mr. Emkin said. "It was a great opportunity a few years ago and many investors took advantage of it in a big way, investing many billions of dollars."