Decline in returns could send investors scurrying

Private equity returns are expected to fall, causing some long-time investors in the area to either ease off the asset class or invest in new alternative categories.

Increased competition for deals, an abundance of investor capital and the entry of hedge funds on private equity turf are lowering return expectations.

Performance that merely exceeds stock and bond returns seems to be enough for investors new to the asset class; they are adding and increasing allocations at an ever-growing rate.

Seasoned investors, however, are taking another tack. The $197.4 billion California Public Employees' Retirement System, Sacramento, reduced its private equity allocation by a percentage point to 6% earlier this year. A few other pension funds are considering lowering their allocations by a percentage point or two now, with a view to slowly moving them back up in the future.

Many large private equity investors also are looking for newer niches to invest their money in. Some are diversifying into private equity real estate funds, hedge funds and timber, said Gary Robertson, senior vice president of consulting firm Callan Associates, San Francisco.

According to a report to its board, CalPERS staff expects net annual returns to fall to 13.5% — the $9.3 billion private equity program earned a return of 20.8% in the fiscal year ended Sept. 30. Earlier this month, the CalPERS board adopted a plan that increases the program's international investments and invests more in niche programs such as clean technology and the California Initiative Program, which focuses on in-state investing.

The C$87 billion (US$74 billion) Canada Pension Plan Investment Board, Toronto, is concentrating on infrastructure and making investments in niche Canadian private equity funds.

"There's a lot of capital in the market chasing not enough opportunities," said Mark Wiseman, vice president, private investments for the CPP Investment Board. "We are taking a very cautious view to the private markets generally."

Specifically, CPP executives are shunning private equity in the United States, Europe and Asia in favor of small risk-weighted opportunities in Canada.

For the fiscal year that ends next June 30, officials at the $59 billion Ohio State Teachers' Retirement System, Columbus, expect their private equity portfolio to generate 11%, down from 19.7% a year earlier. In 2006, fund officials expect to decrease investment in venture capital and to decline requests for commitments to follow-up funds raised by existing managers with disappointing track records.

Most institutional investors are showing restraint in their investments, said Michael Schlachter, managing director of consultant Wilshire Associates, Santa Monica, Calif. "But in some cases it is inevitable," Mr. Schlachter said. "The top tier is becoming the second tier because they (managers) have more money than they are capable of investing."

However, even in a world of lower returns, there is a difference between the expected performance of top tier and second-tier private equity funds, he said.

"It's logical to expect lower returns because there are more efficiencies in the marketplace," said Callan's Mr. Robertson. "I think there will still be a return premium above public markets. It's still a worthwhile pursuit."

Mark Heesen, president of the National Venture Capital Association, Washington, said venture capital returns are still suffering from the burst of the technology bubble earlier this decade. The five-year performance for venture capital is still negative, he said.

According to the Private Equity Performance index by NVCA and Thomson Venture Economics, for the five years ended June 30, venture capital returned an annualized -6.3%; buyout, 2.9%; and all private equity (including mezzanine), 0.1%.

Investors will not realize the full potential of venture capital until 2007, 2008 and 2009, and even then most investors and their money managers are aiming for returns in the high teens, Mr. Heesen noted.