Private equity and the efficient DC portfolio

Defined contribution plan sponsors know full well the challenges they confront as they seek to provide investment options to their participants that can generate higher and more consistent levels of return in today's low return and volatile investment environment. The role for alternatives, including private equity, in helping them to meet those challenges is well documented for defined benefit sponsors, and will continue to grow in importance for defined contribution plans.

Before discussing the mechanics of implementing private equity in a DC plan, it is worth looking at the fundamental rationale for doing so, namely, the impact of private equity on portfolio efficiency and the ability to generate sustainable alpha.

Portfolios that include private equity in their asset mix have the potential to generate a higher level of risk-adjusted returns relative to those consisting of mainly public equities and bonds. The result is a more efficient overall portfolio.

Private equity's main contribution to the efficient portfolio comes from its lower level of correlation to those traditional asset classes. For example, the correlation between the Preqin Private Equity Committed Capital index and the MSCI World index from December 2000 to December 2011 amounted to 75.7%.

If one separates alpha from beta, the portfolio efficiency benefits resulting from adding private equity to a traditional asset mix can be further understood. Specifically, it is worthwhile looking at how a private equity fund investor approaches diversification when constructing and managing a portfolio.

At the same time, it is also important to note that these benefits do not apply to all private equity investors to the same degree. In order to optimize the benefits of the asset class it is useful to think in terms of gaining exposure to the “best” (top quartile) private equity investments by picking the best private equity managers. This achieves not only greater diversification due to lower correlation to other asset classes, but also adds alpha to the overall portfolio. Simply put, in private equity maximizing risk-adjusted returns is highly dependent on successful manager selection.

Both of these benefits are evident in the experience of defined benefit plans that incorporate private equity, especially during the worst years of the financial crisis. DB plan allocations to private equity accelerated since 2008, a time when correlations between traditional asset classes dramatically increased.

The Private Equity Growth Capital Council recently looked at the returns of eight public pension plans from the private equity asset class. PEGCC found that up to the end of March 2012, these funds experienced median private equity returns greater than those from the S&P 500 of 4.2% points per annum over five years and 7% points per annum over a 10-year timeframe.

It is no surprise, therefore, that among the 200 largest U.S. plan sponsors, allocations to private equity investments within their DB plans went from $269.8 billion as of September 30, 2010, to $313 billion as of Sept. 30, 2011, according to Pensions & Investments (Feb. 6, 2012). Private equity by some calculations has amounted to as much as 3% of the asset mix of many U.S. DB plans. That exceeded those DB plans' allocations to hedge funds in the same time period, according to CEM Benchmarking Inc..

Diversification benefits can be defined as the increase of expected excess return per unit of risk, as measured by volatility. Hence, by adding assets with low correlation to a portfolio it is possible to decrease the systematic risk (beta), while keeping expected returns constant. In this context, private equity can improve the efficiency of a traditional portfolio: the lower correlation shifts the efficient frontier further left. Apart from improving the portfolio efficiency, intelligent manager selection and seizing of market inefficiencies can also generate alpha.

Arguably, achieving this degree of diversification as well as alpha-generating potential are not achievable with a traditional asset mix. At the same time, getting that benefit comes with a challenge: It is important for the private equity investor to try and select future winners from the myriad of opportunities that will present themselves.

Investors should not underestimate the importance of the number of funds in a private equity portfolio as a key determinant of any diversification benefit. Too few funds leads to individual fund selection having a disproportionate effect on the overall portfolio; too many can dilute individual fund performance. Careful choice of type of private equity investment (e.g., buyout, growth, venture capital) and geography also provides diversification benefits, especially if mixed appropriately. However, the overriding factor affecting diversification is the number of funds in the portfolio.

To understand the alpha-generation process in private equity, it is instructive to look at the difference between average, top and bottom quartile private equity returns. The dispersion in performance of direct private equity firms amounted to 13% to 14% from October 2002 to September 2012. An unfavorable selection of private equity funds would therefore have resulted in a flat performance, while a favorable selection would have resulted in a 14% annualized return.

The relative inefficiency of private equity markets leads to a much stronger deviation between top and bottom quartile returns. This occurs because private equity firms have differing levels of market access, information advantages and skill. In such an environment investment acumen and reputation, among other important aspects of managing the asset class, are rewarded with upside potential.

Kevin K. Albert is a partner with Pantheon Ventures LLP.