Portfolio size no guarantee of protection

New analysis of U.S. pension plans' buyout portfolios reveals that the largest are not necessarily the most successful when evaluated for both risk and returns.

The $22.1 billion Los Angeles Fire and Police Pensions' $2 billion private equity portfolio ranked No. 1 on the inaugural list of 11 funds, achieving the highest average of its risk and return scores. The $11 billion private equity portfolio of the Florida State Board of Administration, Tallahassee, which oversees a total of $209.7 billion, including the $167 billion Florida Retirement System, was in second place, and the $26.8 billion private equity portfolio of the $351.5 billion California Public Employees' Retirement System, Sacramento, was third on the risk-return ranking.

HEC Private Equity Observatory, Paris, partnered with Pensions & Investments to conduct a transaction-level analysis of the risk and return of domestic asset owners' private equity portfolios. The initial analysis focused on U.S. buyout funds and uses data from London-based alternative investment research firm Preqin, methods by eFront and PERACS and analysis by Oliver Gottschalg, Paris-based associate professor at HEC.

The study aimed to assess the most successful private equity programs: portfolios that produce solid returns but would also perform well if the next financial crisis — such as another Great Recession — occurred in the next 12 months, said Mr. Gottschalg, co-founder and director of the HEC Private Equity Observatory.

Mr. Gottschalg and his team assessed the aggregate return score of each portfolio for buyout funds vintages 2004 through 2013. They also calculated the value at risk of portfolio on all active investments made by the funds to assess how each portfolio would do if the absolute worst happened, he said.

"As an LP, it is absolutely crucial to build a portfolio based on what could happen," Mr. Gottschalg said. Investors are in a tricky position; they could reduce ​ risk by investing in more funds but that could increase costs and lead to lower returns, he added.

The study reveals that choosing funds based on characteristics of the expected underlying transactions would lead to a more balanced portfolio and the highest returns with the lowest risk, Mr. Gottschalg said.

When it comes to its private equity portfolio, the Los Angeles fire and police system took a less traveled path. Rather than follow the now-popular route of making larger commitments in fewer funds, the portfolio is highly diversified, with 350 funds. Unlike most pension plans of its size, LAFPP can make small commitments of as little as $5 million.

Other funds have to make commitments in $100 million, $200 million or even $300 million chunks, CIO Tom Lopez said. These large commitments tend to create a portfolio heavy in large and mega buyout funds, he added.

By contrast, LAFPP's private equity portfolio has always had a tilt toward medium and small buyout funds. It is now divided into a core portfolio, a specialized manager portfolio — made up of small and emerging managers — and a commodities private equity portfolio.

Outsourcing fund selection under the guidance of Mr. Lopez and the two private equity staffers allows the fund to manage the highly diversified portfolio.

Mr. Lopez said he expects to continue to have a diversified private equity portfolio because "it works."

"We've had a successful private equity program," Mr. Lopez said.

According to the pension plan's last private equity report, LAFPP's portfolio exceeded its benchmark median returns for 18 of the 20 reported vintage years, with 10 years exceeding the median benchmark by more than 300 basis points and six years exceeding the median benchmark by more than 600 basis points.

Since 1996, LAFPP began investing in private equity with about a 2% target allocation. As the portfolio grew, pension officials have continued to increase the target allocation. Last year, LAFPP increased its target private equity allocation to 12% from 10%.

Florida State Board of Administration took another route to achieving its high risk-return ranking. Officials there are limiting the number of active private equity relationships to 50 to 55, said John Bradley, senior investment officer, private equity, in an interview. The board currently has an active roster of 49 private equity managers and an inactive list of 12 managers that won't get further funding for reasons of portfolio construction, Mr. Bradley said. For example, a manager might end up on the inactive list if a new fund is much larger than the current fund, which results in the manager investing in larger companies — moving the firm from a midcap buyout specialist to large-cap buyout.

"We set guidelines on allocations to large, midcap and small-cap buyout" and there may be no more room for a new large buyout manager, Mr. Bradley said.

Currently, FSBA's private equity portfolio is tilted toward buyouts, with 65% of the private equity in those funds. The buyout portion of the portfolio is evenly divided between small, medium and large because pension officials can commit as little as $25 million and as much as $300 million to a fund, Mr. Bradley said.

Fund officials are comfortable with the smaller manager roster because they maintain a deeper focus on diversity of exposures to everything from geography and industry to the average size of the investments, said Ash Williams, FSBA's CIO and executive director, in the same interview.

Referring FSBA's ranking on the P&I and HEC list, he said: "We are pleased and thankful that our efforts have been validated by our results."

HEC's Mr. Gottschalg said diversification can make a portfolio less risky, but achieving diversification it is trickier than it seems.

A private equity portfolio could hold hundreds of funds, but if most are invested in similar companies in the same industries, the portfolio is exposed to a greater risk should that industry falter, Mr. Gottschalg said.

In creating the rankings, Mr. Gottschalg and his colleagues took the average of two scores: one based on portfolio return and a risk score based on a bottom-up, value-at-risk approach on all active investments made by buyout funds of vintages 2004 to 2013. The higher the average, the better the ranking.

But some industry researchers aren't convinced that there is enough data available to make a risk assessment. The American Investment Council, a private equity trade group, releases quarterly returns that aren't risk adjusted, said Bronwyn Bailey, Washington-based vice president of research and investor relations.

"I'm skeptical of anyone who says they have found the quantitative measurement of risk in private equity," Ms. Bailey said. "Usually, finance defines risk as volatility but private equity doesn't have the same volatility as the public markets and it's difficult to measure risk associated with illiquidity."

She said researchers have been trying to unravel this knotty issue. Making matters worse is that the data researchers need are not publicly available because neither LPs nor GPs are required to make it public, Ms. Bailey said.

"Company level data is the holy grail," she said. "I think it would be great for researchers to look at portfolio companies and roll the analysis up to determine which firms are really creating alpha but without direct access to this data, external researchers will have hard time finding a relevant data set at the company level."