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The P&I 1000: Alternatives

Private equity, real assets make gains with funds wanting safety

Stephen J. Nesbitt said plan sponsors moved to private equity to circumvent risks in a volatile stock environment.

Leery of equity markets, plans see alternatives as better avenue for returns

U.S. pension plans continued their move into private equity and real assets in search of return and a safer alternative to equities.

Many alternative investment asset classes represented in Pensions & Investments' annual survey of the largest U.S. retirement plans exhibited growth in the 12 months ended Sept. 30. Among defined benefit plans in the top 200 retirement systems, energy and infrastructure investments had the greatest increases, up 40.8% to $32.1 billion and 24.2% to $28.7 billion, respectively, albeit from small bases. Growth rates for private equity and real estate equity in the survey period were similar to the year-earlier gains, up 10.7% and 6%, respectively.

But the wave of capital moving into alternatives did not lift all sectors. Mezzanine reversed course from P&I's 2017 survey data, dropping 28.3%, while for the third straight year, distressed debt assets fell, dropping 12.3%.

"It was a risk-off year," said Stephen J. Nesbitt, Marina del Rey, Calif.-based CEO of alternative investment consulting firm Cliffwater LLC. "People found stocks are risky and moved to private equity."

Across P&I's top 200 universe, private equity accounted for 8.7% of the aggregate defined benefit allocation as of Sept. 30, compared with 8% as of Sept. 30, 2017. Public pension plans had the largest average percentage of their portfolios in private equity at 9.3% as of Sept. 30, up from 8.8% in the year-earlier survey. Among corporate plans, private equity was up to 6.2% from 5.7%, and the average exposure among union plans was 5.8%, a slight increase from 5.7% as of Sept. 30, 2017.

The net return for Cambridge Associates LLC's U.S. Private Equity index was 13.52% for the nine months ended Sept. 30, and for the Cambridge U.S. Venture Capital index it was 18.07%.

At the same time, investors are not accepting alternative managers' business-as-usual terms and conditions because "there's a big push to reduce fees," Mr. Nesbitt said.

This pushback most likely had an impact on hedge fund assets, he said.

Hedge fund assets flat

Hedge fund assets overall were flat within P&I's top 200 universe, up 0.1%. Direct hedge fund investments showed a 4.2% gain in the 2018 survey, close to 2 percentage points shy of the 6.1% gain in the year earlier survey. However, hedge funds of funds continued their free fall with a 20.1% drop from Sept. 30, 2017. Looking at the past five years of survey data, assets in hedge funds of funds have dropped 36.9%.

"The hidden story is not only the decline in (hedge fund-of-funds) assets but also fees … Hedge fund-of-funds fees cratered," Mr. Nesbitt said. The decline in hedge fund-of-funds assets "would have been worse if not for the repricing of fees," he added.

For example, a 2017 study by consultant bfinance showed the median quoted hedge fund-of-funds fee fell to 80 basis points in May 2017 from 100 basis points in January 2015.

In the 12 months ended Sept. 30, 2018, the HFRI (Hedge) Fund Weighted Composite index gained 3.95%, the HFRI Fund of Funds Composite index rose 3.06% and the HFRI Fund of Funds Conservative index was up 3.64%.

Credit strategies accounted for close to 1% of assets of the defined benefit funds among the 200 largest plans. Credit tracked by P&I not only includes $20.6 billion in distressed debt and $3.3 billion in mezzanine, but also $16.1 billion in private credit and $6.6 billion in bank loans. This is the first year P&I has asked for private credit and bank loan asset breakdowns.

Still, distressed debt assets are on the decline among institutions, mainly because "there's not a lot of distressed debt out there," Mr. Nesbitt said.

Three of the five largest investors in distressed debt in P&I's database had a decline in distressed debt assets during the survey period.

Top ranked $99.1 billion Ohio Public Employees' Retirement System, Columbus, saw its distressed debt assets drop 19% to $2.4 billion. The distressed debt assets of the $375.1 billion California Public Employees Retirement System, Sacramento, ranked second, but fell 12.8% to $2.4 billion, while the distressed debt assets of the $229.2 billion California State Teachers' Retirement System, West Sacramento, ranked fourth, were down 10.8% to $1.6 billion.

Instead, energy was the new distressed debt, gaining ground during the survey period as investors looked to the sector for distressed opportunities.

With the oil crisis and the shakeout in energy in the year ended Sept. 30, "you can view the increase in energy as pseudo-distressed," Mr. Nesbitt said.

Indeed, four of the five largest energy investors saw double-digit growth in their assets during the survey period. (Second-ranked North Carolina Retirement Systems did not provide energy data in the prior survey.)

No. 1 with energy assets

The $153.1 billion Teacher Retirement System of Texas, Austin, topped the list with energy assets up 39.6% to $7.9 billion. Energy investments reported by the $55.1 billion Pennsylvania Public School Employees' Retirement System, Harrisburg, grew 18.8% to $2.8 billion; at the $79.4 billion New Jersey Pension Fund, Trenton, energy rose 15.2% to $2.4 billion; and at the Minnesota State Board of Investment, St. Paul, which oversees $68.3 billion in state pension assets, energy grew by 10.4% to $2.2 billion.

Infrastructure was another high-flying sector, with the top nine investors in the asset class showing at least double-digit increases. Cal- PERS, whose infrastructure assets rose 17.7% to $4.4 billion in the year ended Sept. 30, topped the ranking.

However, there is a lot of overlap between infrastructure and energy as many U.S. investors have a large exposure to energy in their domestic infrastructure portfolios.

For instance, CalPERS increased its maximum exposure to developed markets infrastructure by 10 percentage points to 60% of its infrastructure portfolio, because "a significant portion of U.S. deals are in the power and energy space," Paul Mouchakkaa, managing investment director, real assets, told the investment committee in December.

Overall, infrastructure assets growth was mainly the result of institutional investors' increasing their commitments to the asset class.

"In our view, the primary reason for the increase was due to private infrastructure managers raising capital," said Wilson Magee, New York-based director of global real estate and infrastructure securities, Franklin Templeton (BEN) Investments (BEN). in an email. "Ultimately, investors continue to find that the stable, long-duration cash flows of infrastructure assets are appealing additions to institutional portfolios that are dominated by stock and bond investments."

Rounding out the top five infrastructure investors on P&I's ranking are CalSTRS, with infrastructure assets up 21.8% to $2.8 billion; Oregon Public Employees Retirement Fund with a 49.2% increase to $1.8 billion; $213.2 billion New York State Common Retirement Fund, Albany, rising a whopping 170% to $1.7 billion; and the New York City Retirement Systems, up 75.2% to $1.6 billion.

Returns boost real estate

If the increase in infrastructure assets is due to fundraising, much of the increase in investors' real estate equity portfolios can be attributed to returns. The NCREIF Property index was up 7.2% during the 12 months ended Sept. 30. The NCREIF Open-end Diversified Core Equity index returned 8.68% gross of fees.

CalPERS also was at the head of the real estate equity list, with assets up 8% to $34.9 billion, followed by CalSTRS with assets rising 15.2% to $30 billion; Texas Teachers, with $18.3 billion, up 4.3%; Washington State Investment Board, Olympia, which oversees $93.4 billion in defined benefit plan assets, with real estate equity increasing 6.3% to $15.7 billion; and the Florida State Board of Administration, Tallahassee, with $163.6 billion in DB assets, up 17.1% to $15 billion.

Likewise, real estate investment trust assets among defined benefit plans in the top 200, up 4% to $52.1 billion during the survey period, got a boost from returns. For the 12 months ended Sept. 30, the FTSE Nareit All REIT index was up 4.22% on a total return basis, and the FTSE Nareit All Equity REITs index was up 4.31%.

CalPERS had the most in REITs, with assets up 2% to $27.6 billion.