Commentary: Time to go direct

If the definition of insanity is doing the same thing again and again but expecting different results, then, today, U.S. public pension funds have taken an opposite, but equally detrimental, position: They continue investing in stocks and bonds and expect returns will be just as rewarding as experienced since 2008.

The combination of a $4.4 trillion shortfall in unfunded liabilities (according to a 2018 Moody's Investors Service estimate) and possibly lower future returns for stocks and bonds suggest pension funds need a new investment approach. That new tactic could incorporate direct investment allocations and exploring unique asset classes capable of producing outsized returns.

The idea of direct investments isn't new to public pension funds. CalPERS Direct is expected to launch in 2019, with at least $1 billion in annual investments aimed at long-term private equity-type opportunities in technology, life sciences and health care. Michigan Municipal Employees' Retirement System, Lansing, already has a group that looks at direct investments mostly in the agriculture sector, according to Jeb Burns, MERS' chief investment officer. MERS' long-term strategy is to let liquidity dictate asset allocation. MERS buys assets that are undervalued, then allows them to grow.

Size and structure are key

The size of a pension fund and its governance structure are factors in whether it can develop a direct investment capability. For instance, Canadian pension plans are flush with cash, in part because they're set up as independent public companies, much like asset management firms. One way to make this happen broadly in the U.S. would be for American pension funds to get closer to the Canadian model, including improving compensation.

A model for identifying unique investment opportunities

For smaller states and municipalities to engage in direct investment, they have to improve compensation and attract talent that would otherwise work in more lucrative positions in the private sector. Smaller pension funds may think the idea of direct investments is impractical because of cost, structure or hiring constraints. But there is a blueprint for them to follow when considering a direct investment strategy: boutique private equity firms, such as those backed by family offices. These firms tend to have small staffs and can be risk-averse. But they compensate for limited resources by focusing investment strategies on less glamorous, "under-the-radar" opportunities where they don't have to compete with private equity giants that tend to bid up deal multiples.

Most public pension funds wouldn't think of, say, the propane industry as undervalued and capable of outsized returns because the most visible public companies, which have had mixed or even poor results, muddy the market's performance. But there's a history of propane companies delivering exceptional returns to institutional investors. Industry experts say companies like the former Inergy and Heritage Propane delivered triple, even quadruple returns and were ultimately bought. Today, for example, there are companies like Energy Distribution Partners. Founded by Tom Knauff in 2012, he says EDP has completed 22 acquisitions and delivered rapid growth through a customer retention strategy that focuses on building the local brands he acquires.

Similarly, one could argue that many existing apartment buildings boast valuations that make future returns more muted. But for those who take the time to look more closely at a market, they can pick up on shifts that others may fail to see. People like Brett Rentmeester, chief investment officer of the Jaggi Family Office, who are knowledgeable about the rental market, say it's now undergoing a fundamental shift. More and more renters want what feels like a single-family home without giving up the conveniences of a rental property. The Avilla Communities developed by NexMetro Communities are an example of luxury, leased home products that one could point to as outperforming the suburban class A market in leasing velocity and rental rates.

The lending industry provides a similar example. While the banking industry may struggle with the next recession, boutique lending areas such as litigation finance may continue to thrive. Recently launched Kerberos Capital Management offers a vehicle in which it lends to an underserviced area within this nascent industry: post-settlement finance. Here, law firms borrow against their attorneys' fees from settled cases as the settlement slowly works its way through the judicial process for final approval. Such loans can be secured by the legal fees due from the settlement, other such receivables owned by the law firm and the attorneys' personally — yet pay interest in the mid-to-high teens.

For public pension funds willing to adopt some of the strategies of boutique private equity firms and avail themselves of unique asset classes capable of producing outsized returns, the approach could help close funding gaps and meet future obligations.

Christopher P. Casey is managing director with WindRock Wealth Management, Naperville, Ill. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.