Funds dial back expectations for returns

A number of pension funds are lowering their return expectations for private equity at a time when officials are counting on the asset class to help their entire portfolios reach expected rates of return.

Return projections are falling, pushed down by a massive amount of capital flowing into the asset class — a sharp contrast to the double-digit returns investors once had been getting. Investors and their consultants now expect annualized returns in the high single digits over the long term.

As a result, investors are cutting expected returns from the once-standard 300 basis points over the public equity markets and trying to determine how they will invest in private equity going forward.

Some investors have cut their return expectations by as much as in half in the past 12 to 18 months. Among them are the $372.8 billion California Public Employees' Retirement System, $236.9 billion California State Teachers' Retirement System and the $54 billion Los Angeles County Employees Retirement Association. All three have lowered the premium they expect private equity to deliver over the public markets and, in some cases, changed the index.

CalPERS and CalSTRS both cut their premiums to 1.5% from 3% over an equity index. CalPERS also changed the benchmark index to the FTSE Global All-Cap index from a custom blend of two other FTSE indexes. CalSTRS switched its index to the MSCI All Country World index from the Russell 3000. LACERA changed its private equity benchmark to a global public equity benchmark plus 200 basis points from a U.S. benchmark with a higher premium.

Academic studies have noted the declining returns. Buyout funds outperformed the S&P 500 by 1.75% annually in the 1990s and 1.5% in the 2000s, but since 2006 have had the same returns as that index, according to a 2015 study by finance professors Robert S. Harris, University of Virginia; Tim Jenkinson, University of Oxford; and Steven N. Kaplan, University of Chicago.

Some trustees are starting to question whether private equity is worth it. Given falling expected returns, they wonder if they are being fully compensated for the risk. At a minimum, institutional investors are realizing private equity won't boost their portfolio's overall returns in the future unless they can reduce the cost of these pricey investments.

When CalSTRS officials changed the system's private equity benchmark in July, Trustee Keith Yamanaka questioned why the West Sacramento fund was bothering to invest in private equity at all.

Private equity was supposed to be a higher-returning asset class due to risks presented by the investments, Mr. Yamanaka said. "The risks have not changed but the return we are hoping to get is a little bit lower. I would want some assurance … that, in fact, despite the lower potential return, the risk still justifies our investment in the asset class. We may not want to overlook a potential issue that might come back to haunt us."

Like many institutional investors, CalSTRS is banking on changes to its investment strategy in the form of its collaborative model to cut costs and more efficiently invest its capital, including bringing more aspects of its investment activity in-house.

Currently, 8.7% of CalSTRS' private equity portfolio is in co-investments. Under the pension plan's collaborative private equity model, that is expected to increase substantially.

The collaborative model could be one tactic CalSTRS can use to reduce costs and gain more return, said Steven Hartt, principal at CalSTRS' private equity consultant Meketa Investment Group Inc.

The Oregon Investment Council, which runs the $76.6 billion Oregon Public Employee Retirement Fund, lowered private equity's annual expected return to 9.25% from 9.5% when it changed its asset allocation in April. The council did not change its 17.5% private equity allocation target or its benchmark.

Earning outsized returns in private equity is far from guaranteed, experts say.

"Performance of private equity is not that high unless you select the very best funds," said Ludovic Phalippou, professor of financial economics at Said Business School, University of Oxford.

"I do not see a drop in private equity returns just yet, but would expect one for future returns due to silly fee structures'' negotiated during boom times, Mr. Phalippou said.

Private equity and venture capital managers had a combined $3.3 trillion in assets under management, including $1.1 trillion in dry powder — capital raised but not yet invested — at the end of 2018, according to a recent PitchBook Data study. All that capital chasing private equity deals has led to a five-fold increase in transaction value over the last nine years, to $1.7 trillion in 2018, the report noted.

Whenever the stock market performs well, investors wonder why they are bothering to lock up their money in private equity, said Sasha Grutman, co-founding partner of merchant bank Middlemarch Partners LLC.

"If you have a long-term perspective, there is absolutely a place for private equity," Mr. Grutman said.

Mr. Phalippou said large investors have the edge because they can push back against their general partners on certain terms. "They can co-invest and get other side benefits. They may save on transaction costs compared to deploying large amounts on public markets," Mr. Phalippou said.

CalPERS and CalSTRS are doing just that. CalPERS' new investment plan will boost co-investments but also invest directly alongside a new outside entity that it will seed.

The $145 billion Texas Teacher Retirement System, Austin, in July unveiled a five-year plan to go beyond co-investing to co-underwriting, which is helping general partners find investment targets. The new private equity strategic plan is the result of a study the system launched in 2018 with help from consulting firm McKinsey & Co.

Neil Randall, TRS private equity head, recently told the board past returns have delivered a premium over the public markets. Between 2000 and 2018, the pension plan's $21.5 billion private equity portfolio delivered a total of $12.2 billion more than investing in the MSCI All Country World index.

Part of this excess return was the result of what the pension plan calls its principal investment portfolio. In that portfolio, the plan invests in private equity through innovative structures including co-investments, he said.

The principal investment portfolio currently — 23% in 2018 — now accounts for 26% of TRS' private equity allocation and is slated to rise to 35% by 2023. This portfolio will include the new co-underwriting strategy.

TRS is upping the ante in response to a more challenging private equity world that features high valuations and leverage, Mr. Randall told the board. "The message today is extremely similar to the message I have been delivering in the last few years, and that is valuations continue to be high in private equity," he said. "Private equity continues to be a challenging environment to navigate."

So far, the higher valuations are being supported by the markets, but distributions and investment of capital have been a bit slower in 2019 and investor competition is stiff, he said.

"(Private equity) space and strategy is becoming more and more crowded by other LPs that are trying to do what we are doing," Mr. Randall said. "Co-underwriting is looking at a transaction in real time alongside a GP," he explained.

He equated co-underwriting to sitting down for dinner with the GP and co-investment to waiting with other LPs for scraps at the end of the meal.

"We can actually get our equity investment (into a transaction) guaranteed," he said. "We are transitioning from being in a group of LPs working on co-investments, to an elite group together on transactions."