GPIF looks to study private equity replication

Japan's Government Pension Investment Fund may be mulling changes to an alternatives investment program that's been cautiously deliberate until now.

On April 20, the ¥177.7 trillion ($1.63 trillion) Tokyo-based giant made two separate announcements speaking to potential changes: the first was a callout for information from managers of domestic real estate, a sign GPIF could be moving beyond the fund-of-funds platforms it's focused on in recent years to directly hire general partners; the second was a paper exploring ways to accelerate allocations via means such as private equity replication strategies.

A Nomura Research Institute paper, "Alternative Asset Replication Using Exchange-Traded Assets," commissioned by GPIF and posted on the fund's website, concluded that a portfolio of exchange- traded assets is capable of tracking the long-term performance of private equity benchmark indexes. Such strategies would open the door for institutional investors to "rapidly scale up exposure without worrying about illiquidity," the Nomura report said.

An overview of alternatives investing GPIF posted on its website on March 26 showed infrastructure accounting for the bulk of the fund's ¥944.5 billion of allocations as of March 31, 2020, at ¥545.1 billion, followed by ¥380.8 billion in real estate and only ¥18.5 billion — or less than 2% — in private equity.

A more aggressive push into alternatives would mark a departure for GPIF. Since issuing its first alternatives-focused RFP in early 2017 for managers of infrastructure, real estate and private equity fund-of-funds strategies, GPIF has moved deliberately and — for its size — incrementally, allocating $2 billion to $3 billion a year to alternatives.

The pension fund's latest report for the quarter ended Dec. 31 showed roughly $11 billion parked in alternative strategies — two-thirds of 1 percentage point of the GPIF portfolio.

The fund's 5% ceiling on alternatives exposures gives GPIF room to allocate another $70 billion to those strategies.

The bull market in equities over the past 12 years — powered by the extraordinary monetary and fiscal policy steps taken to combat the global financial crisis and the coronavirus pandemic — has buoyed GPIF's returns, particularly since late 2014 after a more than doubling of the fund's global equities allocation target to 50% of its portfolio.

While that rally — which could remain well supported this year by a flood of U.S. fiscal spending — may be making the diversification benefits offered by alternative allocations less of an immediate priority, the outlook is murkier on a two- or three-year view.

A GPIF spokeswoman said top GPIF executives were not available to discuss whether they're feeling any pressure now to lessen the fund's reliance on equity market beta.

If private equity replication strategies become an option for GPIF, the fund would be a whale entering what remains a very small pond.

Market veterans say only a handful of firms — including Chicago-based DSC Quantitative Group LLC, Boston-based Man Numeric, Stamford, Conn.-based SummerHaven Investment Management LLC and Toronto-based Mackenzie Investments — offer private equity replication strategies at present.

Spokespeople for heavyweights such as BlackRock Inc., New York, and State Street Global Advisors, Boston, say they don't have dogs in the private equity replication fight just now.

One portfolio manager of a private equity replication strategy, who declined to be named, said there are less than 10 managers offering such strategies now, with very little overlap in how they construct portfolios.

Nomura's report conceded the sector remains at an early stage of development and called for "continued efforts, including research, to improve replication techniques' accuracy."

The portfolio manager said for now, it would be a daunting challenge for the budding sector to absorb anything approaching tens of billions of dollars.

Arup Datta, Boston-based head of global quantitative equity at Mackenzie Investments, said the Mackenzie Private Equity Replication Fund his company launched in December with C$15 million ($12 million) in seed funding can take in $5 billion — reflecting constraints facing a portfolio of listed small- and midcap stocks selected to mimic the characteristics of private equity portfolios.

Arthur Bushonville, DSC Quantitative Group's CEO and founder, contends his firm's approach goes some way to solving the scalability problem.

While a private equity benchmark like that of Cambridge Associates LLC tracks the returns of 1,200 private equity funds, DSC's benchmark — with exclusive access to deal-level data maintained by partner Thomson Reuters — currently tracks over 4,000 underlying portfolio companies of the fund managers, yielding a more granular understanding of the market's characteristics that allows DSC to "construct a tracking portfolio from the top down rather than from the bottom up," using bigger, more liquid companies to do so, Mr. Bushonville said. AUM tracking DSC's private equity and venture capital indexes is approaching $500 million.

"There's a lot of liquidity and capacity in our approach," he said, noting that the average market cap of the roughly 170 stocks in the investible portfolio DSC designed to efficiently track its benchmark index exceeds the average of the S&P 500 index. Even $10 billion or $20 billion of flows to the company's replication strategy shouldn't prove overwhelming, he added.

Executives with firms working on private equity replication strategies report signs of growing institutional interest, as well as allocation trends for the broader private equity industry that could accentuate that interest.

In the institutional world, there are a number of large, sophisticated investors looking into private equity replication strategies right now, Mr. Datta said. "It's interesting to me that the ones we're talking to ... are actually the larger plans" — investors that can access big players like Blackstone Group, KKR and Carlyle Group — looking to earn better returns while they wait for the money they commit to be drawn down, he said.

If Mackenzie can maintain the strategy's early momentum — besting the returns of indexes such as the Russell 2500 or the S&P 500 by 200 to 400 basis points with perhaps two-thirds of the volatility — there should be more conversations with institutional heavyweights looking to garner private equity returns during the long wait for their money to be put to work, he said.

Kurt J. Nelson, CEO of SummerHaven Investment Management, said his firm last year closed down two private equity replication ETFs it launched at the end of 2017 to considerable fanfare because "all of the interest and response that we got was from institutional investors," more comfortable with separately managed accounts.

Those big, seasoned institutional investors are looking for a "liquidity checkbook" — the chance to earn private equity-like returns while they deal with the frustrations of managing the timing of capital calls, draw downs and liquidity events, Mr. Nelson said.

He conceded his firm may simply have been too early in offering up private equity replication ETFs to high-net-worth and mass affluent investors but for now — with $175 million in institutional separate accounts and signs of growing interest — "that's where we have our focus," he said.

Competitors with longer track records say their performance during the pandemic sell-off of the first quarter of 2020 has converted a growing number of prospects into clients.

"Things have really taken off for us materially in the last year" after the company's replication strategies — launched in 2014 — "did exactly what we would have wanted them to" in the market dislocation during the first quarter of 2020, said Jeffrey F. Knupp, president of DSC Quantitative Group.

"That was a major proof point (that) pushed us forward with a lot of different investors," Mr. Knupp said. For example, the firm just took in a $100 million allocation from the 125 billion Danish kroner ($20.3 billion) pension fund P+, Frederikserg, "with other big asset owners likewise looking for different ways to get exposure to private equity and venture capital," he said. A P+ spokeswoman couldn't immediately be reached for comment.

Meanwhile, in light of the GPIF-commissioned Nomura research, Mr. Knupp said there's an internal logic that should drive the biggest institutional investors — with tens of billions of dollars to put to work in alternatives — to consider private equity replication strategies. "The only way they could get exposure to this asset class is effectively by self-indexing themselves," and in lieu of the tremendous time and effort they would face doing due diligence on a diversified set of private equity managers they can get a good chunk of their needed exposure with a much lower cost structure, he said.