Will Pension Funds Bypass Private Equity?

Private equity and pension funds have been engaged in a symbiotic relationship for decades. As the PEGCC explained, “Pensions are the largest investors in private equity in terms of capital invested.” The investments have remained strong, with pension funds still being the largest contributor of capital in private equity investments during 2001-2011.

In exchange for the capital, private equity firms are offering pension funds some of the best returns in their portfolios. With public market and real estate investments delivering weak returns — thanks to the 2008-2009 crisis — the value of private equity investments has become clearer. According to a recent study, “the median public pension fund received 8.8% in returns from private equity compared with 3.7% from public equity and 5.7% in total portfolio returns, annually over the past 10 years.”

Given these returns, and the pressure to address the significant underfunding, many pension funds have been looking to increase their investment allocation to private equity funds. Russell Investments found in a recent survey that a majority of respondents plan to maintain or increase their allocation to alternatives over the next one to three years.

The Rise of Co-Investments

However, many private equity firms and pension funds are also moving beyond basic limited partnerships. Over the past several years, pension funds have become regular co-investors in PE deals. Just yesterday, the Canada Pension Plan Investment Board (CPPIB) joined Ares to acquire Neiman Marcus for $6 billion.

The trend, which is appearing in firms and funds of all sizes, benefits private equity firms because it allows them to stretch some of their undeployed capital if fundraising is a challenge. The good-will could also make favorable impressions on future LPs, prevent the risk of being accused of collusion, and help address issues around majority investments.

Pension funds are similarly, “clamoring for co-investments because most co-investments are made on a no-fee, no-carried-interest basis,” said David Fann, president and CEO of TorreyCove Capital Partners LLC. The elimination of the fees, which is often a gripe of many GPs, is a strong positive for the cash-rich pension funds. According to Preqin, some 43% of institutional investors plan to increase their co-investments in 2013.

As Jim Fasano of CPPIB — one of the pension funds most active in co-investments — explained in today’s Privcap video, “We like to think of ourselves as a deeper partner than just an LP. Our direct private equity business is focused on what we refer to as a co-sponsorship model. We play a very large role; we are involved early; and we are active partners.”

Going Alone

But some pension funds may look to bypass the co-investment model and forge ahead with direct investments.

The route from LP to direct investor has already appeared in family offices. As Howard Romanow of Island Management explained, “Although many more family offices are looking for private investments, many are hesitant to invest in PE firms because they do not see the benefit of the structure,” Romanow added. “If you are capable of directly investing, the idea of fees, the illiquidity of the fund, the lack of control, and the desire to quickly sell the winners and hold the losers is not appealing.”

However, few public pension funds are currently capable of directly investing. While they have the capital to invest, they are significantly lacking in knowledge and experience in the M&A markets. To remedy the situation, they could hire in-house management teams — like many family offices do — but the price of bringing these ex-PE professionals could wind up costing just as much as the management fees. As a result, the tactic would likely only be employed by the largest pension funds — like CPPIB.

An even greater discouragement to direct investing for pension funds is that “more concentrated exposure also means returns — or losses — are amplified.” In a time where many pension funds are focused on consistent returns, such a risk may not be tolerated.

Instead of direct investing, many pension funds are opting for direct loans — a strategy that does not require any on-going management. According to a recent article, “More institutional investors are considering direct-lending strategies in an attempt to capitalize on supply/demand imbalance in the credit markets.” It continued, “With many banks still tightly holding their lending purse strings, pension funds are stepping in to provide middle-market businesses with financing. Plan sponsors and consultants say direct middle-market loans, in addition to delivering better returns than high-yield debt, are relatively recession-proof thanks to high recovery rates.”

Although it seems unlikely that the mutualistic relationship between pension funds and family offices will disintegrate in the near future, the pension funds have been flexing their muscles recently. Because of the pressure from underfunding, many pension funds have begun making more consistent demands of private equity, namely  a greater demand for fee sharing and the sale of the Freedom Group. The recent issues around Sun Capital have also added salt to the wound. Unable to fully separate, the two partners will likely engage in a tug of war.