Thursday, October 10, 2013

Praying For an Alternatives Miracle?

Martin Braun of Bloomberg reports, North Carolina Pension Adds Lagging Private-Equity Bets:
In one of the few things Republicans and Democrats can agree on in North Carolina, the state is adding to its lagging bets on private equity and real estate to pump up its $80 billion public-worker pension fund.

Governor Pat McCrory, a Republican, signed a bill in August raising limits on investments in alternatives to stocks and bonds. The Tar Heel state’s $3.4 billion private-equity portfolio has returned about 7 percent over 10 years, almost 4 percentage points below the pension’s benchmark. Real estate investments returned 2.6 percentage points below target.

“We’re behaving like a losing gambler right now,” said Ardis Watkins, legislative-affairs director for North Carolina’s State Employees Association, the state’s second-biggest public-worker union. “We’re chasing money.”

North Carolina is joining public-worker pensions from neighboring South Carolina to Texas piling into riskier investments as they face an $800 billion funding gap for promises to retirees amid slow growth and record-low interest rates. The state’s experience shows that the private investment pools, which charge higher fees than stock or bond funds, aren’t a magic bullet for hitting targeted annual returns of 7 percent to 8 percent.
Moral Mondays

Investments in alternative assets, which are harder to value and sell, have more than doubled to 24 percent of public pension portfolios between 2006 and 2012, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.

That share will probably grow. Two-thirds of executives at 109 U.S. public funds surveyed last year by Smithfield, Rhode Island-based Pyramis Global Advisors viewed alternatives as the primary asset class they would use to boost returns.

The law McCrory signed, which was backed by Democratic Treasurer Janet Cowell, passed the Senate 48 to 1. It was a rare display of bipartisanship in a state wracked by protests targeting its first Republican-led government since Reconstruction.

More than 600 people have been arrested on “Moral Monday” demonstrations over tax cuts, reductions in education spending and poll restrictions that opponents say are designed to keep blacks from voting.
Lagging Behind

Currently, about 20 percent of the pension’s assets are invested in alternatives, including private-equity funds, which use borrowed money to buy companies, improve their profitability and resell them. On average, those funds outperformed the Standard & Poor’s 500 stock index by about 18 percent over the life of the fund, according to a study co-authored by David Robinson, professor of finance at Duke University’s Fuqua School of Business. Robinson analyzed a portfolio of 450 buyout funds.

More recently, private equity has lagged behind the stock market. It returned 1.33 percentage points less than the S&P 500 for the year ending March 31, according to the Cambridge Associates Private Equity Fund index.

Hedge funds also underperformed U.S. equities. The S&P 500 returned an average annual 5.8 percent in the five years ended March 31, compared with 0.4 percent a year loss for hedge funds, according to data compiled by Bloomberg
Winding Down

North Carolina is winding down its investments in funds that farm out money to hedge funds because of high costs and weak performance, said Schorr Johnson, a spokesman for Cowell.

The state’s $260 million in “funds of funds” lost 0.48 percent annually for the five years ending June 30.

Credit-oriented funds, which invest in distressed debt and junk bonds, now make up 90 percent of North Carolina’s hedge-fund investments. They have helped push overall hedge-fund returns 8.7 percentage points above their benchmark in the last fiscal year, according to Johnson.

Cowell, the sole trustee of the pension for North Carolina’s 875,000 active and retired public employees, is leading the charge to shift the AAA-rated state into riskier assets. She’s doing so even though the state’s retirement system is the third-best funded in the U.S., according to S&P.

The real risk to the eighth-biggest U.S. public pension by assets is that 35 percent of its portfolio is in bonds, Cowell says. She forecasts that bonds will return 2 percent to 4 percent annually over the next five years.
No Guarantee

“While achieving greater investment flexibility does not guarantee that we will meet the target rate of return, the current allocation structure almost ensures that we will not,” Cowell wrote in a June 17 letter to lawmakers urging them to raise investment limits on junk bonds, hedge funds, private equity and assets like commodities that protect against inflation.

North Carolina’s pension returned 6.57 percent annually over 10 years ending June 30, placing it among the bottom 25 percent of government retirement funds with more than $10 billion in assets, according to data from Wilshire Associates, a Santa Monica, California-based consultant.

Higher fees charged by hedge funds, private-equity firms and real estate managers have eroded returns. North Carolina’s pension paid $318 million in investment fees in fiscal 2012, a 37 percent increase from three years before, records show.

In neighboring South Carolina, which had 56 percent of its $27 billion invested in alternatives in fiscal 2012, fees rose to $296 million from $122 million after it started investing in the loosely regulated pools in 2008.
Muted Debate

The relative health of North Carolina’s pension fund has muted debate over its investment strategy, Francis X. De Luca, president of the Raleigh-based Civitas Institute, wrote in an e-mail.

Both Civitas, whose mission is to implement “conservative policy solutions,” and the public-employees’ association warned that putting more money into alternatives could expose taxpayers to more risk.

North Carolina’s pension had 95 cents to cover every $1 in liabilities in 2011, a funding level behind only Wisconsin and South Dakota, according to a July report by S&P.

“People have talked about North Carolina potentially facing problems, but they take comfort in that our system seems to be healthy,” De Luca wrote. Civitas advocates moving North Carolina public employees to 401(k)-style plans, which don’t promise fixed benefits.

The investment bill signed by McCrory raised limits on the percentage of pension assets that can be allocated to alternative assets to 35 percent from 34 percent and lifted the cap on limits placed on categories such as private equity and hedge funds.

One boon to the North Carolina pension has been the “credit” category, which includes junk, or speculative-grade, bonds and direct loans to companies. That group returned 17.45 percent in fiscal 2013, compared with a 3.34 percent benchmark.
‘Bad Things’

Robinson, the Duke University professor, said Cowell’s move was reasonable given low bond yields and the historical performance of buyout funds. Private-equity investments aren’t much riskier than stocks, he said. The Federal Reserve has said it will keep its benchmark interest rate near zero through at least mid-2015.

“Of course, the devil’s in the details,” Robinson said in telephone interview. “If you just go and try to throw money at the asset class, bad things can happen.”

With public pensions allocating billions of dollars more to private equity, future returns may be lower, said Robinson and Richard Warr, a professor of finance at North Carolina State University in Raleigh.

“Now, everyone and their grandmother in is private equity,” Warr said in a telephone interview “Philosophically, I just don’t believe that there are that many good private-equity deals around.”
Robinson is right, the devil’s in the details and if  you just throw money at the asset class, bad things can and will happen.

The first thing that strikes me when reading this article is the huge fees North and South Carolina are doling out to alternative investment managers, rising 37 percent and 56 percent respectively in 2012 to $318 million and $296 million. These fees are enormous especially when you consider the dismal performance of their alternatives investments.

Second, the dispersion in performance in alternative asset classes is huge, which means if you're not invested with top funds, you will underperform your benchmarks over the long-run.

Third, while credit-oriented funds have done extremely well, I warn investors, it's all about beta, not alpha. If rates start rising fast, most of these credit-oriented funds investing in junk bonds will get killed.

In South Carolina, fourteen staff members of the agency that invests pension money for  public employees are receiving a combined $1.4 million in bonuses for the portfolio’s performance. South Carolina's State Treasurer, Curtis Loftis, cast the board's only no vote:
On Friday, Loftis urged the Legislature to revisit the issue, saying “the mismatch of returns, fees and bonuses cost the state hundreds of millions of dollars every year.”

Loftis has long complained the agency pays too much in fees for too little return. “It is clear the commission should spend less time paying outrageous bonuses and more time raising returns and lowering fees.”

The state’s portfolio is worth $27 billion. Last month, the agency reported a net return, after fees and expenses, of 9.99 percent for the fiscal year ending June 30. The state assumes a 7.5 percent annual return when calculating what it needs to keep the pension system solvent.
Curt shared these thoughts with me:
1.4 million dollars for bottom 20% performance. Incredible really...and of course the press misses most of the story. As long as these US pension plans make pay bonuses like these for mediocre performance we will surely continue to have mediocre performance.

Concerning our plan the peer comparison universe used by RSIC is the well respected BNY Mellon pension plans over 1 billion dollars.

1. The RSIC peer comparison performance was bottom 19% for the FY ending June 2013. ( 81st percentile)

2. The plan’s benchmark (the benchmark that reflect the plan’s “goal”) and on which the plan pays bonuses, was bottom 11% (or bottom 89th percentile)

In other words our goal was to be in the bottom 11%...and we exceeded that lowly goal by 8% to be in the bottom 19th %. That 8% allowed 1.4 million dollars to be paid in bonuses to a few state employees.

Had we been in the 25th percentile we would have returned 13.5%, and the 50th percentile would return 12.34%...either percentile would mean that we would have made hundreds of millions of dollars more than we did.

$50,000 to $300,000 bonuses per investment employee for bottom 20% returns is amazing especially in a state where the average state employee makes less than 45,000 per year and the average retirement benefit is $20,000!
He added:
The previous bonus scheme was essentially an on/off switch that activated to pay full bonuses of up to 100% of pay when performance was one basis point over our ridiculously low benchmark. The plan is a perverse incentive that allows low returns to be richly rewarded and so I have worked individually and as a member of a committee to improve the bonus plan.

The three person Committee hired an outside consulting firm and produced a plan that was an improvement BUT still rewarded low performance. I voted for the committee plan as it was an improvement but have voted against the payouts ever since. I have also urged the General Assembly to address these outrageous bonuses for suboptimal performance.

The commission, and perhaps the General Assembly, will re-visit the plan this spring. I hope improvements will be made that encourage higher returns at acceptable levels of risk before paying such large bonuses.

The Commission continues to struggle to find its moral core. Chairman Reynolds Williams is under two separate criminal and ethical investigations concerning conflicts of interest as his law firm made approximately $150,000 for legal work performed for an investment firm he introduced to the Commission and was subsequently hired by SCRSIC. It was recently disclosed that our previous CIO flew back and forth to Bermuda on private jets owned by a money manager with whom we have invested billions of dollars and to date there has been no public conversation about this outrageous breech of standards. The Commission simply must require a higher ethical standard; and actions, not governance policies, determine the moral core of an organization.

Public Pension Plans often give off the illusion of a well managed, well governed organization. However, when the curtain is pulled back, these entities are often found wanting. In case after case it has been shown that many decisions and practices are flawed, and poor decisions and practices are kept from public view, by the complexity of the enterprise or overly zealous interpretation of confidentiality agreements.
I thank Curt Loftis for sharing this with my readers. It only proves my point that the governance at most US public pension plans needs to be improved and they can learn a lot from their northern neighbors.

The bottom line is that alternatives are no panacea and the approach pension funds use is extremely important. Paying high fees while underperforming public market benchmarks is simply unacceptable. It's great for Wall Street but increases costs and exposes these plans to liquidity, operational, investment and reputation risks. If the approach is all wrong, these risks will come back to haunt them.

Of course, it is worth noting that the funded status of these plans is what ultimately counts and they are doing fine in this regard. But this doesn't mean that the performance and fees of alternative investments shouldn't be scrutinized. Praying for an alternatives miracle is simply not a sound strategy. These pension funds should examine their approach to these asset classes and figure out how to improve performance while cutting costs.

Finally, a private equity expert shared these thoughts with me after reading the comment above:
Beating public benchmarks as a goal has always been the problem, not the solution. Risk adjusted returns is the key, prudent investors do care about what one actually does to get returns. How do you know if the Carolinas plan was not simply a well-constructed risk controlled portfolio, perhaps what the low bonus thresholds (but not that high actual total comp) was designed to encourage? There may well be other issues here, but the one dimensional assessment of the activities as described in the article is not confidence inspiring.
There is massive evidence among practitioners that no one is systematically and at scale getting paid for illiquidity across many asset classes including PE, nor in the PE instance actually achieving anything like the completely inappropriate 50% or greater premium over public markets which is often a typical expectation for those with high aspirations. The weight of capital is real, and only lower middle market activities have such potential, but bring their own set of smaller company almost binary types of risks.
So rather than pejoratively saying “so why is it worth doing”, why not instead say “perhaps we are not looking at this the right way”. PE makes sense as an approach and culture for creating high conviction concentrated actively engaged portfolios in companies not otherwise available in indices. That’s why you do it. Yes it’s a costly endeavor, so just make sure you get appropriate talent and resources devoted to the task – that is what you are paying for.
I thank him for sharing these thoughts and he's absolutely right, when done right, private equity is well worth it and makes a lot of sense for any pension fund with long-term liabilities.

Below, South Carolina Treasurer Curtis Loftis talks about governance of state pension funds. He speaks with Deirdre Bolton on Bloomberg Television's "Money Moves." (February 2012)