Wednesday, April 26, 2017

New York City's Private Equity Woes?

Martin Braun of Bloomberg reports, NYC Pensions' Push Into Private Equity Yields Index-Fund Returns:
New york City's biggest pensions have invested about $13 billion with private-equity firms in pursuit of large returns. They would have done better with a low-cost stock index fund.

The city’s $63 billion teachers’ and $58 billion civil employees’ funds have earned an annualized return of 9.15 percent and 9.1 percent after fees, respectively, on their buyout, venture capital and “special situations” funds since the late 1990s. That’s less than the 9.5 percent they would have earned by putting the money into the Russell 3000 -- the stock-market benchmark the plans expect their private-equity portfolios to beat by 3 percent a year.

“We’re more-or-less break even and that’s a disappointing result,” said Scott Evans, chief investment officer of New York City’s pension funds. “What you have here is the mathematics of a very large tail of unproductive funds weighing down performance.”

New York’s experience shows that the private investment pools are no magic bullet for generating gains needed to cover the benefits due as aging workers retire. With state and local pensions holding almost $2 trillion less they need, the funds have piled into riskier asset classes such as private equity, hedge funds and real estate over the past decade, seeing the higher-fee investments as a way to achieve the more than 7 percent returns they count on each year.

New York City’s five public employee pension funds were $65 billion short of the assets needed to cover promised benefits as of June 30, 2016.

Public pensions’ investments in so-called alternative assets such as private equity and real estate -- which are harder to value and sell -- have more than doubled over the past decade and now account for almost a quarter of their portfolios, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.

With the influx of cash leaving the firms competing for takeover targets, the industry has struggled to shine: While average buyout funds historically beat stocks by 3 to 4 percent, those formed since 2006 have done no better than the equity market, according to a 2016 study by professors from the University of Virginia, Oxford University and the University of Chicago, who reviewed the holdings of almost 300 institutional investors through June 2014.

Efforts by banking regulators to limit the amount of high-interest debt that private equity firms can foist onto target companies -- as well as competition from cash-rich public companies mounting their own takeovers -- may also be restraining returns, said Eileen Appelbaum, senior economist at the Center for Economic and Policy Research in Washington.

“More equity and less debt also mean less possibility for outsized performance,” said Appelbaum.

New York’s smaller pensions fared slightly better with their private-equity investments than the civil employees and teachers pensions. Its plans for police officers, firefighters, and school administrators beat the Russell 3000 by 1 percentage point or less.

Still, none achieved the city’s stated goal of earning 3 percentage points more than the Russell 3000, despite the higher fees and risks -- including having money locked up for years.

Too Many’s Too Much

New York City’s private equity portfolio, channeled into about 220 different funds, is “overdiversified,” pension officials say. The civil employees’ and teachers’ pensions committed more than $5 billion to dozens of funds that started investing between 2006 and 2008, when William C. Thompson was comptroller.

The performance of New York’s venture capital and energy investments were particularly poor: The civil employees’ pension returned 3.2 percent and 0.4 percent respectively in those categories. New York has since stopped investing in startups.

Instead of giving up on private equity, New York is concentrating its new investments into about 30 large firms and another 30 "emerging managers," typically women or minority-owned firms, that the city has “high conviction in."

For example, the teachers’ and civil employees’ pensions have committed $630 million to Vista Equity Partners after investments in a 2007 fund returned 18 percent more than the Russell 3000. A 2011 fund returned 8 percent more.

“This is an asset class where it pays to be narrow and to be deep with the partners you have confidence in," Evans said.

Not all of the city’s private equity investments are with firms that have consistently delivered outsized gains. For example, four of New York City’s five pensions committed about $40 million combined to Centerbridge Capital Partners III, a buyout fund, even though the firm’s previous fund returned 4.1 percent as of Sept. 30, 2016, according to data from the California State Teachers’ Retirement System.

Given the 10-year life of a typical private equity fund, it’s too early to render a judgment on the new approach.

However, data from fund vintages in 2011 and 2012 are encouraging, beating the public market equivalent between 2 and 5 percentage point, according to city pension documents.

“The good news is the weight of the new funds and the concentrated portfolio has been rising,” Evans said. “We think we’re on the right track.”
This is a good article which demonstrates a lot of the problems with US public pension funds' approach to private equity.

Here are my quick takeaways after reading this article:
  • Over-diversification: Any public pension fund that is investing in 200+ private equity funds shouldn't be surprised their PE program is delivering mediocre results over the long run relative to public markets. In private equity, it's better to concentrate on a few funds as there is evidence of performance persistence among the "top-quartile funds" but academic studies have cast some doubt on that long-held belief. Still, one thing is for sure, too much diversification in private equity is a losing strategy which will ensure paying excessive fees for mediocre long-term returns. Also, this problem has hampered New York City's pensions for some time now, it's not something new.
  • Fees matter a lot: US public funds need to be a lot more transparent on the fees being doled out to their private equity partners. If over ten years, they are paying multi-millions in fees, this needs to be publicly disclosed so people can understand whether the long-term performance net of fees and all other expenses is worth the effort to invest billions in private equity.
  • Lack of governance: The article demonstrates why US public pension funds consistently underperform Canada's mighty PE investors which have the right governance to hire experienced managers who can thoroughly evaluate the performance of private equity funds and quickly evaluate co-investment opportunities to lower the overall fees of their private equity program. They can also invest directly in companies and keep them on their books for longer periods than the typical PE fund. But to do all this, you need the right governance which separates pensions from political interference and you need to compensate your senior private equity managers appropriately to attract and retain top talent at your pension. US public pension funds are just not there and will likely never be there in terms of adopting this Canadian governance model.
  • VC nightmare: "Unless you're invested with top VC funds, forget venture capital, your pension will lose its shirt." That's what I was told from Sequoia Capital's Doug Leone back in 2004 when I was working as a senior investment analyst at PSP. It took me forever to get through to him, I kept persisting, but he eventually met with Gordon Fyfe and Derek Murphy and told them the same thing: "Don't waste your time with VC, you'll lose your shirt." Later when I worked at the Business Development Bank of Canada (BDC), I saw what Leone was warning of as their VC program back then was a disaster. People have this misperception that investing in venture cap is easy. It's not. Most pension funds and other institutions that invest in this space have lost billions because it's one area where truly top funds differentiate themselves but most of them don't want or need pension money (they are fighting over whether to accept more money from Harvard, Yale, and other top endowment funds).
  • Minority-owned nightmare?: In the US, a lot of public pensions have a mandate to invest in minority-owned funds targeting women and other minorities. While the goal is admirable, more often than not, the performance isn't and there are serious questions as to whether or not these minority-owned fund investments are in the best interests of beneficiaries and stakeholders of these public pensions. Having said this, as someone who has lived with Multiple Sclerosis (MS) for close to twenty years now and has seen and experienced firsthand the negative effects of discrimination due to a physical handicap, I'm a hardcore stickler for real diversity in the workplace and think public pensions have a social responsibility to hire all minorities and help truly qualified emerging managers, especially women and other minorities that routinely get shunned when it comes to raising capital. Still, while there are some success stories when it comes to minority-owned funds, the truth is all public pensions need to first focus on what is in the best interests of their beneficiaries and stakeholders and not invest in minority-owned funds for the sake of fulfilling some social mandate. But these aren't mutually exclusive goals if done properly (see this NAIC  document).
  • Private equity delusions: I honestly don't know where this goal to attain a 3% annualized return over stock market in private equity comes from. No doubt, there needs to be a premium because pensions are tying up capital for a long time, but there is a J-Curve in private equity and most pensions are fine taking some illiquidity risk in private equity, real estate and infrastructure to outperform public markets over a long investment horizon. But as more and more institutional investors rush into alternatives, returns and premiums are necessarily coming down. Still, given the mixed results of private equity programs at US public pensions which are failing to deliver, many need to ask some hard questions in regards to whether their approach to this asset class is all wrong. It's also worth noting these are treacherous times for private equity and there are serious concerns over misalignment of interests. In fact, CNBC's Leslie Picker reports that private equity firms are putting a higher value on buyout targets than at any point since the financial crisis. Given this environment, it's no surprise that many of the biggest private equity investors, including CalPERS, are struggling to deliver the targetted returns in this asset class.
  • Beta bubble keeps expanding: Having said this, as the beta bubble keeps expanding, many investors are growing increasingly scared of what lies ahead. Some legendary investors are peddling nonsense to scare investors but there are legitimate concerns that these markets are going to head south as the next economic shoe drops in the US. In this environment, it makes sense to allocate more in private equity in anticipation of massive market dislocations over the next year.
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Below, Mario Giannini, CEO of Hamilton Lane, talks about opportunities in the private credit and equity spaces in Asia. And CNBC's Leslie Picker reports on what makes tech so popular for private equity. Make sure you read her article on why private equity firms are putting a higher value on buyout targets than at any point since the financial crisis.


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