How Much Private Equity Is Too Much for a Public Pension?
Pension funds around the U.S. are upping their allocations to private equity after a year of record-breaking returns. According to data obtained from Preqin, the average public pension’s allotment to private equity increased to 8.9% in 2021. In contrast, the average allocation was just 6.5% in 2012.
New York City’s pensions are among those that may see an increased allocation to the asset class in their portfolios should a new law pass. Currently, New York State implements a “basket clause,” which prevents public pensions from investing above 25% of their total portfolios in investments considered higher risk, including real estate, infrastructure, hedge funds, international equities, and private equity. The proposed law would increase that allocation to 35% for all pension funds in the state. If the law passed, the boards of New York City’s five public pensions would vote on whether to increase the “basket” for their own pension funds.
New York City Interim CIO Michael Haddad, who is responsible for overseeing investments in the five pension plans across the city, says that while the change in the law isn’t targeted at private equity exclusively, it’s likely that the asset class would increase.
Currently, New York City’s pension system calculates its asset allocation using a formula that primarily involves mean variance optimization, expected return, expected risk, and expected correlation.
“We don’t know for sure if we will increase private equity until we have done the math, but in reality, knowing what those three key variables have been over the past couple of asset allocations, I think it opens the door for it to go up,” says Haddad.
Not everyone thinks that’s a good idea.
“The bubble has probably already popped,” says Olivia Mitchell, a professor at Wharton School of Business at the University of Pennsylvania whose research focuses on employee benefit plans. “Pension funds trying to get into this asset class now will find it’s just too late. Especially taking into account the expenses associated with the investments.”
Mitchell points to an independently published academic study by Richard Ennis titled “The Modern Endowment Story: A Ubiquitous United States Equity Factor.” The study argues that endowments have underperformed public equity indexes by 2.24% to 2.5% due to high management fees during the thirteen-year period between June 2008 and June 2018.
While the study focused primarily on endowments, which are more heavily invested in private markets than are pension funds, the results may still be relevant to those who want to understand the asset class’s performance relative to the public markets.
Haddad of New York City’s pension funds acknowledges these arguments.
“The academic studies would tell you that private equity is not a good value proposition, given the illiquidity and given the fees, unless you can allocate to the top-quartile managers,” says Haddad. “So that’s exactly what we try to do.”
Data obtained from Preqin shows the average of the median private equity return net of fees for North American pension funds was 17.6% from 2009 to 2018. The average return on the S&P index was 13.65% over the same time frame annually. This means that private equity performed 3.95 percentage points better than public equity indexing for pension funds in that period.
The bottom quartile of pension fund private equity investors, however, saw just 11.2% average mean returns from 2009 to 2018. This performance is especially disappointing considering that not only did these pension funds lose out on returns, but they also lost out on liquidity over those years.
But not all the data points to the same conclusion. Andrew Schardt, the head of global investment strategy at Hamilton Lane, says that the data they have collected paints a different picture.
“The outperformance of the private markets has been consistent and proven,” says Schardt. “You could effectively pick nearly any point over the last thirty years, and the historical outperformance of the private markets over public asset classes is apparent.”
He also says that in some ways, private investments can be less risky since they typically have lower observed volatility than public markets.
“Our data shows that the observed volatile utility, which private markets tend to report on a quarter-to-quarter basis, is genuinely half or less than the observed volatility in daily public market pricing,” Schardt says.
Schardt admits that the past year’s performance was unusually high and the returns are likely to come down in the upcoming years. However, he points to internal data that shows that private equity outperforms the public markets by an even more significant margin when the stock market is down. “This is why so many institutional investors like the asset class,” says Schardt. “When public market returns are down or more pedestrian, that’s actually when the relative outperformance of private markets can be greatest.”
Data from Preqin seems to be in line with the data from Hamilton Lane. In 2008, the height of the Great Recession, the median private equity returns were 12.4% for public pension funds in North America. At that same time, the S&P returned -38.49%. However, given that the data for private equity only goes back about 30 years or so, it’s difficult to predict if this trend will continue going into the future.
For most pension funds, returns from private equity will still come down to choosing the right managers. Haddad says that this is a process that takes time and effort, and there are no easy shortcuts.
“The simple thing would be allocate to the firms who were in the top quartile last decade and hope they continue to perform well, but it’s not that straightforward,” says Haddad.
New York City instead focuses on underwriting and trying to analyze both past performance and the present-day changes that managers are making.
“We look at changes in the team, the use of leverage, the use of a subscription line, what industry verticals the manager targets, the level of competition in those verticals, and other factors as well.” says Haddad. “Knock on wood it’s worked well for us so far.”
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