Private equity and pension funds: The honeymoon is over, but the marriage is strong

By Matthew Ng

In today's low interest rate environment, pension fund managers have chased high returns by increasing their exposure to alternative investments such as hedge funds and private equity. As pension funds invest heavily in private equity funds, both industries will struggle to adapt to each other in a protracted and iterative process that is likely to be as competitive as it is collaborative.

In the United States, pensions are usually funded with contributions that are periodically adjusted according to actuarial necessity. Historically, contribution levels were discounted against anticipated investment income, but today’s low interest rates have contributed to a shortfall in investment income which has left pension liabilities significantly underfunded. 

Meanwhile, increases in lifespan exacerbate the problem, while changes in the demographic dependency ratio limit the collection of future funds. Pension fund managers find themselves squeezed on both sides, they are pressured by their inability to secure high returns, and motivated to compensate for demographic trends. Understandably, pension funds have embraced private equity funds for their promise of above-market returns.

Last year pension funds increased their exposure to alternative investments by almost 5 percent, resulting in an influx of billions of dollars into private equity. In recent months, however, several state pension funds have sold major holdings in private equity. California, Wisconsin, New Jersey and New York have collectively sold billion dollars of private equity holdings, while Texas and Illinois are poised to make similar divestures. But these recent highly publicized divestures by major state pension funds don’t signal a loss of interest in private equity, but rather a desire for a higher level of engagement with a fewer number of funds.

The losers in the recent exodus are disproportionately the big names in private equity, such as KKR, Carlyle and Blackstone. These larger funds yielded lower returns over the past few years than their smaller counterparts, largely due to the end of the mega-buyout era. While the loosing private equity fund managers are characteristically silent on recent dumping of their funds, pension fund managers have been more forthcoming, citing a misalignment of interests, insufficient returns and high fees.

Talk of misaligned incentives is a backlash against changes in the ownership paradigm of private equity. Since KKR and Blackstone went public in 2007, ownership of private equity management has been up for grabs with public offerings and sales of equity stakes to third parties. These arrangements, according to Wisconsin’s investment consultants, misalign interests between management and the limited partners.

Private equity must reassure skittish pension fund managers that returns for limited partners is the primary goal of the general partners. Also, fund managers must reposition their services as a partnership rather than just money management. This might include providing more services, or discounting fees in return for a large investment, a continued relationship or a longer commitment.

Private equity and pension funds have much to offer each other. In a world where skittish banks are unwilling to back large deals, private equity needs large institutional investors that can tolerate illiquidity. Pension funds need high yield investments that can produce their target 8 percent while providing returns that are uncorrelated with the market. It is no surprise that pension funds and private equity funds have embraced each other. Recent divestures are not a breakup of the marriage, but rather a lover's spat.

Matthew Ng writes on financial investment news and corporations from across Asia. For further reading, he recommends Crescent Point Venture Capital and David Hand Crescent Point Asia.