Pension Plans' Risky Flirtation With Private Equity

Much like hedge funds, private equity is getting crowded. Michael Mauboussin recently pointed this out in a research note for Credit Suisse:

In 1980, there were only 24 private equity firms and deal volume only modestly exceeded $1 billion. Today, there are more than 3,000 U.S. private equity firms and assets under management for buyout funds are roughly $825 billion, up from $80 billion in 1996 and less than $1 billion in 1976.12 Two of the largest private equity firms, The Carlyle Group and KKR & Co, each have more than 720,000 employees in their portfolio companies, which means they both employ more people than any U.S. listed company except for Wal-Mart Stores, Inc.

This competition will make it harder to earn the illiquidity premium investors seek in this private investment because companies will have to pay up for good companies in an environment where more assets are chasing the same deals.

Private equity investments can generally be summed up this way:

Your money is tied up for 10 to 15 years with little-to-no liquidity. You pay high fees, usually in the range of 2% of committed capital and 20% of any profits. The due diligence and monitoring costs can be off the charts because these strategies are much harder to understand and manage over time. Buyout companies are typically purchasing companies with much greater debt loads than those in the public markets. Cash flows into and out of these funds are lumpy and nearly impossible to plan for. Holdings are typically only valued quarterly and on a lag, meaning investors underestimate the true volatility of the firms in their PE funds. If you’re not in a top quartile fund your results will likely disappoint.

Because the risk is so much higher in private investments, investors have typically looked to earn an illiquidity and risk premium over and above the one available in public markets. As these premiums become compressed it will be even more difficult for the casual investor to earn returns commensurate with the risk and fees involved.

The problem is that pensions have a history of being casual investors in these types of asset classes. Unless you have superior skill and resources available to identify or access top quartile or even top decile private equity managers, you’re almost certain to do worse than you would in the public markets while taking on much more risk.

Pension plans are increasing their risks by piling into private equity investments to try to increase their returns. For those who know what they’re doing the rewards can be great. For those who don’t know what they’re doing the risks can be even greater. Private investments are likely to disappoint most pension plans in the coming years because of this.

— Read What About Alternatives? on ThinkAdvisor.