By David G. Barry
Can one have too much of a good thing?
That’s the question a growing number of institutional investors are starting to ask about a segment that produced exceptional returns in 2021: private equity. Thanks to those returns, a record industry fundraising year and the ongoing decline in stocks, institutions are finding themselves near or above their PE allocation targets – an event that comes while still facing an unrelenting wave of firms raising new funds.
“The issue of overallocation to PE is real for many investors,” said Rose Dean, a managing director with Wilshire Associates, which provides consulting services to pension funds, endowments and foundations.
The Employee Retirement System of Texas, for instance, has an 18% allocation to private equity and a 13% target. Others who are currently overallocated to the asset class include: California State Teachers Retirement System (CalSTRS), Florida State Board of Administration (SBA), Virginia Retirement System (VRS), the Sacramento County (Calif.) Employees’ Retirement System (SCERS), The Employees’ Retirement System of Rhode Island (ERSRI), the Oregon Public Employees’ Retirement Fund, and the Teachers’ Retirement System of Louisiana (TRSL).
It is a list that is growing, thanks in large part to the so-called "denominator" effect, in which a pension fund’s asset value is reduced by the decline in equities. Private equity’s percentage, in turn, rises. It is a phenomenon that reared its head following the 2008 fiscal crisis and led to some institutions opting to sell fund stakes on the secondary market. It also popped up at the start of the pandemic – with institutions generally holding onto their PE stakes.
What is different this time, though, is that it is hitting far more institutions – the result said Jonathan Camp, a managing principal with investment advisor Meketa, of pension funds heeding the advice of his firm and other consultants that private markets are crucial to generating necessary returns. In fact, according to data compiled by Preqin, the average public pension’s allocation to private equity increased to 8.9% in 2021. It was 6.5% in 2012.
But now, said Camp, those pension funds are seeing an environment where markets are taking a “downturn,” private equity is not marked to market and “your allocation to private equity is over where it would otherwise be with more timely valuations.”
In fact, a survey of LPs by Private Equity International found that 23% of investors responding said they are over-allocated for 2022. That's up from 13% in 2021. And it comes at a time when institutions are looking to continue investing in the asset class, putting them in a "pickle," as one LP consultant aptly put it.
To maintain their allocation level while also continuing to back new firms, institutions do have options, including increasing their PE allocation target, reducing their allocation to stocks, utilizing the secondary market, or perhaps reducing commitments to new funds.
Camp said the advice Meketa is giving clients is to "be patient and don't overreact" - especially since it's hard to change plans overnight.
Kathleen Barchick, a senior managing director with investor advisor Cliffwater LLC, said so far "no one is overreacting. Over the past five years, many plans had been chasing their targets and as a result they don't want to make any knee jerk reactions at this time." The key, said Barchick, is what their portfolios look like on June 30th - the end of the fiscal year for most public pension funds. Given that their results will include first quarter private equity numbers, pension funds will have a better sense of what their allocation levels look like and what they may need to do going forward, she said.
Wilshire’s Dean also said patience is key.
“Private markets allocations are best managed with a long term and consistent approach, with a pacing plan that has been constructed from the beginning,” said Dean. With Wilshire a believer in the critical role of "vintage" diversification" in private successful private markets investing or investing on a consistent basis annually, the firm is not recommending changing target allocations because of the denominator effect or “to deviate from the pacing plan unless there are structural changes to the cash flow/liquidity/objectives of the total fund.”
She said that for portfolios that are “meaningfully overweight to private equity,” Wilshire will examine the public/private split of the portfolio’s exposure to growth assets in its entirety. She said that if liquidity constraints permit, lowering the allocation to public equities is an option, as well as allocations to other growth-related assets such as high yield.
Drew Schardt, co-head of global investments for private markets investment firm Hamilton Lane, said that what institutions are going through right now is a “double-edge sword” as private equity performance has been great, “crystallized,” he said, “by 2021, when the industry distributed close to $1.5 trillion.” Pension funds and endowments across the board saw big returns from the asset class.
Massachusetts Pension Reserve Investment Management (MassPRIM), for instance, has over the past year seen a nearly 50% return from the asset class, while The Los Angeles City Employees’ Retirement System (LACERS) saw a 55.2% return from private equity in fiscal year 2020-21.
But with private equity reporting figures a quarter behind public market figures, the overallocation issue is rearing its head. Schardt said that the value of pension funds’ private equity and venture capital holdings should show a decline when they report their second quarter numbers, which will include first quarter PE & VC numbers.
“Although private markets holdings may come down a bit, they will likely be less significant than moves seen in public equities. Private markets won’t be immune,” he said. “At some point the numerator effect will abate as private market values mirror the directional decline already seen in the public markets.”
That being said, Schardt does think some limited partners may opt to reduce the size of their investment in an existing manager’s new fund, or even decide to pass on the fund entirely. PE Firms, he said, “are all coming back and telling boards and trustees, ‘look how good I’ve been doing, look how much money I’ve been sending back as a fund manager. Don’t you want to lean into that fund performance?’” With everybody’s returns “up and to the right,” LPs are facing or will face some “tough choices” and “difficult conversations,” he said. As a result of such issues, fundraising “will be tougher this year than in the previous two or three years for general partners ,” Schardt said.
Jack Weingart, CFO of publicly traded investment firm TPG, said
on the firm’s quarterly call that the traditional U.S. pension fund market is
the “most overallocated” and that with the crowded fundraising market, they are
for the “first time in a while” having
to make choices. What TPG is seeing, he said, is that the firms benefitting
from this change are those who are the “largest and most established GPs with
the strongest relationships” – a group that he put TPG into. The LPs, he said,
also are favoring those who have “returned a lot of capital” as opposed to
those who are simply taking capital.
John Toomey Jr., a managing director with HarbourVest Partners, agreed, saying that fundraising is likely to become “elongated.” He also said that his firm is seeing more “large institutions” giving consideration to putting assets on the secondary market.
Wilshire’s Dean said manager selection “remains critical” for LPs. But that “a growing economy and secular shifts in technology, healthcare, financial services and segments of industrials should provide a tailwind to sector-focused buyout managers with the requisite domain expertise to navigate risk and unlock return.”
Lauren Din, a principal with secondary-focused investment firm Coller Capital, concurred that private equity has performed well, but she also said that the "macro-economic and geopolitical" environment has shift. As a result, Coller is seeing and expects to see more LP portfolios coming to the secondary market, she said.
Din said that institutions overallocated to private equity can take steps to "get through shorter-term impacts" such as increasing the target allocation. But with inflation, rising interest rates and the "hard-to-predict geopolitical situation" in Ukraine in play, the impact on PE could be "multi-dimensional" and may lead to a slower distribution pace for LPs, who , in turn, may need to turn to the secondary markets to generate liquidity, she said.
Meketa's Camp said turning to the secondary market is a "tough question to balance, if everyone's trying to unload." Specifically, he said, "who are your buyers?"
Wilshire’s Dean said manager selection “remains
critical” for LPs. But that “a growing economy and secular shifts in
technology, healthcare, financial services and segments of industrials should
provide a tailwind to sector-focused buyout managers with the requisite domain
expertise to navigate risk and unlock return.”