We accept – in principle – that private equity can deliver (somewhat) excess returns over most other asset classes. But there are a lot of qualifications attached to that, and most of them are very relevant to whether and how pension funds should invest in private equity.
One thing that pension funds and other institutional investors should always keep in mind is that private equity investment is way more than investing in private equity funds. If you can manage a successful direct private equity programme of your own, like the Canada Pension Plan Investment Board, you can invest in the assets yourself without shelling out management fees or percentages of returns, and reap all the benefits without the costs. Of course, to do that, you have to build and retain a high-quality investment team, but their salaries and budgets may not be so different from the fees and share of returns you’d pay to private equity general partners. It’s your call.
If you can’t go the full direct investment route, then co-investment or separate account structures are still there to help you lower the fees of your investment and deliver higher shares of the returns. You can see why the California State Teachers’ Retirement System is so keen to move into the co-investment space. Then again, depending on your organisation, paying fees to external fund managers may be more acceptable than high salaries paid to in-house teams.
But the law of diminishing returns set in on private equity investment a long time ago. Returns are diminishing and will diminish further. The giant new funds being launched by leading firms will benefit those firms, but how far will they benefit the underlying investors? Those immense funds can pay top marketing dollar to convince you that they will. But those firms are typified by an entitlement culture and a past track record of periodically cavalier treatment of their investors. And do you need to spend your pensioners’ money to keep the billionaire general partners in the gossip columns and scandal sheets?
Here’s a back-of-envelope prescription for pension fund private equity investment. Keep your allocation down in the low teens. Don’t be misled by fund marketing hype. Consider first time funds as well as big buyout vehicles. Moderate your expectations. Discipline your general partners and keep them accountable. Look at other ways to tackle your underfunding. Learn, learn, learn.
And above all, if you want to get a bigger slice of the asset class’s returns, do it yourself and pay for it. Go big or go home.