Friday Letter: Alpha provider

In a week when public market volatility has been making headlines, a reminder of why the big US pensions love private equity

There's no question what's been the biggest story in the financial world this week: the big sell-off in global equities markets on Wednesday, with the Dow Jones, S&P 500 and the FTSE 100 (to take just three examples) all tumbling around three percent.

Gloomy economic news from the US was the trigger, but nervousness about Greece, geopolitical tensions, energy prices, deflation and the Ebola outbreak have also contributed to investors' new-found nervousness. Indeed, such is the volatility on the stock markets at the moment (the VIX volatility index also jumped to its highest level since 2011), it's no surprise that a number of planned floats have been either pulled altogether or come in right at the bottom of their range. In the short term, that's bad news for any GPs hoping to exit their investments via IPOs.

All of which provides an interesting backdrop to another story that came out on Wednesday – which (not surprisingly) garnered rather less attention. This was the US-based Private Equity Growth Capital Council's annual analysis of the private equity returns generated by US public pensions over the last decade. Its headline finding was that the Teacher Retirement System of Texas is now the top-ranked pension in the US (up from third last year), with an impressive 10-year annualised return of 18.2 percent. The entire top ten posted a ten-year return of more than 14 percent.

But perhaps the more interesting finding is that for these pensions, private equity has been by some distance their best-performing asset class over the last decade. The median return was 12.3 percent – compared to 7.9 percent for public equities (real estate returned 7.4 percent, and fixed income 5.6 percent). In real terms, that means that the median $1 invested into private equity returned $3.2, while the median $1 invested into public equities returned $2.1. In fact, says the PEGCC, the 25th percentile of private equity returns (i.e. the top end of the worst-performing quartile) was still almost three percentage points ahead of the bottom end of the best-performing public equities quartile.

There are a couple of interesting implications here. First, it makes it very clear why private equity is still hugely attractive to US pensions (and other big investors). That's going to be particularly true at a time when the public markets are volatile.

And second, it implies that those pension plans which have recently been disposing off their hedge fund portfolios – citing complexity and cost – are unlikely to ditch private equity next. Take CalPERS, which doesn't make the top ten of this year’s performance ranking but has the biggest private equity allocation of any of these pensions, at $32.3 billion. How is it going to hit its benchmark return of 7.5 percent consistently without the kind of performance private equity can provide? As its private equity chief Real Desrochers told us last year, the asset class is “the alpha provider for the whole system”.

Judging by these PEGCC numbers, that’s going to be the case for a lot of other public pensions too. At a time when the investment of public money in these 'expensive' asset classes is under unprecedented scrutiny, that should give critics some food for thought.