Headier times

US pensions may be increasing their allocations to private equity. But the current row over fund expenses shows they’re also keeping GPs on a tighter leash.

This week, the California State Teachers’ Retirement System, the largest teachers' retirement fund in the United States, announced it was upping its target private equity allocation from 12 percent to 13 percent.

This should come as welcome news to the private equity industry, especially those general partners who’ve been slogging away to raise fresh capital for months or even years on end. After all, it’s not every day that a $170 billion pension fund decides to invest more of its money in private equity.

And CalSTRS is not the only one. The average allocation to private equity among US public pension plans rose from 7.5 percent in January 2012 to 8.3 percent this January, according to a study released this week by fund administrator SEI. The increase was even more significant for large pensions with $5 billion or more in assets, where the average allocation rose to 9.7 percent. 

Generally speaking, however, SEI study’s findings – which are based on a survey of 654 institutional investors, fund managers and consultants – did not paint a very rosy picture of the global private equity market. It pointed out that many GPs are struggling to exit portfolio companies “purchased during headier times”, and that some firms are in danger of going out of business if they fail to raise successor funds. 

SEI even highlights the downside of more money coming into private equity at a time when dealflow is weak: the accumulation of dry powder (it pegs this at $1 trillion), which, it argues, is “leading to more competitive bidding situations, raising the price expectations of sellers, and making fundraising more difficult”. Ultimately, that’s likely to reduce returns for investors.

Nonetheless, the fact remains: pensions still love buyouts, in part because they have no better options. As CalPERS’s Joe Dear told us on the sidelines of the Milken Institute’s annual Global Conference in Los Angeles in May: “It’s necessary to achieve our return objectives”.

But although many of these big LPs are eager to ramp up their private equity investment, and hand over more money to GPs, it doesn’t mean they’re willing to let managers get away with some of the excesses of the boom years. 

One row that seems to be gathering pace in the industry at the moment is over fund expenses. LPs are becoming increasingly vocal about some of the costs being billed back as expenses – which according to one US-based fund formation lawyer, can even include things like first-class travel as standard, or even private planes.

Many of these practices are long-established. One investor told us recently that some GPs have been able to bury costs and expenses in financial statements without disclosing each individual charge – so rather than having to fill out an itemised expense report like most people, GPs have enjoyed relative freedom to determine what counts as a cost of doing business and what can be charged to the fund. Now more and more LPs are balking at this sort of behaviour.

It's not 2007 anymore. Pension funds may not have lost their appetite for private equity; indeed in some cases appetite is increasing. But the days of LPs allowing managers to jet around the world at their expense are long gone. GPs who want to get their hands on some of this extra capital would do well to take note.