As overseers of large, complex pools of capital, board members already have their work cut out for them. But following an excruciating three-year period marked by equity price swoons, corporate scandals and money-manager malfeasance, boards of directors are scrambling to reassess investment policies and allocations – or at least the good ones are.
Some boards have more scrambling to do than others, particularly with regard to private equity. Many in the US alternatives industry view foundations, endowments and corporations as typically having the more sophisticated boards among institutional investors. Not only have many of these institutions been active in private equity for decades, their board members often come from financial or business backgrounds, giving them the wherewithal and experience to adapt to changing economic environments and shrewdly embrace (or shun) new investment opportunities.
On the other end of the perceived sophistication spectrum are public pensions, whose boards – while differing greatly from plan to plan – are deemed by many in the private equity industry to, quite frankly, not know enough about private equity.
The relationship between the pension boards and the providers of private equity funds and services is made more complex by an added layer in the form of the pension investment staff members. These professionals are often among the most knowledgeable and canny participants in the private equity market. They are also underpaid. Sadly for the public pensioners of America, the expertise, judgment and connections of the investment staff often far surpasses their ability to educate and persuade in the boardroom.
One private equity investment professional at a large state pension, who asked to speak off the record, notes that he is, on balance, lucky that his board doesn't get overly involved in the private equity activities of the pension.
But he also says that it is nevertheless more than a little disconcerting to manage a private equity program that the board members can neither fully appreciate nor understand. “Most of the board members don't even have general financial backgrounds, let alone private equity backgrounds,” the staff professional says. “I have no problem answering any questions that the board has, but I don't think they always understand the question they're asking or the answer they get. You'd really like to go in and get into some meaty discussion about what is occurring and why, but you end up not doing that.”
Pension funds set themselves up to be losers when they have a board full of laypeople
Where board approval is required for all investments, an under-informed board can be a major source of frustration to pension staff and private equity fund managers. Private equity GPs and their placement agents know well the long waits that board approval often implies, which can delay fund closings. From a staff perspective, board-related delays can mean missing the opportunity to commit to a top-tier, oversubscribed fund.
What kind of return?
Where some pension boards may be less sophisticated with regard to the finer points of private equity investing, they often posses keen political instincts – another frequent complaint from the private equity professionals who deal with boards. Pension board members are accountable to the pensioners, but the decisions they make are not always focused purely on investment return. For example, some private equity professionals see the recent crop of state-sponsored investment programs targeting business owned by ethnic minorities, women, or businesses located in rural or poor areas, to be political concessions made to pension board members. These investment programs are always described as seeking strong investment returns, but they also are designed to pay political dividends to board members who want to be seen as ushering funds toward underrepresented demographics.
As the boards have struggled with declining values, there is an increased focus on alternatives and whether or not that asset class can help them out
A former placement agent, who made many presentations to pension boards while fundraising, says the preference for mixing of “social returns” with investment returns never played to his or his clients' strengths. “The boards on some of these larger state funds tend to be myopically focused on political manifestations,” he says. “It's amazing – I would hear things like, ‘what impact will this have on the Hispanic community?’ I mean, hello?”
Clearly, a board that does not understand the private equity asset class can be a hindrance to good performance, but also will likely fail in its duty to detect and root out a problem in a pension's alternatives portfolio. It's safe to say that there have been many problems of late in pension portfolios, and board members, with a burst of fiduciary and/or political fervor, now are reassessing every asset class in their plans. “They know they're being held accountable,” says a private equity consultant.
The consultant notes that pension board members are showing an “increased level of interest” in private equity for two reasons. First, to the extent that they perceive their private equity portfolios are in a mess, they want to tidy up. Second, the consultant says, “As the boards have struggled with declining values, there is an increased focus on alternatives and whether or not that asset class can help them out.”
In other words, despite much-publicised deal disasters in private equity funds, the asset class remains one that investors think may help juice returns – a crucial consideration in a market where many pension funds are in danger of becoming underfunded.
The dreaded J-curve
A recent study seems to back up the assertion that institutional investors see private equity as a form of salvation. According to a survey released by Goldman Sachs International and Russell Investment Group, North American institutions plan to increase their allocations to private equity to 8.1 per cent in 2005 from the current 7.5 per cent. The average North American institution surveyed assumed a 12 per cent return from private equity by 2005. The survey also found that private equity has been the best-performing asset class in institutional portfolios.
Many public pension board members are aware that private equity may help them meet future liabilities, but they are struggling to understand how. The private equity consultant says that he now frequently gets calls from pension board members who “know nothing about it. They wake up and don't realise they're in a J-curve.”
Members are actually coming to our office on due diligence visits. This has never happened before
Steven Hart, a private investment veteran who recently stepped down as the chairman of the Connecticut State Treasury's investment advisory council, says: “The general message put out there by consultants is that there's not going to be a lot of return from more liquid assets. If you're looking for extra alpha, consultants are pointing toward private equity and hedge funds.”
Board members do due diligence
Anecdotally, the consultant source claims that there is currently an ‘unbelievable’ amount of searches being conducted by public pensions for private equity consultants and program managers. He says that most of the searches are from institutions seeking to change their private equity managers, rather than significantly increase exposure to the asset class. More importantly, the board members themselves appear to be more personally involved in the search process now. Whereas typically, board members are forced to hear presentations from a ‘blur’ of competing potential private equity consultants over a several-day ‘beauty contest’, the consultant source says, now the board appears to be paying much closer attention. “The boards are being more proactive in the process,” he says. “Members are actually coming to our office on due diligence visits. This has never happened before.”
As board members now seek to educate themselves about private equity, the usual stumbling block emerges – lack of liquidity. Another private equity consultant to institutions says the question he hears most from boards is: “We're in this private equity thing for 10 years?” Another question is: “Can we get out?”
With regard to the ever-present potential conflict between sound politics and sound investing, some pensions are exploring ways to minimise even the appearance of impropriety. Connecticut's Hart notes that prior to his stepping down as chairman of the state's investment advisory council, the treasury formalised procedures for how the board is to interact with its own investment staff and with fund managers. “We want to discourage someone on the investment advisory council from lobbying on behalf of a manager,” Hart says. “You want to see your staff pick the best manager, and to the extent that you have familiarity with the industry, you can help make introductions, but you can't cross the line in becoming an advocate.”
The source on the investment staff of a public pension says much more will need to change in the pension industry before these large pools of capital move toward true sophistication in private equity. “Pension funds don't have the resources,” he says. “And they set themselves up to be losers when they have a board full of laypeople.”