The dangers of a dissenting voice

Add this to the many risks private equity firms face today: public pension board members, arguably less schooled than they might be in the intricacies of the asset class, determining that alternatives are not a good idea and abandoning the strategy.

If it sounds far-fetched, heed an example taken from the minutes of a May meeting of the $63 billion New Jersey State Investment Council.

At the gathering held 21 May 2009, William Clark, director of the pension's division of investments, reported that New Jersey's private equity holdings had declined by about 16 percent. He said the write-downs were expected “knowing that private equity performance is volatile by nature”.

After Clark's report, James Marketti, a member of the pension board appointed by the state's governor from a list of AFL-CIO labour union nominees, asked about the logistics of reneging on existing private equity commitments. Clark answered that the pension “could be charged interest and could see their value of the fund lowered”, according to the minutes.

Clark continued: “Distributions come when income is earned; investments are made over three to four years from the time of the commitment as investment opportunities are identified via ‘capital calls’ issued by the fund for each investor's pro-rata share of the investment”.

Marketti then threw down the gauntlet, asking if it were possible for the pension to “unwind alternative investments” and whether investment staff were inclined to take that kind of action.

A bit of context is required here. The pension did indeed pull back from alternatives after the collapse of Lehman Brothers in September last year, choosing not to finalise a number of proposed commitments to GPs. Rescinded commitments included $50 million to UK buyout house Charterhouse Capital Partners and $150 million to Morgan Stanley Real Estate Fund VII Global.

New Jersey also approached existing GPs and requested they drop their fund size “in the belief they were unlikely to invest all they had initially targeted because of changes in market conditions”. Clark said several of the funds had responded favourably, the minutes said. The pension declined to name the funds in question, but several firms, including TPG and Permira, have made such a concession to investors.

To return to the meeting: Clark warned Marketti that “pulling out of existing alternative commitments would incur penalties”.

At one point, the council's chairman, Orin Kramer, chimed in that exiting alternatives completely would make New Jersey “anachronistic against other pension funds, and would mark a retreat from diversification, resulting in higher risk”. Marketti presented the council with – as it were – an alternative to alternatives, saying that other ways to diversify include a shift to Build America Bonds. The bonds, part of the Obama administration's federal stimulus package, offer a 35 percent federal interest rate subsidy and a lower-cost way for state and local governments to fund infrastructure projects.

Marketti has sat on the pension board since September 2008. He readily admits that he is “not an investment professional”, according to testimony before the state Senate Budget and Appropriations committee last year at a special meeting to examine three hedge fund investments the pension made.

He stated during testimony that he is opposed to the pension's alternative investment programme and has objected to several private equity investments in the past.

“My opposition is based on my belief that the alternative investments have not shown by actual results that they will add positive value to the pension portfolio. The hedge fund portfolio, for example, has lost 14.3 percent of initial investments since its inception in 2006 – more than $500 million,” Marketti said.

Alternatives make up 18 percent of the portfolio and about $150 million has been paid in fees to managers since the programme's inception in 2005, he said. “I firmly believe that the alternative programme has gone too far too fast, has had meager results but at great expense,” Marketti said.

In New Jersey, Marketti may be a lone voice of dissent against private equity investing, but as losses in portfolios pile up, the Markettis of the world might start sounding more reasonable to people once convinced of the benefits of alternatives.

Private equity firms have an essential task in educating members of pension boards on the intricacies of the asset class, the long-term nature of investments and the patience needed to withstand financial storms. Failing this, voices like Marketti's might fill the silence.