US public pensions have come in for a lot of criticism lately about their exposure to alternatives.In this column last month, for example, we looked at how the North Carolina Retirement System had come under attack from the State Employees Association of North Carolina (SEANC), which claimed that the system was paying too much in fees to hedge funds and private equity firms given the sort of performance it was extracting from them. In September, SEANC called on NCRS to divest its hedge fund holdings altogether – just as the California Public Employees Retirement System did recently – and start being more transparent about the value for money it gets from alternatives.
Meanwhile over in New Jersey, where rumoured future potential Presidential candidate (and friend of Wall Street) Chris Christie is currently governor, there has been a lot of coverage (initially led by online outlet Pando Daily) attacking the amount of money the pension system there is spending on alternatives.
The argument for pension funds paying sizeable fees to alternatives managers is that it enables them to tap into the sort of outsized returns they can’t get from the public markets. The trouble is that in some cases – New Jersey being one of them – that hasn’t happened. According to the system’s most recent results (which are online in great detail for all to see), for the year ending July 31 2014, its alternatives portfolio delivered a 14.21 percent return, while its domestic equities portfolio, by way of comparison, returned 16.99 percent (international equities returned 14.57 percent). The cost of this shortfall – in terms of fees paid and returns missed – amounts to about $5 billion, according to some estimates.
Another example is Rhode Island, where the Democrat State Treasurer is Gina Raimondo, a former venture capitalist (she co-founded Port Judith Capital). Again, she’s increased the system’s exposure to alternatives; again, this has coincided with its returns starting to trail the median for US pension systems.
The narrative of critics, therefore, is that the likes of Christie and Raimondo are funnelling a ton of pensioners’ money back to their chums on Wall Street in fees, only for them to deliver lower returns than an index-linked tracker fund would have done – thus leaving the pensions with an even bigger shortfall as they look to meet their ballooning liabilities. (The more swivel-eyed of critics also like to claim that this is all just a conspiracy to ensure that the campaign contributions keep coming in – which in turn encourages bigger allocations and more fees, which leads to more contributions, and so on.)
So where does this leave private equity? It’s true that in recent months, much of the opprobrium has been directed at hedge funds, as per North Carolina. But in practice, the critics don’t always bother differentiating between the various types of alternatives. If a system like CalPERS chooses to get rid of its hedge fund investments because they’re too costly and too complex, shouldn’t private equity – which is also costly and complex – be next in the firing line?
Perhaps the best antidote to this kind of thinking can be found in the latest performance figures from the Private Equity Growth Capital Council, which carries out an annual analysis (based on publicly disclosed data) of the private equity returns generated by US public pensions over the preceding ten-year period.
Its headline finding was that the top-ranked US pension, the Teacher Retirement System of Texas (up from third last year), enjoyed an impressive 10-year annualised return of 18.2 percent, while the entire top ten posted a ten-year return of more than 14 percent.
What’s more, 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, 7.4 percent for real estate, and 5.6 percent for fixed income. In fact, according to the PEGCC, the 25th centile of private equity returns (i.e. the top end of the bottom quartile) was still almost three percentage points ahead of the 75th centile of public equities returns (i.e. the bottom end of the top quartile).
With numbers like these, it’s no wonder that US pensions still love private equity – especially at a time when they’re struggling to make enough money to cover their liabilities, and especially when the public markets are so volatile. Take CalPERS, which doesn’t make the top ten of this year’s ranking but has the biggest private equity allocation of all, at $32.3 billion. How is it going to hit its benchmark return of 7.5 percent consistently without the kind of outperformance 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”.
Even within that ‘under-performing’ New Jersey portfolio, it’s worth noting that its private equity investments returned 23.70 percent last year – suggesting that if anything its problem was too little private equity, not too much.
Of course, it goes without saying that there’s a huge dispersion of returns within private equity. So the systems who aren’t so good at manager selection may still end up lagging the public markets, making the fees harder to justify. But as long as private equity is continuing to deliver for most – and these numbers suggest that it is – it’s perfectly rational and sensible for every public pension in the US to want more of it. ?