Protection vs returns

Could the increasing focus on protection of capital actually undermine the risk/return proposition that has been the bedrock of the industry’s growth?

At PEI's CFO & COO Seminar in Hong Kong this week, several delegates talked about how the big private equity GPs are increasingly focused on protecting investors' capital, rather than absolute returns.

As one put it: “I think there [has been] a shift. Returns are obviously important, but I think protection [has] become priority number one, especially because of the compliance and regulation [requirements] and also simply because of the difficulty of [pricing]. So I think priority number one is to convince our investors that we will be a safe house.”

This is not entirely surprising, in light of some of the structural changes since the crisis. “Since the issues of 2008, the legislation that has come into play has been focused on protection of investors and it does not consider returns,” Greg Lapham, a managing director at BlackRock Asset Management, pointed out. “So it is getting harder to maintain returns as your costs are going up.”

This risk-averse mentality is already evident in the fundraising market. One placement agent recently emphasised to us the current importance of a firm having 'no zeroes' in its portfolio when it hits the fundraising trail (i.e. no complete write-offs). This helps to persuade LPs that the manager can be trusted with their money, he said.

It's difficult to criticise firms for working hard to preserve investor capital. But the danger is that this conservatism goes too far, and ends up destroying some of the reasons why LPs like private equity in the first place.

Take US public pensions. According to a Private Equity Growth Capital Council study published this week, private equity has generated a median 10-year annualised return of 10 percent for systems that commit more than $1 billion to the asset class. That means it has outperformed all other asset classes, including real estate (6.8 percent), fixed income (6.7 percent) and public equities (5.8 percent).

“Time and again, private equity has proven that it's the single best asset class for public pensions, by delivering superior returns over long time horizons,” said Steve Judge, the PEGCC’s president and CEO.

In an exclusive interview in the latest issue of Private Equity International, CalPERS' head of private equity Réal Desrochers tells us that he was asked on arrival at the system (in mid-2011) to assess what private equity's role should be for the giant pension scheme. His conclusion? “Private equity should be producing 300 basis points above equities. That’s its role. It’s the alpha provider for the whole system.”

In other words: CalPERS relies heavily on private equity to produce the sort of returns that allow it to hit its overall return target. The fund currently has an allocation of 14 percent to the asset class (above the market average for these big pensions of 10.3 percent). But it’s been finding it hard to maintain this allocation as public equity markets have risen, boosting the value of its overall portfolio: currently the allocation is below 13 percent, and given its big drop-off in commitments after the financial crisis, it’s hard to see that trend reversing.

For CalPERS, this is a worrying problem. As research chief Sarah Corr puts it: “If you think about the dynamics of what happens as distributions come off those 2006/7/8 funds, and there are no contributions to replace them because we made so few commitments in 2009/10/11, staying at 14 percent will become increasingly difficult. Impossible, in fact. And if you think about the entire portfolio, the danger is that if private equity falls too far below where it is now, it will make it very hard for the portfolio to meet its overall return [target].”

In short: institutional investors, particularly public pensions, need private equity to deliver outsized returns in order to meet their liabilities/expectations. Protecting capital is one thing: but if it diminishes GPs’ risk appetite to the extent that these outsized returns become impossible, it’s going to make it harder for private equity to justify its existence in the portfolio – especially since it’s relatively less liquid and transparent than most of the other options open to investors.