A recent Investment News article promotes the idea that, “for advisers, the addition of private equity opens new doors and poses new challenges.” The idea of opening “new doors” is rooted in the fact that DC assets have been slow to adopt private equity options and, thus, unable to benefit from the type of returns that many of the large endowments such as the Harvard Management Company have achieved. On average, traditional pension plans are more than 8% invested in private equity.
The fact that pension investment best practices tend to be eventually adopted by DC plans would seem to indicate that it is only a matter of time before this asset class becomes more prominent in DC investment lineups, especially in DC asset allocation constructs.
The article focuses on several challenges when placing private equity investments in a DC lineup: liquidity, accounting for quarterly distributions and communicating the risks to participants. Without going into great detail, given the right application of technology, the record keeping issues are all manageable. And participant risk can be mitigated via the inclusion of the private equity in the allocation funds, as opposed to being part of the core menu. Other big questions have to do with historical return and correlation relative to public equities.
The issue of the long-term return of private equities versus public equities is the subject of a 2011 study, “Private Equity in the 21st Century: Cash Flows, Performance and Contract terms from 1984-2010.” The upshot of the study from a return perspective is that, as the study notes, “on average, our sample funds have outperformed the S&P 500 on a net-of-fee basis by about 15%, or about 1.5% per year.” Other studies, such as “Private Equity Performance: What Do We Know?”, a paper published by Robert S. Harris, Tim Jenkinson and Steve N. Kaplan, looks at performance from a different angle — buyout versus VC funds. The authors conclude that, “we find better buyout fund performance than has previously been documented — performance consistently has exceeded that of public markets. Outperformance versus the S&P 500 averages 20% to 27% over a fund’s life and more than 3% annually.” They go on to report that VC funds outperformed public equities in the 1990s but underperformed them in the 2000s. As might be expected VC funds are, by their very nature, more volatile.
As it relates to the issue of how private equity correlates with public equities, it is a mixed bag. Joshua Brown, a New York City-based investment adviser, argued in a recent blog post that private equity has been the greatest beneficiary of quantitative easing. In short, easy money combined with a frothy market bodes well for private equity funds. This would seem to indicate that certain market cycles favor private equities over public ones.
While the author points out that between 1992 and 2012, private equities had a correlation of 0.80 compared with public equities, he believes that, “private equity is correlated as hell when it really counts.” He provides an example, The Blackstone Group, which “lost over a billion dollars in 2008, saw the assets on its books marked down by more than 30% and its stock price decline by 70% — twice as bad as the S&P’s drop and on a par with most other public financial firms.”
This background would seem to indicate that private equity has more potential to boost returns rather than reduce portfolio volatility, when “it really counts.”
As it relates to the plan advisor, the Investment News article says it best: “The emergence of liquid alternatives in investor-friendly structures also provides advisers with an opportunity to differentiate their services and compete with consultants for new DC clients. Advisers who are early adopters of new alternative strategies and products are leveraging their alternatives knowledge into managed DC models and investment options for their clients.”
