“Generally speaking, there will be more money coming into private equity from pension funds,” said Kelly DePonte, a partner at Probitas Partners, a placement firm.
According to a recent Buyouts survey, roughly one-third of all private equity capital in the United States was sourced from public pensions, making public pensions the largest source of capital for the industry.
Large, mature private equity investors, such as the Oregon Investment Council, must pledge hundreds of millions of dollars just to maintain their current allocation levels and spread that money out evenly over many vintage years. Oregon, which is over-allocated to private equity (it has a 23.8 percent allocation compared to its 16 percent target), still committed $1.5 billion in 2012 and is expected to commit roughly $2.3 billion to private equity funds in 2013, according to Oregon Investment Council spokesman James Sinks and a recent presentation by its consultant, TorreyCove Capital Partners.
Larry Schloss, the chief investment officer at the New York City Bureau of Asset Management, which oversees five municipal pension funds, told Buyouts in Oct. 2012 that the system planned on committing between $2.5 billion and $3 billion a year to private equity in each of the next three years.
But despite the fact that most pensions with large private equity programs are at or above target allocation levels—no top-10 pension was substantially under-allocated, and only Oregon and the State of Michigan Retirement System were substantially above their median targets—these pensions still are likely to see a rise in the amount of money that they commit to funds in 2013, experts said. That’s because when rising stock markets help pensions grow overall, it frees up money for additional private equity commitments even if target allocation percentages remain the same. Call it the reverse denominator effect.
DePonte cites strong distributions as another reason commitments could rise in 2013. Distributions are often—but not always—plowed back into new private equity funds, but it’s hard to know “just how much of that is recycling,” he said.
A third reason large pensions may have more to invest in 2013 is the expiration of the investment period for 2007-vintage funds. Funds from that year raised $300 billion, more money than funds from any other year, and some of those funds still had ‘dry powder’ left to invest. DePonte says that un-drawn commitments to those funds have expired, meaning that pensions would now be free to reallocate that money to other investments. This, he said, might add a bit to 2013 commitment levels “at the margin.”
Of course, persistent underfunding means that many state pensions, particularly mid-sized plans, have boosted their private equity allocations. “If a pension is only 70 percent funded, what does that imply for the investment program?” asked Keith Ambachtsheer, director of the International Center for Pension Management at Canada’s Rotman School of Management. “Many of them roll the dice and add money to riskier investments,” but few take the opposite view, where they admit “we’re already 30 percent in the hole. Let’s de-risk and not make the hole bigger.”
Just this year, the Maine Public Employees’ Retirement System doubled its private equity allocation to 10 percent, while the New Hampshire Retirement System boosted its alternative portfolio to 15 percent from 10 percent, including 5 percent for private equity, 5 percent for private debt and 2 percent for opportunistic private investments. Last year the state of Georgia passed a law allowing most of its public pensions to invest in alternative investments. Georgia was the last holdout among states that had previously refused to allow its pensions to do so.
Just how will large pensions plans spend their private equity dollars in 2013?
One theme likely to continue is a greater willingness by big pensions to leverage their size and long investment horizons to extract lower fees and better terms. “Fees have to come down if there is any sense of a rational market here,” said Ambachtsheer.
One way that pensions are likely to use their market size in 2013 is with separate managed accounts, where they dedicate substantial sums, often more than $1 billion, to large GPs, such as The Blackstone Group, Apollo Global Management and Kohlberg Kravis Roberts & Co.Often these special, one-client arrangements have sharply lower fees, greater investment flexibility and recycling provisions to extend the investment period if the arrangements work out well for both parties.
Another trend to watch is rising demand for co-investment opportunities, where pensions invest alongside GPs on terms that are far better than they could expect with co-mingled funds. Such arrangements are likely to become more common in 2013 and beyond as big pensions such as the California State Teachers’ Retirement System boost their capabilities to quickly perform due diligence on such investments, allowing them to make decisions within the timeframes that GPs need to close a deal. Other pensions to have made a point of pursuing co-investments include the CalPERS, the Illinois Teachers’ Retirement System and New York State Common Retirement Fund.
“Co-investing is a rational thing to do,” said Ambachtsheer. “But you still need a good decision process to know that co-Investment X is a good deal.”
A third trend to look for in 2013 is the formation of private equity funds with substantially lower fee structures. Two such funds that came to market in 2012, the Alvarez & Marsal Partners Buyout Fund LP and Public Pension Capital LP, had ‘1 and 10’ fee structures for at least major investors, roughly half the fees of funds charging the standard ‘2 and 20’ fee arrangement. Already, Oregon has committed to both funds, while the Minnesota State Board of Investment has invested with Public Pension Capital.
A final trend to look for this year and beyond is the continuing trend of pensions to reduce their private equity relationships. That was the impetus behind two large secondary deals in 2012. The first one was a $1.5 billion sale by CalPERS. Joe Dear, the chief investment officer, told Buyouts in August that the sale helped the pension fund reduce its private equity relationships by 23. Also driving to reduce relationships was the New York City Bureau of Asset Management, which sold off nearly $1 billion in private equity holdings, reducing the system’s private equity relationships to 99 from 108.
Reducing the number of relationships necessarily leads to larger commitments to fewer general partners. But because pensions are making larger commitments of, say, $200 million to $500 million, there are fewer funds able to handle such large amounts without being dominated by just a couple of investors. As such, this trend toward reducing relationships gives a large advantage to larger firms.
Said DePonte: Most big pensions “are committing more to relationships they want to maintain…And they are still in triage mode, deciding who they don’t want to re-up with…”