Danger ahead? LPs push pace of commitments

“Some of our peers have had a lot of volatility in commitment pacing. They tend to pile it into the top (of the market), so they’re too heady when everyone’s raising capital,” said one Oregon Investment Council staffer in a recording of its Feb. 4 meeting.

While it’s too early to call 2015 the top of the market, several pensions are preparing to outlay more to private equity this year to keep up with their target allocations. In February, the Massachusetts Pension Reserves Investment Management Board (PRIM) released an investment plan that calls for up to $1.7 billion of commitments, 30 percent more than last year’s total.

PRIM’s allocation to private equity fell over the previous three years as distributions outpaced capital calls and soaring equity valuations created a “denominator effect.” (As its public equity portfolio’s value grew, private equity’s share of the PRIM allocation fell.) PRIM, a $60.6 billion pension that committed $1.3 billion to private equity in 2014, needs to commit more to “to replace older funds,” according to a copy of the plan made available to Buyouts.

PRIM is not alone. Other LPs that are well below their target allocations to private equity plan to push the tempo this year. The Los Angeles County Employees Retirement Association recently approved an investment plan that calls for $2 billion of commitments this year, almost double the $1.1 billion it committed in 2014. In September, an official at the New Mexico Educational Retirement Board told Buyouts it would increase annual commitments by more than a third to accommodate a 3 percentage point hike to its private equity allocation. Meanwhile, the $2.1 billion San Jose Federated City Retirement System has plans to invest in the asset class for the first time since 2011.

LPs want to maintain allocations and, with more money coming in to LPs than they are putting into their capital calls, many have money to spend. However, some are concerned the deal market will not support the returns those same LPs expect from the asset class.

Cheap debt and an already massive pool of dry powder propelled prices for new portfolio companies to pre-crisis-era EBITDA multiples last year, according to data provider Pitchbook. LPs pumping fresh commitments into this sort of market could drive up prices even more if GPs choose to invest in the high-priced environment instead of exercising caution.

Commitments from major pension funds like the California State Teachers’ Retirement System and Connecticut Retirement Plans and Trust Funds (among many others) spiked prior to the Financial Crisis, fueling record-setting fundraises. Many GPs invested those funds in an expensive deal market, paying high prices for heavily levered companies that were ill-prepared to withstand the economic downturn. Fund returns suffered, with 2005-2007 vintage funds generating the three lowest median IRRs of the last decade, according to Buyouts data.

The current climate feels similar to the pre-crisis era, sources said. Buyouts data suggests 2014 was the best year for U.S. fundraising since the Financial Crisis, with limited partners injecting more than $200 billion into new funds. PitchBook recently reported that 89 percent of fund managers hit their fund targets last year, up from 80 percent the prior year.

“This is a time in the market where everybody’s cautious,” one LP told Buyouts. “Guys like me, where we’ve got longer-term relationships, we’ve got our spots in (oversubscribed) funds.” But some LPs that are new to buyouts may “feel like they have to push all this money out the door, (and) those guys are likely to do dumb things,” the veteran LP said.

Slave to allocation

Public pensions construct their asset allocations to ensure adequate funding for their beneficiaries. That is a struggle for many retirement systems, and some are willing to commit to inferior managers to meet the requirements of their asset allocation model, one LP consultant told Buyouts. 

If a consultant tells a trustee on a public pension board that the pension needs to allocate more to buyouts, it is hard for the trustee to not go along with whatever is advised, the LP consultant said, adding: “Be disciplined, don’t succumb to the temptation of putting more capital out.”

John Haggerty of Meketa Investment Group said LPs who commit more to 2015 funds as a means of keeping their allocations in line will expose themselves to a riskier marketplace.

Most LPs “work with pacing studies that spread out commitments over time – to achieve critical vintage year diversification,” he wrote in an email. ”In other words, LPs will not necessarily look to address the shortfall to target only in 2015, but will rather increase the pace of commitment over the next few years.”

Those pacing studies will fluctuate, depending on distributions and equity market valuations. Some LPs are careful not to become slaves to their allocation model.

Indeed, Los Angeles County’s investment plan states that, despite a bigger $2 billion commitment pace, investment staff will “not dilute the quality of general partner relationships” by committing to sub-par managers, even if it means missing its planned allocation, according to an investment report. To that point, the $1.1 billion that Los Angeles County committed last year was well off the $1.8 billion pace its board approved at the start of the year.

PRIM, similarly, has not been afraid to miss its planned allocation target. While the retirement system came close to hitting the $1.4 billion it expected to invest in private equity last year, it committed just $200 million to private debt, considerably less than the $700 million it had allocated.

Maintaining vigilance in manager selection will be key, even as allocations dip below their targets.

“There’s never a mandate to meet that level if there aren’t quality opportunities out there,” said one public pension LP. If anything, it is better for an LP to “undershoot” its allocation rather than commit to sub-par managers, the LP said. “If the quality is not there, the capital isn’t committed.”