Despite the arrival of spring, there’s a dark cloud hovering over private equity firms that receive commitments from state pension funds. While upcoming changes to the Florida Retirement System could possibly give the group less to invest in alternative assets when they take effect next year, they also mark the start of a slow, steady and potentially damaging storm.
Last May, the Florida State Legislature passed HB 2393, which gives current employees of state agencies the option of transferring their money from a defined benefit plan to a defined contribution plan – two programs that might not seem so drastically different to pension participants, but when looked at more closely, present quite a conundrum for GPs – the new plan does not invest in private equity.
“We’re all of a sudden going from a large institutional product to a retail product, and just as private equity is not available for investors in 401(k) plans or mutual fund-type investments, there is no real fit for the defined contribution-type program,” says Frank Fernandez, senior portfolio manager for the Florida State Board of Administration. “This means any dollars siphoned into that plan are going to have a negative impact on private equity going forward until someone figures out the regulatory and liquidity issues at hand.”
Surprisingly, however, many GPs across the U.S. that were contacted for this article were completely unaware of the changes taking place in Florida and what they could eventually mean to the private equity world. The fact is, the changes mean a lot, and GPs are bound to take notice sooner or later.
The Florida Retirement System saw a surplus of more than $9 billion in the last few years – a fact that told the Legislature the system needed to be enhanced. The 2000 Legislature debated two options: increasing benefits and reducing contributions in the current defined benefit system, or adding an optional defined contribution plan. The group chose the latter option.
Presently, Florida’s pension, like many state pensions, uses the defined benefit plan, which is a contract between an employee and his or her employer that entitles the employee to a certain level of retirement income based upon earnings and length of service, as determined by the employer in the plan provisions. This plan gives pensioners no say in how the money is invested, but guarantees a certain retirement income.
Historically, pensioners accepted this plan as their only option. However, the 2000 Florida Legislature voted to give pensioners a choice of plans in an effort called the Public Employee Optional Retirement Program (PEORP). This program allows employees to choose between the current plan and the newly established defined contribution plan, which puts investing more in the hands of the pensioners themselves.
In a defined contribution retirement plan, the employee retirement benefit amount is variable and not pre-determined, with the employers’ cost being known because it is a percentage of the covered employees’ earnings. This puts no risk on the employer since there is no stated benefit amount. While the employees’ retirement income still depends on length of employment and earnings, investment return becomes more important in the total benefit. It is this point – the added significance of investment returns – that keeps defined contribution plans from investing in private equity and other illiquid assets because they are, well, illiquid.
The nature of the defined benefit plan meshes well with private equity investments because of the incredibly large pool of capital that has a long-term liability stream. Moving into a defined contribution program complicates the issue.
Members of Florida’s State Board of Administration estimate that approximately 40% to 50% of pension participants will transfer to the PEORP. That means about $13 billion would flow out of the $108 billion Florida Retirement System during 2002 and into funds managed by financial institutions like Fidelity Investments, Morgan Stanley, Aetna, Prudential Life Insurance Co. and Variable Annuity Life Insurance Co. Not surprisingly, it was those groups that lobbied the Florida State Legislature to make changes to Florida’s plan since they stand to gain business with the switch.
However, the institutions did not come up with the idea of changing Florida’s system on their own. The issue came to the forefront as Florida’s government became one filled with Republicans over the past few years. The Florida law that changes the retirement system was originally introduced by members of the American Legislative Exchange Council (ALEC), a group that partners with corporations and drafts model legislation. ALEC proposed the new law in hopes that if it is successful in Florida, with its large population and somewhat outdated pension system, the new plan will be copied by other pensions in different states and, eventually, the Social Security System.
Of course, if this happens, then it will be time for GPs to worry. But until then, many are keeping their cool – or at least they say they are.
This quite possibly is because even if Florida’s defined benefit pension sees a decrease in its funds, there aren’t a whole lot of firms that will immediately be affected. First of all, Fernandez says in order to continue the program’s “steady state,” the allocation to alternatives would probably be increased, maybe even to 6% from its current 3%. Issues such as this, however, will be addressed by the board of trustees over the next few years as the new plan is implemented, he adds.
Secondly, when it comes to changes in Florida’s pension’s alternative asset allocation, only one private equity group will feel the initial rift. Liberty Partners, based out of New York, is the sole recipient of any funds Florida’s pension wants to contribute to private equity vehicles. Steve Fisher, a Liberty Partners managing director, declined comment.
GPs will probably start to take notice that their worlds might be turned upside down when a second state decides to make changes to its pension plan. Virginia and Texas reportedly will be the next states to take action, although President George W. Bush tried and failed to convert Texas’s pension funds to defined contribution plans while he was governor. Two placement agents confirmed the potential upcoming changes in Texas and Virginia as rumors, but declined to be identified, saying they aren’t 100% confident in the truthfulness of the information.
In the meantime, at least one group is experimenting with a product that would allow retail investors to buy interests in its private equity funds. The Carlyle Group is in talks with Fidelity to develop a joint product that would be listed alongside other investment products on a defined contribution options form.
One GP says, “More power to Carlyle on this. If anybody can figure this out, it’s them.”
The questions are, though, how likely is it that investors will choose a private equity product with a long lock-up period? And, unlike institutions that can come up with $20 million on the spot when funds are ready to draw down capital, how is a retail investor going to contribute money?
“These are the things people are going to have to overcome in order to tap into this very large pool of capital,” concludes Fernandez.