Oregon prepares to live with PE overweight during downturn

Oregon Public Employees Retirement Fund, already over its PE target, should prepare to live with an oversized PE portfolio for a long time if a recession hits soon, according to its CIO.

The Oregon pension has a 21.3 percent allocation to PE, with a 17.5 percent target. Oregon Investment Council recently approved an asset-allocation change that would cut public equity by 5 percent and increase both risk parity and diversifying strategies by 2.5 percent.

While the council did not change its private equity target, one member asked CIO John Skjervem how the state should react if market changes caused the portfolio to drift materially from the strategic targets.

“You have to have the fortitude to recognize that and carry on,” Skjervem said.

In the four years after the 2008 recession, Oregon was 10 percentage points overweight to private equity and 10 points underweight to public equity, due simply to the illiquid nature of PE assets.

The investment staff was comfortable with that balance and the investment council should expect a similar response in the event of another recession, Skjervem said.

“The council would need to persevere over months, quarters or perhaps years, with a headline of 25, 30 percent private equity just because of the denominator effect,” Skjervem said. “To force a rebalance in that environment would be the worst possible thing to do.”

Council also discussed its private equity benchmark and how it should value its PE portfolio, given that portfolio companies are often sold for more than their appraisal value.

Michael Langdon, Oregon’s senior investment officer for PE, said the portfolio, valued at $16.9 billion, may be worth even more than that, since portfolio companies often see a “pop” in value at exit.

“The history is very clear: They’re undervalued when they’re in the portfolio,” Langdon said. “In the whole, we see a pop at exit still to this day of 20-plus percent, and over the past year, it’s been 50 percent.”

The increase in value at exit may result from GP efforts to temper return expectations while holding the investment, or differing methodologies used to value PE holdings, Langdon said. It often reflects real value creation, he said.

Despite the persistence of the exit pop, Langdon recommended against any effort to try to adjust valuations before an exit, since those effects aren’t guaranteed.

“Really great managers can actually create value on the exit, and they shouldn’t get rewarded for that before they actually pull off the execution,” Langdon said.

Langdon also discussed the difficulty in choosing the right benchmark for PE, given the increasing divergence between private markets and public markets.

Oregon’s private equity portfolio used to focus on small-cap value investing, with more leverage than public markets, for which comparisons were easier to find, Langdon said.

Now, with private markets taking up a greater share of the economy, moving into niches that public markets can’t access, and focusing more strongly on value creation, the comparisons aren’t as clear.

“Increasingly, the public markets don’t serve as a great proxy for what’s happening in the private equity markets,” Langdon said.

“We’re really relying on a different governance model to hopefully generate extremely large numbers of excess earnings growth. So how do you proxy that with a public equity benchmark?”

Oregon uses a variety of benchmarks, all imperfect, and judges its success based on a public markets benchmark plus 300 basis points. Council made no change to its benchmarks after the discussion.

Action Item: Oregon’s latest investment return and asset allocation report: https://bit.ly/2XZ5FIV