Why some LPs swim against the private equity tide

Many LPs upped their PE allocations in 2020, but there were some notable exceptions, too.

As the coronavirus crisis burned through the economy this year, many limited partners have tried to keep steadily committing capital to private equity, which often shows strong returns after major economic disruptions.

As 2020 passed by, the LPs that announced increases to their private equity or private debt allocations in some form included California State Teachers’ Retirement System, Texas County and District Retirement System, State of Wisconsin Investment Board, Harvard Management Company, Los Angeles Fire & Police Pension System and New Jersey Division of Investment. Other LPs have pledged to maintain their commitment pace, namely Los Angeles County Employees Retirement Association, as Buyouts reported.

But some pensions have chosen to go the other way. Pennsylvania Public School Employees’ Retirement System, which pumped as much as $3 billion a year into the asset class in the 2000s, recently decided to cut its allocation and sell older holdings on the secondaries market, as Buyouts reported. The reason was its concentration of commitments to some weaker vintage years leading up to the 2008 financial crisis.

“Those have been very challenging vintage years,” said chief investment officer Jim Grossman, as Buyouts reported.

Consultant Aon Hewitt also recommended the decrease, saying it gave PA Schools a better chance of closing its sizable funding gap.

This skepticism about private equity’s ability to provide the kinds of returns that many LPs look to the asset class to provide, and about its high fees and illiquid nature, is not just limited to PA Schools.

San Diego County Employees Retirement Association also reduced its private equity allocation in July, as Buyouts reported, along with an overall reduction in private assets. The reduction of the PE target from 8 percent to 6 percent brought the pension’s PE portfolio closer to its actual allocation at the time, 6.6 percent. As of September 30, the actual allocation to private equity was 4.7 percent.

The $15 billion system has been hesitant to commit to private equity for a few years now, as Buyouts has reported.

In an interview with Buyouts, chief investment officer Stephen Sexauer said he and his staff have nothing against private equity as an asset class, but have adopted stringent standards for whether they will commit. Dubbed the “Underwriting Model,” it requires potential private markets managers to demonstrate exactly how they plan to make their promised returns.

“We need to be able to understand and verbalize for ourselves and our board how we will earn a specific level of return, how much risk we are taking, and what is the theory and evidence that it’s attainable,” he said.

Sexauer expressed skepticism with the way many pension systems do their asset allocations, wherein a consultant sets an asset allocation which the staff must fill. Too many consultants, investment staffs and board members do not take enough care to develop procedures for evaluating return and risk before feeding them into a mathematical model to create an allocation.

“There’s no detailed conversation about how much we will earn and how, where it will come from. We’re just chasing an allocation directed by our board based on a mathematical model [that is] over most people’s heads,” he said.

Sexauer said this was a result of many pensions making high returns during the original boom period of the 1980s and 90s, which was helped along by a score of other economic factors and a greater amount of companies to take private compared to today, but now every pension wants to make those types of returns despite there being many more firms competing for assets.

“We’re prisoners of our own design,” he said.

According to documents from SDCERA’s website, the goal of the Underwriting Model is not to create an asset allocation slot for private equity investments that must be filled, but instead to deliberately choose strong, long-term partners and to have a firm understanding of how much return and risk is in each investment and the specific markets and expected cash flows of each private investment.

According to Buyouts data, its most recent commitments in private equity include Blackstone Capital Partners VII and EQT‘s seventh flagship fund. More recently, it committed to Public Pension Capital, as Buyouts reported.

As of November 30, its private equity assets were valued at $679 million and its real assets at $551 million, Sexauer told Buyouts.

Sexauer stressed he is willing to consider any private equity investment opportunity, as long as he and his staff are able to ascertain where the returns will come from.

“We have a high respect for the determination and the capability of private equity managers, we would just like the incentives to line up, so that we end up investing in firms where we can get the returns and only then do they get their returns,” he said.

As of September 30, SDCERA’s private equity holdings had returned -0.9 percent over one year, 7.5 percent over three years and 9.2 percent over five years, according to a consultant report. Private equity returns are usually lagged a quarter.

Action Items: read more about SDCERA’s Underwriting Model here and check out its 2019-20 CAFR here.