Top 5 Reasons Why Pension Funds Invest in Private Equity

Pension funds traditionally invest in safe assets
to ensure that retirees get paid in all market conditions.
Why are they investing in the high-risk Private Equity sector?

– By Michael Megarit

In OECD member countries and around the world, pension funds are the financial institutions responsible for collecting pension contributions and paying retirement benefits to retirees. Worldwide, pension funds manage more than $56 trillion in assets.

In theory, a pension fund’s business model is simple: workers contribute to the pension fund during their employment years, the pension fund invests the money in safe financial assets and the workers receive guaranteed income for life when they retire.

The world’s largest pension funds are in fact major investment firms.

In practice, pension fund managers must find a way to invest the contributions in a risk-adjusted way to ensure that current and future retirees receive their retirement benefits.

Thus, a pension fund’s two primary goals are protecting the value of its assets from inflation and generating returns that guarantee the plan’s solvency.

Traditionally, pension funds are invested in safe assets such as fixed-income and income-producing equities. However, in recent years, they have been allocating higher portions of their capital to alternative asset classes such as Private Equity, which is reputed to be a high-risk investment.

Since 1999, global pension funds have nearly quadrupled their alternative assets allocation.

Private Equity investing refers to the act of buying and selling companies that are not listed on the public markets, with the intention of either selling them to other investors or cashing out when said company decides to go public. This is considered high risk because these are usually smaller companies with few revenue streams and plenty of competition. The risk of these companies going bust and losing their investors’ capital is significant.

Given their conservative risk profile, why are pension funds investing workers’ contributions in these seemingly high-risk investments?

In this article, we will present six reasons why pension funds’ decision to invest in Private Equity is not as unreasonable as it sounds.

1. The Death of Bonds

The first reason why pension funds are investing in Private Equity is because bonds have been yielding negative inflation-adjusted returns for over a decade.

From the 1940s to the mid 1980s, US bonds experienced a secular bull market. The peak of this golden age came in the mid to late 1980s, when yields reached a peak of 16%. This was an exceptional situation for fixed income investors, who were able to generate double digit returns with virtually zero risk.

Despite the recent ‘surge’ in yields, the US Treasury’s  10-Year Note is still yielding negative inflation-adjusted returns.

Despite the continued fall in yields during the 1990s and early 2000s, bond yields remained relatively attractive to conservative investors. Indeed, yields hovered around the 5% mark, which managed to net positive inflation-adjusted returns.

This was enough to satisfy most risk-averse investors.

Unfortunately, the 2007-08 financial crisis marked the beginning of a 10+ year US Treasury bear market that resulted in bonds yielding less than 3% for most of the 2010s.

This meant that fixed income investors could barely keep up with the 2% average annual inflation rate over the same period.

Naturally, investors were forced to seek alternative investments that offered better returns. For pension funds in particular, the decrease in yields was particularly worrying because their plans were under tremendous pressure due to increasing longevity of the retirees receiving benefits.

The low bond yields could no longer guarantee the fund’s long-term solvency, and thus forced pension funds to seek alternative investment ideas.

2. Retiree Longevity

The second reason why pension funds are investing in Private Equity is because life expectancies are increasing. This means that retirees are receiving income for longer than expected, which is straining the pension plans.

Longer life expectancies are forcing pension funds to seek greater returns.

How can pension funds remain solvent in this situation?

The first solution is to force the working population to increase their contributions into their public pension plans or push back the age of retirement. Obviously, this is politically sensitive.

The second – arguably more politically acceptable solution – is investing the pension funds’ capital in higher risk assets, with the objective of generating returns that can pay for the benefits.

Generating high returns in a risk-efficient way is not an easy task, so pension managers must identify asset classes that present the most favorable risk-profile.

As it turns out, Private Equity fits that description.

3. Performance

Due to the decline in bond yields and the increase in life expectancies across the developed world, pension funds were effectively forced to invest in riskier assets simply to generate positive inflation-adjusted returns.

While equities were the obvious answer, their volatile nature is not always adapted to pension funds’ search for stable long-term capital appreciation. Further, pension funds manage billions of dollars, so they also need to diversify their holdings.

The top 10 US public pension funds invested in private equity have more than $280 billion invested in the asset class.

Private Equity is an attractive proposition for many reasons.

First, despite its reputation as a high-risk asset class, Private Equity has delivered the best returns of all major asset classes: over the 1980-2019 period, Private Equity generated average annual returns of 15%, compared to the S&P 500’s 10.7% annualized return.

This significant difference in returns – referred to as alpha – explains why pension funds are pouring billions of dollars into Private Equity.

Since 1980, Private Equity is by far the best performing asset class.

Second, Private Equity has consistently outperformed equities over the past four decades. The global Private Equity market has generated substantial alpha compared to the MSCI World Index across all time horizons.

Since 1980, Private Equity’s consistent returns speak for themselves.

So yes, Private Equity is theoretically the riskier asset class, but its historical returns have justified the extra risk.

  1. Best in Class

Before investing in an asset, financial institutions assess how it compares to other investment ideas. When it comes to alternative investments, pension funds evaluate how Private Equity performs compared to Private Debt, Real Estate, Natural Resources, and Infrastructure.

The data reveals that not only is Private Equity the best performing asset class in general, but it is also the best performing alternative asset class available to investors. So, when it comes to high-risk ideas, Private Equity is arguably the ‘safest’ high risk investment.

Private Equity is also the best performing alternative asset class of the past decade

For this reason, pension funds choose Private Equity over other alternative assets because it has historically proven to be the most favorable risk-adjusted investment available.

5. Diversification

The fourth reason why pension funds invest in Private Equity is because it helps them diversify their bond and equity heavy portfolios. In fact, Private Equity provides access to investments and market segments that are not available through public markets.

In addition, the proportion of companies listed in Private Equity funds is rising. As a result, investors who ignore this asset class are sitting out on novel – and ever-increasing – investment opportunities. The reality is that public markets are shrinking due to increasing regulations and tougher requirements; an increasing number of companies are either being taken private (Elon Musk’s recent takeover of Twitter is but one example), choosing to remain private for longer periods of time (companies such as Stripe come to mind) or refusing to go public.

Some of the USA’s largest companies, such as Cargill and Koch Industries, are privately owned.

Thus, investing in Private Equity provides lucrative opportunities that also diversifies and reduces the overall risk of the pension funds’ portfolios.

6. Illiquidity

Finally, the fifth major reason why pension funds invest in Private Equity is because it is a highly illiquid investment that rewards patience. Since pension funds have very long-term investment horizons, illiquid investments such as Private Equity provide excellent time-adjusted rewards.

It is a commonly held view that illiquid investments should be avoided at all costs: who wants to be stuck with an asset they no longer want but can’t sell?

The reality is more nuanced.

First, pension funds manage billions of dollars of assets. Thus, since they have plenty of cash to invest, they need to diversify to reduce their overall risk. Public markets generate great returns over time, but the year-to-year volatility can be extreme.

For this reason, it makes sense to invest in Private Equity that is less sensitive to short term market fluctuations, but also provides very high returns over time.

Second, pension funds can afford to wait 5-10 years for private companies to grow and deliver superior returns. Since most of a pension fund’s capital is allocated to the highly liquid public markets, immediate cash needs are covered. Private Equity is the ‘long play’ of its portfolio that is given time to mature.

Third, as mentioned earlier in this article, successful Private Equity investments generate incomparable returns. For example, both the Illinois State Board of Investment and the West Virginia Investment Management Board generated 19%+ annualized 10-year Private Equity returns from 2011-2021.

The top performing pension funds post the type of returns that rival the world’s best investors.

These types of returns are simply not feasible in the public markets without taking on substantial risk.

The Bottom Line

Pension funds are investing in Private Equity to generate the required returns to ensure their plans’ solvency. Indeed, declining bond yields and increased longevity are exerting tremendous strain on pension funds’ assets.

Further, historical data proves that Private Equity can deliver superior risk-adjusted returns. In fact, Private Equity has been the best-performing asset class over the past few decades, and this trend should continue if private markets continue expanding at the expense of public markets.

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