Issue: Mar/May 2011
Private equity for pension funds?
Most certainly, argues Sasfin Financial Services chief executive GAVIN CAME, in response to the FSB's revised draft of Regulation 28. Stand by for the wrath of the SRI lobby.
A change is proposed in the percentages that retirement funds may invest in the category of "hedge funds, private equity funds and any other asset not referred to in this schedule". Investments are permitted to a maximum 15% of the value of the fund.
Of this 15% proportion, private equity funds may constitute a maximum of 10%. In turn, a maximum of 2,5% may be invested in a single private equity fund (implying a minimum of four such funds) or 5% in a private equity fund-of-funds.
Providing responses, in regard to private equity and hedge funds, some stakeholders reportedly argued: "In recognising potential diversification, hedging and growth opportunities for a pension fund investor into these products, not to mention the expected broader developmental impact of growing these market segments, regulation should ideally create a platform for their regulated and controlled use."
This highlights a dilemma for trustees in committing pension money to private equity.
The 'social good' argument
It is not appropriate, in my view, for pension fund money to provide "broader developmental impact" and "grow market segments". A fund's investment policy statement must be narrowly confined to the objective of optimising returns of the funds entrusted to the trustees.
It is arguable that, in a defined-benefit arrangement where the employer and not the member takes the investment risk, the employer can pursue a policy of enlightened self interest by investing funds in directions that enhance its market space or help to meet developmental goals. In the case of defined-contribution funds, however, it's the attitude of the ultimate risk taker (the average member) that must be prioritised.
His or her answer almost always will be 'no you may not!'. Wisely, National Treasury has not canvassed this aspect of private equity investing. It has focused exclusively on the investment aspects.
The 'investment merits' argument
Now consider the merits and demerits of private equity, in its own right, as an investment for fund members:
Came . . . investment case
The first challenge is the limit on liquidity, driven by lock-up periods and even simple inability of exiting an unlisted vehicle in adverse market conditions. This makes trustees loathe to invest in private equity on behalf of their members. In truth, however, the nature of a retirement fund – by providing for members over a 10, 20 or even 30-year working lifetime – allows plenty of time for a correctly planned exit from a private equity or series of private equity arrangements.
Arguably, of all the products and services in the financial sector, the time horizons inherent in pension funds are the longest. Nevertheless, an investment in private equity could be problematic where a particular pension fund has a relatively aged membership or has negative cash flows.
The second is the real or perceived difficulty in getting a true or mark-to-market valuation. By definition, since investments underlying a private equity fund are largely unlisted, there is no market allowing for a price to be determined. The argument against this fear is that, especially since the pension fund is invested in a private equity fund, there are a number of parties on all sides of the transactions.
They have an incentive, even an obligation, to agree a single valuation. Also, in 2005 the combined global Private Equity Associations (the IPEV Board) published globally-accepted valuation guidelines which provide significant comfort to all involved in private equity.
The third issue, given the relatively small 10% investment proposed by the draft Reg 28 for private equity, is whether the possible enhancement to performance that a private equity fund investment might bring can be worth the trustees' effort in identifying, assessing and monitoring it. The answer involves analysing the performance of private equity funds relative to other conventional asset classes in SA.
A most authoritative and perhaps only analysis was presented to the 2006 convention of the Actuarial Society of SA. In their paper*, the authors also calculated Sharpe ratios to measure risk-adjusted performance and correlation.
Their finding was that an aggregated portfolio of private equity funds returned 18,0% per annum more than SA equities and 16,8% p.a. more than small-cap equity over the 1992-2005 period studied. The calculated average outperformance of all funds over the same period was 13,1% p.a. and 8,3% p.a. respectively relative to SA equity and small- cap equity.
Turning to risk, the aggregate portfolio produced the second-best Sharpe ratio of 1.2, while the average funds' Sharpe ratio is 2.0. This suggests the second-best risk-adjusted performance in the set of nine considered asset classes.
Finally, they reported that the private equity funds' aggregate portfolio displayed an exceptionally low correlation to the other asset classes. In particular, the correlation of their aggregate portfolio to listed equity and small-cap equity was in the order of 0.1
Assuming that the pension fund invests the full 10% of its assets in private equity, this data reflects a possible yield enhancement of some 1,8% per annum at acceptable risk in relation to equities. Surely, then, trustees should seriously consider an appropriate investment in private equity funds.
* Is private equity a suitable investment for SA pension funds?, a paper presented to the convention of the Actuarial Society of SA in October 2006 by I Missankov, R van Dyk, A van Biljon, M Hayes and W van der Veen.