Private equity portfolios outperform listed shares to enhance pension fund returnS

Tamas Kulcsar, Head of Manager Research at Novare Actuaries & Consultants

Because private equity portfolios have the potential to outperform listed shares, larger pension funds should consider this avenue with a view to achieving higher investment returns for members. Tamas Kulcsar, Head of Manager Research at Novare Actuar

From a pure returns perspective, the Riscura SA Private Equity Survey showed an internal rate of return of 21.7% a year for a pool of private equity funds, compared with the annual 16.5% total return of the All Share Index over the 10 years to 30 September 2011.

Regulation 28 of the Pension Funds Act considers private equity an alternative investment alongside commodities, unlisted bonds and hedge funds. Pension fund exposure to private equity is limited to 10%, while combined exposure to private equity and hedge funds is limited to 15%.

Private equity investments, or investments in unlisted companies, usually serve the purpose of providing seed capital, development capital for expansion, or buyout funding. Financing the various stages of the life cycle of a company carries different levels of risk, with the provision of seed capital representing the highest risk due to the unproven track record of start-up enterprises.

Kulcsar said: “Before investing in private equity, trustees need to consider some important factors. The first is diversification. Unlike other alternative investments that have a low correlation to equity markets, private equity investments have a higher correlation to listed equity. So the main reason to invest would not be to reduce risk, but to achieve a potentially higher return.

“Private equity investments have a greater return potential than their listed counterparts due largely to higher levels of debt (leverage), the ability to follow longer-term strategies, better alignment of the interests of management and owners, and improved activism where owners can more easily influence company strategy.”

On the other hand, with private equity funds returns in the early stages can be poor, improving slowly as commitments are invested and companies start generating profits. While some funds generate returns early, it may take three to five years before private equity investors experience positive returns and net cash-flows.

According to Kulcsar: “In terms of liquidity and cash flow management, private equity investments are long-term and investors are usually tied in for periods of seven to 12 years. Cash flow management is also more difficult than with public investing and, turning to costs, private equity investments attract higher fees due to the hands-on involvement of management. A typical fee is 2% a year plus 20% for outperforming a specified hurdle.”

Pension funds can access private equity investments through a variety of vehicles with different fee structures. Direct investing requires a high degree of oversight and is reasonably expensive, but is cheaper than a fund of funds, which charges an additional management fee but makes the investment decision and monitoring far simpler.

Limited partnerships are the most popular approach internationally and involve a company raising an initial capital amount by issuing debentures or preference shares to investors. The capital is used to buy into a number of companies in different stages of the business cycle.

“Private equity investments have the potential for attractive returns for pension fund investors but the unique characteristics, risks and limitations of the asset class need to be understood by trustees. This requires in-depth industry knowledge, track record analysis and an understanding of available private equity vehicles. Once the groundwork has been done, patience is required to fully benefit from this alternative asset class,” said Kulcsar.