How do you bring liquidity to an illiquid asset class?
That’s the challenge that private equity managers face as the U.S. pension fund industry shifts away from a defined benefit model and increasingly embraces the defined contribution approach that has gained popularity abroad. Defined benefit pension plans have traditionally been one of the major sources of funding for private equity in the U.S. Private equity accounts for 10 percent of fund allocations for most mature defined benefit plan managers, according to Hartley Rogers, New York–based chairman of Hamilton Lane, an investment management firm that advises institutional investors on private equity allocations. Defined contribution pension schemes, by contrast — which have taken root most forcefully in Australia, Chile, Israel and Sweden — generally allocate only 2 to 3 percent of their assets to private equity.
Defined benefit plans are nearly a decade into what appears to be a terminal decline, driven by funding volatility, increased competition and changes in the workplace. As these plans decrease in size and take on shorter-dated liabilities, the private equity industry has to think more carefully about how it is going to make itself more attractive to defined contribution schemes.
“Private equity, as a higher-yielding, long-term asset class, potentially has a very beneficial role to play in handing more choice to participants in defined contribution plans,” Rogers says.
But this will not be easy. The reason allocations to private equity in defined contribution plans are comparatively low is because of private equity’s illiquidity. The charters of defined contribution schemes often require managers to show beneficiaries, on a daily mark-to-market basis, where their holdings lie; participants also need to have the freedom to make periodic (daily or weekly) investment reallocations between different investment options and buckets. Unless a way can be found to price the underlying companies in private equity portfolios on a daily basis and give pension participants a better source of data through which to make reallocation choices, private equity will arguably struggle to get beyond the 3 percent allocation ceiling it appears to have hit in defined contribution schemes.
“The problem with private equity is that it doesn’t always offer obvious liquidity, unless you take on the vagaries of the secondary market,” Rogers says.
The reason is because private equity is, well, private: Limited partners commit money to a fund, the general partners call on that money when they are ready to make an investment, and the money is returned years later, once the general partners have exited the investment. Everything is furtive, contained and unblemished by public scrutiny. As such, and in contrast to public equities or even other alternative investment vehicles like hedge funds, private equity is “a very difficult market to rely on for people who need daily liquidity,” says Rogers. The goal, as he sees it, should be to “find a way to get more frequent valuations in private equity and offer liquidity based on those valuations.”
Regulators require private equity funds to report valuations of holdings in specific companies in their portfolios every quarter, but there’s “not that much information” in those reports, and they usually are released 60 to 90 days after the end of the quarter, according to Rogers. “There’s a gap from quarterly reporting to daily valuations that scares a lot of defined contribution investment managers,” he explains. “They want to know, ‘How am I going to know how much this stuff is worth?’ The question is: How do you bridge the gap?”
Hamilton Lane, Rogers contends, may be on the cusp of unveiling a mechanism that answers that question. His firm has an interest in $167 billion in private equity assets. Some $140 billion of those are “advisory assets,” on which the firm provides reporting and performance metrics to institutional investors; for the remaining $27 billion, Hamilton Lane holds the assets directly under management, standing in as a kind of outsourced limited partner on behalf of institutions. The firm contributes an average of 20 percent of total capital in the funds it backs on behalf of its clients. The result of this is that the firm has “great visibility into data within the private equity universe,” says Rogers. “We have a lot of influence and a lot of data we can mine.”
Drawing on a database that stretches back to 1980 and takes in more than 2,000 unique partnerships and more than $2 trillion of fund-level commitments (only 26 percent of which the firm has itself invested in on behalf of clients), Hamilton Lane has built an algorithm around the historical returns of private equity portfolios and modeled their movements in comparison to various market indicators, including relevant equity market indexes, credit spreads in high-yield bond and loan markets, and underlying economic indicators. Rogers expects this algorithm, which could be adapted to track the periodic price movements in current private equity portfolios, to be up and running within the next few months.
“Our goal is to get to daily pricing,” he says. “That won’t happen immediately, but we’ll get there eventually.”
The quality of the data is paramount. Hamilton Lane relies on the private equity funds themselves to provide accurate and honest performance data. Critics contend that private equity creates a perfect environment for data falsification, especially in quarterly reporting, as the accuracy of periodically stated portfolio net asset values cannot be verified in a real sense until the general partners have exited their investments, usually months and sometimes years after the publication of performance data.
Rogers has some sympathy with this argument: “In private equity, a lack of transparency can exist for a long time.” But, he contends, most private equity general partners tend to be “conservative. Our feeling is that the industry has generally not inflated net asset values.”
Hamilton Lane’s research backs up its claims. Using a historical sample of 30 companies included in private equity portfolios, the firm compared exit valuations to the net asset values reported by the funds controlling them six months prior to exit. More than 80 percent exited above the mark, with a 20 percent average premium on exit relative to the mark six months prior.
“A lot of people think net asset values are all just nonsense,” Rogers says. “That’s not the case at all when you look at the data. But it’s having the data in the first place that allows you to correct the misperception.”
Rogers’s jolly debunking campaign extends to another market canard as well: the view that private equity returns are low and provide no compensation for illiquidity. Employing various measurements of performance and drawing on Hamilton Lane’s proprietary fund database, he shows how private equity has recorded an annualized total return of 13.2 percent in the ten years ended March 31, 2013, outperforming most other asset classes, including U.S. public equities (7.7 percent), high-yield bonds (10.2 percent), hedge funds (6.7 percent) and real estate investment trusts (11.8 percent). Only emerging-markets equities, up 16.5 percent, have performed better over that period.
Today many private equity firms are reluctant to show data related to the performance of the underlying companies in their portfolios, whose average holding period is about four to five years, as they want to be able to have the time to “restructure and revitalize companies away from the public eye,” Rogers says. This is part of what makes private equity a powerful investment vehicle, he adds: “The elimination of public noise and the alignment of interests create an industry dynamic that is very healthy.”
Rogers says the private equity industry’s traditional unwillingness to be more public with its data will need to change if it is to claim a greater share of the institutional investor cash pool, especially as the shift to defined contribution plans gathers pace. “We limit our own growth potential by having crappy information,” he explains. “It’s poor information that has allowed poor performers in the industry to get away with it for a long time.”
The ideal scenario, from the perspective of efficient pension allocation at least, will be for general partners themselves to provide more and better data on the performance of underlying companies in their portfolios. This would, Rogers contends, be preferable to the approach his firm currently has to employ, whereby an algorithm is used to model periodic prices as a function of proximate companies, indexes and indicators on which data is already available in the public arena. But coaxing general partners into the open will be more than an exercise in gentle diplomacy; adverse market conditions demand it. “It’s been a painful readjustment for the private equity industry post-crisis,” argues Rogers. “Limited partners have never had more power.”
Rogers’s hope is that better data will give private equity a better footing to meet change head on. This, he says, will not just push private equity closer to the “efficient frontier” of a 10 to 12 percent allocation in defined contribution pension plans; it will also allow participants in those plans to take advantage of private equity’s superior returns.
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