All Your Eggs?

Reallocating pension assets to alternative investments seems prudent.

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In April 1998, the California State Teachers’ Retirement System (Calstrs) decided to allocate 10 percent of its pension assets to investments other than publicly traded stocks and bonds. Calstrs chose instead to put the money into lightly regulated partnerships that invest mostly in privately held Þrms and real estate.

Calstrs’s alternative investment portfolio hasn’t performed as well as hoped of late. During the year ended last May 31, the portfolio’s value rose from $2.2 billion to $2.6 billion, a 16.5 percent return, compared with 18 percent for the Russell 3000 index, its benchmark.

But handsome returns aren’t the only reason Calstrs has boosted its commitment to the nonpublic markets. The lofty levels reached by the public markets are making the plan sponsor squeamish about keeping all of its assets there. Simply put, Calstrs sees more downside than upside in the stock and bond markets.

Calstrs isn’t the only pension fund to move money from the public markets to the private. Over the past five years, the average pension- fund allocation to alternative investments has more than doubled, from 2 percent of assets to 5 percent, according to Wilshire Associates, a Santa Monica, California-based pension consultant. And Wilshire expects those allocations to rise as high as 10 percent in the foreseeable future. No wonder the total amount of dollars flowing into private equity funds and partnerships reached a record level last year.

Interest in alternative investments isn’t limited to public pension plans. Among the companies whose plans are allocating at least some assets to the category are AT&T; General Motors; Mobil; SBC Communications; Sears, Roebuck; and Sempra (the recent combination of Pacific Enterprises and Enova). And many, if not most, are increasing their allocations. AT&T, for instance, has upped its target allocation to 10 percent of plan assets from 8 percent in 1996.

But so far, at least, corporate participation has been limited to the largest plans. Since alternative investments are considered riskier than traditional ones, most plans still limit their exposure to less than 5 percent. To get sufficient diversification at that level, generally speaking, a plan needs to have at least $500 million in assets.

And even many plans of that size have yet to take the plunge. “For the most part, corporate plan sponsors have been pleased with the returns they’ve gotten from their public market portfolios,” says Jeanne Murphy, a consultant with the Bethesda, Maryland-based firm Watson Wyatt & Co.

Another likely reason for limited participation in alternative investments has to do with the experience of pension fund managers who have gotten burned in the past on private partnerships that made particularly risky bets on derivative instruments. As a plan fiduciary, “making a little extra money on the upside won’t necessarily get you a big bonus,” says James Abbott, a partner in the New York law firm Carter, Ledyard & Milburn. “But having a really bad downside return can get you fired.”

Yet that view seems shortsighted. Modern portfolio theory holds that allocating a portion of a portfolio to riskier assets can actually decrease its overall volatility, if those assets move in the opposite direction of the less risky holdings that dominate the portfolio. In theory, at least, there should be a higher correlation of returns among publicly traded securities than between public and private ones.

Fans of private equity are confident the theory would hold up if the public markets turn down. “When the markets are down, there is some impact on private equity, but not 100 percent, because the companies have different growth characteristics,” says Barry Gonder, senior investment officer for alternative investments at the California Public Employees Retirement System (Calpers), which has also been increasing its exposure to such alternatives.

An Exclusive Club?

Granted, portfolio theory may not be enough to overcome other obstacles. For one thing, private equity funds are organized as limited partnerships, so access to the top performing ones is limited. General partners can choose the investors they want as limited partners. And the better the performance, the harder it will be to get in.

One way around this obstacle–as well as that of lack of asset size — may be to invest in a fund of funds, which is a private equity fund that invests in a mix of other private funds. The fund-of-funds arrangement has been ridiculed, because the fund’s fees, typically 1 percent of assets under management, are layered on top of those charged by the funds it invests in. The typical underlying fund’s fees run about 2.5 percent of assets. But in addition, they charge a percentage of profits after they reach a certain level, typically 15 percent to 20 percent of the additional profits.

The total cost, to be sure, can be sizable. But the extra return added by a fund of funds may more than offset the extra expense, says Murphy of Watson Wyatt. “You’re really paying somebody a small percent of that return enhancement to gain their expertise,” she says. And because of the steep learning curve in alternative investments, she thinks a fund of funds makes particularly good sense for pension plans just getting into the category.

Another development that might help pension plans get into the best partnerships is a 1997 ruling by the Securities and Exchange Commission that allows private equity funds to be set up with more than 99 investors. The buyers have to be qualified purchasers — sophisticated investors who understand the risks involved in unregistered securities. Pension fund sponsors clearly fall into this category. However, the best private equity funds have no need for more money at the moment. As Abbott of Carter, Ledyard sees it, the most sought-after funds “have as much money as they want, and take as much as they think they can manage.”

Legal Pitfalls

There are also legal hurdles facing pension plan sponsors. Because private equity funds are lightly regulated, sponsors must take extra care to make sure they aren’t running afoul of federal pension law. Under the Employee Retirement Income Security Act (ERISA), for example, plan sponsors cannot invest in parties that have an interest in the plan. Since private investment partnerships needn’t publicly disclose their holdings, it’s tough for sponsors to tell whether investing in them would violate that rule. However, many if not most partnerships have been given a clean bill of health on that score by the Department of Labor, and can boast DOL exemptions to prove it.

Funds that hide behind their exemptions to keep their holdings secret present a different problem for sponsors. Without access to their portfolios, it’s tough to tell whether their investment strategy is appropriate for the plan. What’s more, ERISA requires sponsors to understand the liquidity, market, credit, operational, and legal risks of the investments they make. That obviously suggests that no plan sponsor should get into a private equity fund without gaining access to trustworthy information about its portfolio.

On the other hand, it is possible that plan sponsors would be vulnerable to charges of violating their fiduciary responsibility by failing to consider alternative investments. If, after all, stocks are a risky choice because of their valuation but have little correlation with private equity, diversifying into such alternatives would seem only prudent. In fact, pension law experts contend that a fiduciary’s lack of understanding of a class of investment is not a valid reason for not using it. As a result, the experts say, the onus is on a plan sponsor to consider private investments, even if that means hiring an expert to do the job. In that case, the sponsor has to be able to assess the expert’s advice.

However, a growing number of companies do not have defined benefit plans, through which alternative investments are easiest to make. Instead, they offer defined contribution plans, such as 401(k) plans. Even if a pension plan administrator is able to evaluate these investments, that’s of limited use in a 401 (k), where plan participants make the actual allocation decisions.

Some 401(k) sponsors are nonetheless considering the possibility of adding alternative investments as options. “We’ve been trying for years to figure out a way to make these available to defined contribution plan participants,” says Bob Angelica, CEO of AT&T Investment Management Corp. Ronald Richman, a pension expert at the New York law firm of Schulte Roth & Zabel, notes that he himself is engaged in “an ongoing discussion” with a corporate client about the possibility. And though Richman won’t identify the client, he says the discussion is “more than theoretical.”

But he also says that he is advising that client to exercise extreme caution. For one thing, says Richman, the lack of liquidity in alternative investments may raise questions about the appropriateness of the use of private equity as a 401(k) investment vehicle. Many private equity fund managers, for instance, require that investors keep assets in the fund for at least a year before liquidating any of them. But as Richman notes, 401(k) investments need to be liquid to meet the requirements of section 404(c) of ERISA, which limits the fiduciary liability of sponsors that offer at least three types of investment options.

The limited amount of disclosure by most managers of alternative investments poses an additional concern for 401(k) plan sponsors. Since participants are making allocation decisions, says Richman, “you need to be able to describe [the investment] in a way that people understand.” With many, if not most, alternative investments, Richman would recommend that “there be warning stickers all over them.”

Victims of Success?

Paradoxically, the growing popularity of alternative investments could make them less attractive. As more money flows to those investments from pension plans, competition among private fund managers could drive up the prices they pay for companies or other properties, reducing potential returns. At the moment, the problem is especially severe with buyout funds–in essence, late-stage venture capital funds.

But instead of withdrawing from alternative investments, plan sponsors have become more selective. While Calstrs is focusing on buyout funds, it is also making separate investments in so-called secondary interests from other limited partners, and in co-investments, where the plan itself invests alongside a fund. Both can offer a better return than buyout funds themselves, because secondary interests are typically purchased at discounts to book value, and partnership fees are cut out with a co-investment. Calstrs has purchased a number of secondary interests, totaling almost $200 million, and put $95 million into three co- investments.

Calpers has become even more selective about alternative assets. Unlike Calstrs, Calpers is actually reducing its exposure to buyout funds. It traditionally has focused on those devoted to corporate restructurings. Three years ago, for example, those buyout funds accounted for 89 percent of Calpers’s alternative investment portfolio. Today, the proportion is down to 43 percent. The reason, says chief investment officer Gonder, is that the amount of leverage these funds use has been rising. That is troubling, adds Gonder, because it reflects the fact that “in a lot of corporate restructuring, you’re engineering [market] value, as opposed to creating true economic value.”

So while Calpers will continue to put money into the best buyout funds in which it is already invested, Gonder expects to diversify by putting new money into venture capital funds, where he sees true economic value being added as new businesses and technologies are funded.

Other areas in which Gonder is looking include distressed securities and turnarounds. Also, the retirement fund has 24 percent of its investments overseas. Gonder is focusing on distressed securities in Asia, which are abundant, and later-stage venture capital and restructuring situations in Europe, where early-stage opportunities are limited.

The trend toward greater selectivity is also at work among sponsors of corporate plans. GM, for instance, is building up its foreign equity holdings and also venturing into private debt. Mobil is putting as much as 35 percent of its alternative investment allocation into international private equity. The oil company’s approach to alternative investments of all kinds is cautious. It is slicing its total $125 million investment into three or four commitments per year over five years.

Another alternative is being eschewed outright, at least for the time being. Hedge funds, private partnerships that invest in a much wider variety of assets, remain tainted by the widely publicized meltdowns of such operators as Long-Term Capital Management in fall 1998 and Askin Capital Management four years earlier. And consultants do not see that changing any time soon.

But while pension funds shied away from real estate investments after the market collapsed in the late 1980s and early 1990s, real estate has returned to favor, according to Timothy Welch, executive managing director at Cushman & Wakefield, a real estate adviser in New York. Granted, core real estate funds, which invest in stable-income-producing office, retail, and industrial properties, are so prolific that some pension plans do not even consider them alternative investments anymore. And while these funds may be an effective hedge against a market downturn, their safety comes at a price: They’ve been returning only 10 to 12 percent of late.

Seeking higher returns, some pension plans are looking toward more opportunistic real estate funds, says Welch. These are higher-risk vehicles that focus on properties with higher vacancies or near-term lease expirations. “There’s an opportunity, if they can manage them effectively, to get returns that are higher than a more-stable real estate return,” he says.

Calstrs, for instance, currently invests $2.2 billion, or 2.3 percent of its total assets, in real estate. Most of that, 73 percent, is directly invested in individual properties, with the aid of several traditional real estate investment firms, such as CB Richard Ellis, Lend Lease, SSR Realty Advisors, and MIG Realty Advisors. The remainder is in partnerships and funds run by such investment banks as Morgan Stanley and Lazard Freres, which invest in everything from land development to loan portfolios.

Yet another alternative to investing in private equity funds is to buy directly into new and developing companies. But this requires expert advice. Calpers uses Pacific Corporate Group, of La Jolla, California, to help with its direct investments, and says the fee for the advice is negligible.

Investing in alternative assets may seem daunting, but Watson Wyatt reports more inquiries from corporate sponsors, as concern over valuations in the public markets mounts. And Carter, Ledyard’s Abbott predicts that corporate sponsors will take their cues from the experience of big public plan sponsors like Calpers and large corporate plans. “Over time,” he says, “as it becomes clearer that it’s an acceptable and prudent strategy with big players like that, you’re going to see other company-sponsored plans deciding they should follow suit.”

———————————————– ——————————— Private Equity 101
A study of private equity investment in 1996, by consulting firm William M. Mercer Inc. on behalf of the California Public Employees Retirement System, addressed two key questions that investors should ask when considering such an investment, which is typically made through a limited-partnership arrangement. First, are financial interests between general partners and limited partners aligned? And second, do the ongoing management practices of the general partner maintain such an alignment?

In light of those questions, the study reached the following conclusions:

FEES. The management fee, expressed as a percent of committed capital, may appear small, but must be considered along with the amount of capital being raised and the contractual terms of the partnership. The resultant absolute dollars in fees over the term of the partnership have to be evaluated with respect to the general partners’ ability to add value and a “reasonableness” check. There are alternatives to fees based on the percentage of committed capital that investors should know about. Budget-based fees and sliding fees that ramp up and down over time are two such alternatives.

TERMS. These can address and mitigate the risk that organizational or personal events will diminish the general partners’ incentive or ability to perform. They include:

  • Advisory boards. These should be well defined within the contract with respect to their purpose, responsibilities, and authorities. Due diligence should be conducted on individual board members.
  • Distribution policy. This should specifically address how and when general partners and limited partners receive profits as investments are liquidated. The timing and form of distribution (cash versus securities) also need to be defined.
  • No-fault divorce. This allows limited partners to halt additional capital contributions if there is a loss of confidence in the general partner. It will also create the incentive to get the fund fully invested within an acceptable time frame.
  • Termination of general partners. The ability to terminate the general partner is an important right that limited partners should demand. This assures a proper check on the general partner in case he disrupts the managerial harmony of the partnership.
  • Wind-down provisions. These address the last stage of a partnership, when remaining assets are liquidated and distributed, outstanding liabilities are paid, and any remaining escrows are settled or adjusted. Provisions in use today vary considerably, so investors can avoid problems if these are carefully defined and structured from the start.

Source: William M. Mercer Inc.

———————————————– ——————————— A Brief Respite?
Although new capital flowing into private equity funds is down sharply from last year’s record pace, the flow is expected to pick up soon. This year’s slowdown, experts say, doesn’t reflect a lack of interest on investors’ part, but instead a lack of opportunities. The dearth should end once the supply of new partnerships catches up with demand. Eighteen investment firms had unveiled new partnerships during the second half of the year, or were planning to do so as this issue went to press.

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