Pension funds beware

The private equity market is a tricky asset class to invest in – so pension funds have been warned. What are some of the risks that pension funds ought to consider?

Pension funds would do well to be more selective about private equity investments, according to a new report from consultancy firm Watson Wyatt. The report says the top quartile of private equity managers outperforms the public markets, however it also states that private equity as an asset class underperforms.

Part of the problem for European pension funds lies in their relative inexperience.

Martin Potgieter, senior investment consultant at Watson Wyatt, says: “US pension funds have been investing in private equity for some time and so are more experienced private equity investors and have better access to good managers. European pension funds, on the other hand, have only been investing in the asset class for the last 5 or 6 years and so lack the experience of their US counterparts.”

This is compounded by the excessive leverage creeping into deals. Potgieter again says: “The amount of leverage in private equity deals is a particular concern for pension fund investors. However, some GPs are more disciplined about the use of debt than others, and pension funds ought to differentiate between GPs in this respect.”

Another fundamental concern for pension fund investors is unattractive valuations. However, Potgieter offers some comfort when comparing the present situation to the boom: “It does seem that private equity managers are not paying quite such big premiums for public companies as in the era, but valuations are nonetheless unattractive.”

The report identifies funds of funds as one way in which pension funds can be more selective about private equity investments.  Potgieter says: “Funds of funds present an attractive alternative for pension funds seeking to invest in private equity – they offer both risk diversification and better access to top quartile managers. However, the fee structure of funds of funds does mean that pension funds are forced to pay two layers of fees – one to the funds of funds themselves and one to the underlying private equity funds.”

Above all pension fund investors ought to be most cautious of the cyclicality of the private equity market. Says Potgieter: “The private equity market is about as good as it gets right now – the good times might last for another two years or so, but sooner or later, there has to be a downturn.”