For Public Pension Funds, Complexity Rises with Pivot to Private Equity

In an effort to maximize long-term investment performance, public pension funds are shifting more of their assets to private equity. Last week, New Jersey’s $80 billion state employee pension fund said it would increase its target allocation to private equity funds to 12%, compared to a current target of 10.25% and a current allocation of 9.4% as of April 30.

And New Jersey is not alone: in recent months, Ventura County, the Canada Pension Plan Investment Board and CalPERS all signaled increases in their private equity allocations, aiming to improve overall returns and guard against a drop in public equity markets.

In fact, investments across private asset class categories by state and local pension funds have been on the rise. Last year, target allocations to private equity, hedge funds and other alternatives averaged 14.7%, up from 13.9% in 2017, according to a survey of 167 pension managers. Current allocations to these asset classes averaged 12.5% in 2018 and 11.9% in 2017. The boost in allocations to private assets was made as pension funds trimmed their targets for domestic equities, and domestic and global fixed income.

Awards of new asset management mandates confirm this trend. In 2018, public pension plans announced 954 new private equity mandates, putting private equity investments in the top spot for new allocations among public pensions last year.

The strong performance of private equity investments in recent years is clearly a driver of these higher allocations. From 2010 to 2016, the asset class notched a 25% return before fees, compared to 14.9% for traditional equity investments.

Those are impressive numbers for state pension funds, which have traditionally sought to minimize volatility at any given level of expected return. Regulations like FASB 158, however, have been shifting the definition of pension fund risk over the last decade.  There is an increasing dependence on strong investment returns to show they will be able to meet future benefit obligations to retirees, especially in states facing underfunded pension systems. The largest state pension plans have an average of 74 cents on hand for every dollar of promised benefits. They’re counting on stronger investment returns to help close the gap.

But if this all sounds too familiar, you may also be aware that the turn to private equity brings multiple operational investment challenges. It adds to an already complex reporting and information management process as these organizations cope with how to collect and aggregate data from an increasing number of private asset managers and assimilate that into a holistic portfolio view that can be shared across internal and outsourced investment teams. The number of data sources, presentation formats and reporting schedules are multiplying, making the task of understanding the fund’s overall risk position, investment selection and allocation across multiple asset classes that much harder to determine. These organizations are already inundated with dizzying varieties of cash flow, valuation and performance data from private equity managers at the end of every quarter. It goes without saying that many are cringing at the prospect of getting more.

Along the same lines, pension funds must recognize funded status, which requires accurate calculation of fair value of plan assets, in the statement of financial position. But most limited partners – pension funds included – struggle to obtain asset valuation transparency for complex assets such as private equity.  And while there is an emerging trend toward creating industry standards for private equity reporting, the adoption and realization of these standards is not yet here.

At a time of heightened market volatility, the ability to model the impact of asset price changes or interest rate variations becomes even more important. That’s all but impossible without a strong multi-asset class portfolio management platform that provides a simplified view of all investment data, across all asset classes, normalized and synchronized for accuracy at any point in time.

In fact, a number of state pension funds have a growing urgency to acquire technology that provides a more holistic view of their investments. They recognize this is the first step in truly capitalizing on promising opportunities, while having a more complete picture of existing risks. Spending less time scrubbing data and more time analyzing and managing investments and long-term strategy makes sense to them – and to their trustees.

A larger allocation to private equity investments by state pension funds needn’t mean greater complexity. In fact, it might be an ideal opportunity to introduce a new approach that puts powerful investment data, modern technology and intelligent, flexible portfolio analytics tools to work.

We are in a new era of investment strategy that is likely to live on for years to come. It’s time for pension funds and other asset allocators to leave behind legacy technology and break down silos – shedding inefficiencies, transforming data accuracy and aligning people and processes.

Contact Solovis today to get started.