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distressed debt, and direct and mezzanine
lending. We look to construct portfolios
that today would generate a net-of-fee
return of about 6%. "
The higher returns of private market
investments come at a cost, however, or
several costs, relative to public markets:
illiquidity of the investments, higher fees
and more complex governance.
Capital is drawn down by managers
at times that are unknown at the start of a
fund, and similarly returned at unknown
times, Disdale says. In corporate buyouts,
for instance, the largest segment of
private equity funds typically has a life
of about 10 years. Investors pay in capital
over five years or so, and returns are typically
realized in years three through 10,
through dividends and proceeds of sales
of refurbished target companies.
Private debt funds can see more
timely cash flow, Disdale says. " The
lifespan of private debt is typically shorter
than that of private equity, at five to
seven years for the life of a fund, and an
investment period of two to three years. "
Interest on loans is paid currently.
" Because private investments are
illiquid, sponsors need to develop a pacing
plan, " suggests Brian Roberts, senior
consultant at NEPC, Boston. " [They need]
to project out the total size of the program,
the commitments to be made each year
to maintain it, and the liquidity needed
to meet benefit payments. " Roberts says
it is a best practice to revisit that pacing
plan annually-or sooner if something
significant occurs. " Assumptions are only
assumptions, and something changes
every year. "
At the same time, " once you have that
commitment pace, you don't want to be
slavish to it, just filling the bucket every
year, " McDonnell says. " If a manager that
rates just a B+ presents you with a fund,
you may not want to allocate to [him], and
wait instead for a best-in-class manager. "
Fees for private investments are
considerably higher than for most public
assets and are typically set at 2% for annual
management, plus 20% of fund profits
to cover incentive performance fees. In
the current environment, private investments
are popular, and investors have
little leverage with managers. " It's a bad
place for a limited partnership, " Disdale
observes. " With all the demand out there,
it's difficult for investors to push back on
fund terms or fees. It's been a tough time. "
Investing in private markets also
requires specialized knowledge, raising the
complexity of fund governance. Consulting
firm Callan Associates compiled an
extensive survey in 2017 on the staffing,
administration and governance called
for by private markets. " Earlier adoption
tended to be from larger plans, but in the
last two decades there have been many
more small plans coming onboard with
private equity, " says Gary Robertson, head
of Callan's private equity research team,
in San Francisco. " Plan staffs and boards
have come up the learning curve on private
equity, so as an asset class it's become
more Main Street than Wall Street.
" We have a theme that success is
defined before you make the first investment, "
he adds. This is advanced by
" establishing a good governance structure,
setting out who will make which
decisions, and what the portfolio should
look like when it's done. " Invoking the
credo of woodworkers, he advises sponsors
planning private equity investment
to " measure twice, and cut once. "
Many plans opt for turnkey solutions
such as outsourced chief investment
officers (OCIOs) to manage their private
equity. " The OCIO route can supplement
the knowledge of a board that feels
it doesn't have the resources, " Robertson
says. " That was not an option five or 10
years ago. OCIOs also may be able to
arrange lower minimum commitments
than sponsors could get on their own. "
A plan's funded status can also add
complexity, again, from a liquidity angle.
" Some sponsors' aversion to private asset
classes is straightforward, " McDonnell
observes. " They want to eventually get
to 110% or 115% funded and then get out
of the pension game, so taking on a big
illiquid investment program seems crazy.
I would say two things about that. One is
that strategies such as direct lending put
the money to work in two years or so, and,
while you may not have full liquidity on
demand, you can realize a nice cash flow
pretty quickly. "
The other, McDonnell continues,
involves applying the extra returns to an
uncertain and costly future. " Even if you
are 'fully funded' you still have PBGC
[Pension Benefit Guaranty Corporation]
premiums and administrative costs to
pay, and the actuarial world is frequently
making adjustments to liabilities that all
seem to go in one direction. Sponsors
need a return greater than just their
liabilities to retain fully funded status,
and that calls for an allocation to assets
that are going to grow-such as private
equity and debt. " -John Keefe
KEY POINTS
* Private equity investments outpaced large- and small-cap stocks for
the 15 years ending this past March. Their performance was based
on market managers' choices of investment sectors, companies and
premiums for illiquidity.
* The higher returns come with several costs, relative to public
markets: illiquidity of the investment, higher fees and more complex
governance.
* Investing in private markets requires specialized knowledge, raising
the complexity of fund governance, with many DB plan sponsors
opting for turnkey management solutions. A plan's funded status
comes into play, as well.
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