Private Equity on Pension Funds: Underallocated?

In this article

• What is happening?

• Current Allocation to PE

• Public Pension Funds allocation by asset type

• Funds under PE target Allocation:

• Pension Funds Over Private Equity Target Allocatio …

• PE Performance

• Conclusion

What is happening?

For decades, pension funds have adhered to a traditional investment strategy heavily reliant on stocks and bonds. These assets provided the stability, liquidity, and predictability needed to meet their obligations to retirees. However, this approach is no longer sufficient in today’s evolving financial landscape. Rising life expectancies, aging populations, and diminishing yields in traditional asset classes are pushing pension funds to rethink their strategies. 

The search for higher returns and portfolio diversification has driven pension funds to explore alternative investments, particularly private equity, real estate, and infrastructure. Among these, private equity stands out as a compelling option, offering the potential for higher, uncorrelated returns compared to public markets. This shift gained momentum following the 2008 financial crisis, which ushered in an era of prolonged low interest rates and stock market volatility. For pension funds with long-term horizons, private equity presents an opportunity to navigate these challenges while generating the robust returns necessary to fulfill their liabilities.

Interest rates, which have risen sharply since 2022 in response to inflationary pressures, further complicate the equation. On one hand, higher rates lower the valuation of future liabilities, providing some pension funds with more flexibility to pursue riskier assets like private equity. On the other hand, rising bond yields make fixed-income investments more attractive, potentially pulling some funds back toward traditional allocations. 

The regional dynamics of this shift are also noteworthy. North American pension funds have led the charge into alternative assets, with U.S. state pension funds increasing their allocations to alternatives from 30% to 40% over the past five years, including a significant jump in private equity holdings. European pension funds, while slower to adopt alternatives, are gradually increasing their exposure to private equity, often aligning these investments with sustainability and ESG goals.

Private equity’s appeal is clear: it aligns well with the long-term investment horizons of pension funds, provides diversification benefits, and offers the potential for outsized returns. However, the journey into private markets is not without challenges, including illiquidity, risk dispersion, and the need for specialized expertise. As pension funds navigate this shift, they must carefully balance their portfolios to manage both short-term liquidity needs and long-term growth objectives, ensuring the financial security of their beneficiaries in an increasingly complex investment environment.

Current Allocation to PE

Global pension funds are increasingly turning to private equity as a key component of their portfolios, yet many remain underallocated relative to their targets. As of the first quarter of the year, the median target allocation to private equity among 365 global pension funds stood at $280 million, with actual allocations slightly lower at $276 million, creating a $4 million net underallocation. This shortfall highlights the challenges of meeting allocation goals in today’s complex investment landscape.

Notably, the California Public Employees' Retirement System (CalPERS), one of the largest pension funds in the world, exemplifies this trend. Despite private equity being the highest-performing asset class in its portfolio, CalPERS fell $11.34 billion short of its target allocation. This gap stems from a recent increase in its private equity allocation target, which rose from 8% to 13% for the 2022-23 fiscal year.

These figures underscore both the growing commitment to private equity among pension funds and the practical hurdles they face in fully realizing their allocation targets. This segment explores the factors driving these trends and the implications for the broader private equity landscape.

Public Pension Funds allocation by asset type

The allocation strategies of public pension funds are evolving as they adapt to the changing investment landscape. A comparison of allocations between 2022 and 2023 highlights key trends, particularly the increased emphasis on alternative investments like private equity and real estate, alongside some notable reductions in traditional asset classes.

Key Trends in Allocation Changes

• Rise in Private Equity Allocation

  • Private equity saw a significant rise in allocation, increasing from 14.5% in 2022 to 17.0% in 2023.

  • This shift reflects the growing confidence in private equity as a tool for generating higher returns and diversifying portfolios, particularly in the face of public market volatility.

• Increased Focus on Real Estate

  • Allocations to real estate rose from 8.1% in 2022 to 10.7% in 2023, signaling a continued interest in tangible, income-generating assets.

  • Real estate provides a hedge against inflation and offers stable returns, making it an attractive choice for pension funds seeking predictable income streams.

• Decline in US Equities

  • US equity allocations dropped from 27.3% in 2022 to 24.7% in 2023, illustrating a shift away from traditional public equities.

  • This decrease suggests that pension funds are diversifying away from potentially overvalued public markets and reallocating capital to alternative investments.

• Slight Reduction in Fixed Income Allocations

  • US fixed income allocations remained relatively stable but saw a slight decline from 20.0% in 2022 to 19.7% in 2023.

  • Non-US fixed income also dropped marginally, reflecting caution around rising interest rates and their impact on bond performance.

Implications for Public Pension Fund Strategies

The observed allocation shifts underscore a strategic pivot by public pension funds toward higher-return and less correlated asset classes, such as private equity and real estate. These changes are driven by several factors:

• Diversification Needs: To mitigate risks associated with public market volatility, funds are increasingly adopting alternative investments.

• Inflation and Interest Rate Dynamics: Rising interest rates have made bonds less attractive, while real estate provides a hedge against inflation.

• Long-Term Growth Objectives: Private equity remains a favored asset class for its strong historical performance and long-term growth potential.

Funds under PE target Allocation:

Many pension funds globally are falling short of their private equity allocation targets, as highlighted by recent data. Institutions such as the California Public Employees' Retirement System (CalPERS), Afore XXI Banorte, and Shell Asset Management Co. exhibit significant gaps, with CalPERS leading the list with a $11.34 billion underallocation. This shortfall is indicative of broader trends and challenges within the private equity investment landscape.

Contributing Factors to Under allocation

·  Reduced Fund Launches

The number of new private equity and venture capital funds has declined sharply. In the year leading up to April 3, only 30 funds with sizes over $100 million were launched, compared to 450 funds during the same period in 2022. This drop has limited the available opportunities for pension funds to deploy capital in private equity.

·  Macroeconomic Uncertainty

Investor hesitancy has grown amid an uncertain outlook for inflation and interest rates. High borrowing costs and unpredictable economic conditions have led to a more cautious approach, slowing commitments to private equity investments.

·  The Denominator Effect

As public market valuations have fallen, some institutional investors found themselves overexposed to private equity. This “denominator effect” has forced pension funds to reassess their allocation strategies to maintain balance within their portfolios.

·  Shift Toward Other Asset Classes

Rising interest rates have increased the appeal of fixed-income assets like bonds, which now offer more competitive yields. Additionally, the collapse of Silicon Valley Bank and tightening bank regulations have drawn attention to private credit funds, further complicating allocation decisions.

Pension Funds Over Private Equity Target Allocation

In contrast to the underallocation trend seen in some pension funds, a number of major institutions have exceeded their private equity allocation targets. These funds highlight the growing confidence in private equity as a high-performing asset class and showcase the ability of well-funded pensions to capitalize on private equity opportunities.

Key Drivers of Overallocation

·  High Confidence in Private Equity Returns
Many funds, particularly those with robust financial health, view private equity as a cornerstone for achieving their long-term return goals. The strong historical performance of private equity continues to justify exceeding target allocations, especially for funds with the ability to manage illiquidity risks.

·  Market Outperformance
In some cases, the value of private equity portfolios has grown faster than anticipated due to outperformance. This natural growth can lead to allocations exceeding targets without additional commitment.

·  Institutional Priorities
Certain funds have prioritized private equity as a critical diversification tool, particularly in light of volatile public markets. Funds with strong funding ratios are better positioned to take on the long-term risk associated with private equity.

PE Performance

Private equity (PE) has consistently outperformed public equities, delivering significantly higher cumulative and annualized returns. Despite this, pension funds remain underallocated to this asset class, highlighting a disconnect between its performance potential and actual portfolio allocation. Over the past two decades, PE has generated an average annual return of 11%, compared to the 6.2% annual return of public stocks. This performance premium of 4.8 percentage points underscores the value of PE investments, particularly for long-term strategies such as those employed by pension funds.

As seen in the data, the cumulative return for private equity continues to diverge sharply from public equity benchmarks, showcasing its resilience and growth potential across different market cycles. While public stocks remain more liquid, the consistent outperformance of PE offers pension funds an opportunity to bolster their returns and meet long-term liabilities. The following analysis delves deeper into the historical performance trends of private equity relative to public equities.

Analysis

The graph and accompanying data illustrate private equity's cumulative and annualized performance compared to public stocks over the last two decades, providing a clear picture of its significant outperformance.

1. Private Equity’s Cumulative Outperformance

• Cumulative Returns: Private equity's cumulative returns have steadily increased, reaching a staggering 35.9% in 2022 before moderating to 35.6% in 2023. In contrast, public equities exhibit far slower growth, with cumulative returns of 6.2% per year over the same period.

• Private-Public Premium: The cumulative return gap highlights a sustained 4.8% annualized premium of private equity over public equities. This performance differential reflects private equity’s ability to capture value through operational improvements, strategic investments, and long-term growth strategies.

2. Resilience in Market Downturns

• During the 2008 financial crisis, private equity showed greater resilience. While public equities dropped sharply, leading to negative 11.1% returns for PE in 2009, the asset class quickly rebounded, delivering 20.3% returns in 2010. Public equities, by contrast, required longer to recover fully.

• More recently, private equity showed robustness through the COVID-19 downturn, outperforming public equities during a period of heightened volatility.

3. Volatility in Excess Returns

• The private equity excess return for fiscal years demonstrates periodic fluctuations, reflecting the inherent risks of the asset class. For example:

  • In 2022, private equity delivered a significant 35.9% excess return, its highest performance in recent years.

  • However, in 2023, excess returns declined to -16.7%, likely due to macroeconomic factors such as rising interest rates and slowing deal activity.

4. Long-Term Growth Trajectory

• The long-term growth trajectory of private equity, reflected in its cumulative performance, underscores its value as a long-term investment. From a modest start in 2000, private equity has consistently outpaced public equities, growing at nearly double the annualized rate.

5. Implications for Pension Fund Allocations

• Despite its proven performance, private equity remains underallocated in pension fund portfolios relative to its potential. This underallocation could be attributed to factors such as illiquidity concerns and historical risk aversion.

• The sustained premium in PE returns presents an opportunity for pension funds to revisit their allocation strategies and consider increasing exposure to capitalize on its outperformance.

Private equity has consistently demonstrated its ability to deliver superior returns compared to public equities, making it an increasingly attractive option for institutional investors like pension funds. The chart below highlights this performance advantage across various time horizons, emphasizing the long-term value of private equity investments. This section builds on the earlier discussion of state pension fund performance by reinforcing how private equity outperforms public equity, such as the S&P 500, across 5-, 10-, 15-, and 20-year periods.

Chart analysis

• 5-Year Horizon:

  • Private Equity: Returns of 18.3%, nearly double the 9.9% delivered by the S&P 500.

  • This shorter-term outperformance underscores private equity’s ability to capitalize on market inefficiencies and deliver strong gains even in volatile conditions.

• 10-Year Horizon:

  • Private Equity: Returns of 17.3%, significantly exceeding the 11.9% from public equities.

  • Over a decade, private equity showcases its capacity for sustained growth and value creation through active portfolio management.

• 15-Year Horizon:

  • Private Equity: Achieves 14.3%, maintaining a premium over the 11.3% from the S&P 500.

  • This period includes the aftermath of the 2008 financial crisis, demonstrating private equity’s resilience and long-term focus.

• 20-Year Horizon:

  • Private Equity: Returns of 15.2%, far ahead of the 9.7% delivered by public equities.

  • Over two decades, the compounded growth underscores private equity’s ability to deliver consistent superior returns, making it an invaluable asset for long-term investors like pension funds.

Conclusion

Private equity has solidified its position as an indispensable asset class for pension funds, offering superior returns and diversification benefits that surpass traditional investments like stocks and bonds. Over the past two decades, private equity has achieved an average annual return of 11%, significantly outpacing public equities, which delivered 6.2%. This performance differential is even more pronounced over longer time horizons, with private equity’s 20-year returns reaching 15.2%, far ahead of the S&P 500’s 9.7%. These results highlight private equity’s ability to generate robust, consistent growth while providing resilience during market downturns, as demonstrated in the aftermath of the 2008 financial crisis and the COVID-19 pandemic.

Despite its clear advantages, many pension funds remain underallocated to private equity. The $4 million median allocation shortfall across global pension funds and significant gaps in major institutions like CalPERS, which fell $11.34 billion below its target, reveal missed opportunities to maximize returns. Addressing these underallocations is critical for pension funds to harness private equity’s potential fully and meet their long-term liabilities in a volatile economic environment.

As pension funds adapt to an increasingly complex investment landscape, the shift toward private equity and other alternatives is becoming more pronounced. In 2023, allocations to private equity rose to 17.0% from 14.5% in 2022, reflecting growing confidence in its ability to deliver higher returns and hedge against inflation. However, challenges such as illiquidity, reduced fund launches, and macroeconomic uncertainties require careful portfolio management and strategic planning.

Nevertheless, the data presented underscores a compelling case for pension funds to increase their private equity exposure. By capitalizing on its unmatched long-term growth, pension funds can bridge allocation gaps, diversify portfolios, and secure financial stability for beneficiaries. In a world of shifting market dynamics and growing liabilities, private equity’s outperformance positions it as an essential cornerstone of modern pension fund strategies, enabling institutions to achieve their objectives while navigating economic uncertainties with confidence.