North Carolina Pension Adds Lagging Private-Equity BetsMartin Z. Braun
In one of the few things Republicans and Democrats can agree on in North Carolina, the state is adding to its lagging bets on private equity and real estate to pump up its $80 billion public-worker pension fund.
Governor Pat McCrory, a Republican, signed a bill in August raising limits on investments in alternatives to stocks and bonds. The Tar Heel state’s $3.4 billion private-equity portfolio has returned about 7 percent over 10 years, almost 4 percentage points below the pension’s benchmark. Real estate investments returned 2.6 percentage points below target.
“We’re behaving like a losing gambler right now,” said Ardis Watkins, legislative-affairs director for North Carolina’s State Employees Association, the state’s second-biggest public-worker union. “We’re chasing money.”
North Carolina is joining public-worker pensions from neighboring South Carolina to Texas piling into riskier investments as they face an $800 billion funding gap for promises to retirees amid slow growth and record-low interest rates. The state’s experience shows that the private investment pools, which charge higher fees than stock or bond funds, aren’t a magic bullet for hitting targeted annual returns of 7 percent to 8 percent.
Investments in alternative assets, which are harder to value and sell, have more than doubled to 24 percent of public pension portfolios between 2006 and 2012, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.
That share will probably grow. Two-thirds of executives at 109 U.S. public funds surveyed last year by Smithfield, Rhode Island-based Pyramis Global Advisors viewed alternatives as the primary asset class they would use to boost returns.
The law McCrory signed, which was backed by Democratic Treasurer Janet Cowell, passed the Senate 48 to 1. It was a rare display of bipartisanship in a state wracked by protests targeting its first Republican-led government since Reconstruction.
More than 600 people have been arrested on “Moral Monday” demonstrations over tax cuts, reductions in education spending and poll restrictions that opponents say are designed to keep blacks from voting.
Currently, about 20 percent of the pension’s assets are invested in alternatives, including private-equity funds, which use borrowed money to buy companies, improve their profitability and resell them. On average, those funds outperformed the Standard & Poor’s 500 stock index by about 18 percent over the life of the fund, according to a study co-authored by David Robinson, professor of finance at Duke University’s Fuqua School of Business. Robinson analyzed a portfolio of 450 buyout funds.
More recently, private equity has lagged behind the stock market. It returned 1.33 percentage points less than the S&P 500 for the year ending March 31, according to the Cambridge Associates Private Equity Fund index.
Hedge funds also underperformed U.S. equities. The S&P 500 returned an average annual 5.8 percent in the five years ended March 31, compared with 0.4 percent a year loss for hedge funds, according to data compiled by Bloomberg.
North Carolina is winding down its investments in funds that farm out money to hedge funds because of high costs and weak performance, said Schorr Johnson, a spokesman for Cowell.
The state’s $260 million in “funds of funds” lost 0.48 percent annually for the five years ending June 30.
Credit-oriented funds, which invest in distressed debt and junk bonds, now make up 90 percent of North Carolina’s hedge-fund investments. They have helped push overall hedge-fund returns 8.7 percentage points above their benchmark in the last fiscal year, according to Johnson.
Cowell, the sole trustee of the pension for North Carolina’s 875,000 active and retired public employees, is leading the charge to shift the AAA-rated state into riskier assets. She’s doing so even though the state’s retirement system is the third-best funded in the U.S., according to S&P.
The real risk to the eighth-biggest U.S. public pension by assets is that 35 percent of its portfolio is in bonds, Cowell says. She forecasts that bonds will return 2 percent to 4 percent annually over the next five years.
“While achieving greater investment flexibility does not guarantee that we will meet the target rate of return, the current allocation structure almost ensures that we will not,” Cowell wrote in a June 17 letter to lawmakers urging them to raise investment limits on junk bonds, hedge funds, private equity and assets like commodities that protect against inflation.
North Carolina’s pension returned 6.57 percent annually over 10 years ending June 30, placing it among the bottom 25 percent of government retirement funds with more than $10 billion in assets, according to data from Wilshire Associates, a Santa Monica, California-based consultant.
Higher fees charged by hedge funds, private-equity firms and real estate managers have eroded returns. North Carolina’s pension paid $318 million in investment fees in fiscal 2012, a 37 percent increase from three years before, records show.
In neighboring South Carolina, which had 56 percent of its $27 billion invested in alternatives in fiscal 2012, fees rose to $296 million from $122 million after it started investing in the loosely regulated pools in 2008.
The relative health of North Carolina’s pension fund has muted debate over its investment strategy, Francis X. De Luca, president of the Raleigh-based Civitas Institute, wrote in an e-mail.
Both Civitas, whose mission is to implement “conservative policy solutions,” and the public-employees’ association warned that putting more money into alternatives could expose taxpayers to more risk.
North Carolina’s pension had 95 cents to cover every $1 in liabilities in 2011, a funding level behind only Wisconsin and South Dakota, according to a July report by S&P.
“People have talked about North Carolina potentially facing problems, but they take comfort in that our system seems to be healthy,” De Luca wrote. Civitas advocates moving North Carolina public employees to 401(k)-style plans, which don’t promise fixed benefits.
The investment bill signed by McCrory raised limits on the percentage of pension assets that can be allocated to alternative assets to 35 percent from 34 percent and lifted the cap on limits placed on categories such as private equity and hedge funds.
One boon to the North Carolina pension has been the “credit” category, which includes junk, or speculative-grade, bonds and direct loans to companies. That group returned 17.45 percent in fiscal 2013, compared with a 3.34 percent benchmark.
Robinson, the Duke University professor, said Cowell’s move was reasonable given low bond yields and the historical performance of buyout funds. Private-equity investments aren’t much riskier than stocks, he said. The Federal Reserve has said it will keep its benchmark interest rate near zero through at least mid-2015.
“Of course, the devil’s in the details,” Robinson said in telephone interview. “If you just go and try to throw money at the asset class, bad things can happen.”
With public pensions allocating billions of dollars more to private equity, future returns may be lower, said Robinson and Richard Warr, a professor of finance at North Carolina State University in Raleigh.
“Now, everyone and their grandmother in is private equity,” Warr said in a telephone interview “Philosophically, I just don’t believe that there are that many good private-equity deals around.”