NYC Pensions' Push Into Private Equity Yields Index-Fund Returnsby
Private equity gains for NYC’s two biggest funds lag benchmark
After scattershot approach, a new focus on some 60 firms
New York City’s biggest pensions have invested about $13 billion with private-equity firms in pursuit of large returns. They would have done better with a low-cost stock index fund.
The city’s $63 billion teachers’ and $58 billion civil employees’ funds have earned an annualized return of 9.15 percent and 9.1 percent after fees, respectively, on their buyout, venture capital and “special situations” funds since the late 1990s. That’s less than the 9.5 percent they would have earned by putting the money into the Russell 3000 -- the stock-market benchmark the plans expect their private-equity portfolios to beat by 3 percent a year.
“We’re more-or-less break even and that’s a disappointing result,” said Scott Evans, chief investment officer of New York City’s pension funds. “What you have here is the mathematics of a very large tail of unproductive funds weighing down performance.”
New York’s experience shows that the private investment pools are no magic bullet for generating gains needed to cover the benefits due as aging workers retire. With state and local pensions holding almost $2 trillion less they need, the funds have piled into riskier asset classes such as private equity, hedge funds and real estate over the past decade, seeing the higher-fee investments as a way to achieve the more than 7 percent returns they count on each year.
New York City’s five public employee pension funds were $65 billion short of the assets needed to cover promised benefits as of June 30, 2016.
Public pensions’ investments in so-called alternative assets such as private equity and real estate -- which are harder to value and sell -- have more than doubled over the past decade and now account for almost a quarter of their portfolios, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.
With the influx of cash leaving the firms competing for takeover targets, the industry has struggled to shine: While average buyout funds historically beat stocks by 3 to 4 percent, those formed since 2006 have done no better than the equity market, according to a 2016 study by professors from the University of Virginia, Oxford University and the University of Chicago, who reviewed the holdings of almost 300 institutional investors through June 2014.
Efforts by banking regulators to limit the amount of high-interest debt that private equity firms can foist onto target companies -- as well as competition from cash-rich public companies mounting their own takeovers -- may also be restraining returns, said Eileen Appelbaum, senior economist at the Center for Economic and Policy Research in Washington.
“More equity and less debt also means less possibility for outsized performance,” said Appelbaum.
New York’s smaller pensions fared slightly better with their private-equity investments than the civil employees and teachers pensions. Its plans for police officers, firefighters and school administrators beat the Russell 3000 by 1 percentage point or less.
Still, none achieved the city’s stated goal of earning 3 percentage points more than the Russell 3000, despite the higher fees and risks -- including having money locked up for years.
Too Many’s Too Much
New York City’s private equity portfolio, channeled into about 220 different funds, is “overdiversified,” pension officials say. The civil employees’ and teachers’ pensions committed more than $5 billion to dozens of funds that started investing between 2006 and 2008, when William C. Thompson was comptroller.
The performance of New York’s venture capital and energy investments were particularly poor: The civil employees’ pension returned 3.2 percent and 0.4 percent respectively in those categories. New York has since stopped investing in startups.
Instead of giving up on private equity, New York is concentrating its new investments into about 30 large firms and another 30 "emerging managers," typically women or minority-owned firms, that the city has “high conviction in."
For example, the teachers’ and civil employees’ pensions have committed $630 million to Vista Equity Partners after investments in a 2007 fund returned 18 percent more than the Russell 3000. A 2011 fund returned 8 percent more.
“This is an asset class where it pays to be narrow and to be deep with the partners you have confidence in," Evans said.
Not all of the city’s private equity investments are with firms that have consistently delivered outsized gains. For example, four of New York City’s five pensions committed about $40 million combined to Centerbridge Capital Partners III, a buyout fund, even though the firm’s previous fund returned 4.1 percent as of Sept. 30, 2016, according to data from the California State Teachers’ Retirement System.
Given the 10-year life of a typical private equity fund, it’s too early to render a judgment on the new approach.
However, data from fund vintages in 2011 and 2012 are encouraging, beating the public market equivalent between 2 and 5 percentage point, according to city pension documents.
“The good news is the weight of the new funds and the concentrated portfolio has been rising,” Evans said. “We think we’re on the right track.”