That's Not Private Equity, That's a Pension Fund

Retirement plans cut out the middleman to acquire smaller and midsize businesses or invest directly in their private debt.
Photographer: Andrew Harrer/Bloomberg

Pension funds are in an increasingly tight spot. They face falling investment returns and a growing volume of bills as more employees near retirement.

So it's not surprising that they've been looking for innovative ways to juice returns. As a result, some of these funds, which were set up to cover health benefits and stipends to retired public service employees, are looking more like the private-equity funds in which they've invested historically.

Pension funds are increasingly opting to acquire smaller and midsize businesses themselves or invest directly in their private debt rather than employing an alternative-asset manager. For example, OMERS, the pension plan for municipal employees in Ontario, agreed this month to acquire a minority stake in National Veterinary Associates, which operates pet boarding and day-care centers. (Sticking with the theme of dogs and cats, the Ontario Teachers' Pension Plan bought PetVet Care Centers several years ago.)

By making the investments themselves, these pension funds avoid paying big fees to alternative-asset managers, ostensibly generating bigger returns for themselves. In some cases, these funds are deciding it's worth it to just hire their own people to find investments like private, middle-market loans, which on average pay more than a percentage-point more in yield than broadly syndicated ones.

"They build their own teams," sometimes hiring from specialty direct-lending firms or banks, Andrew Steuerman, head of middle-market lending and late-stage lending groups at Golub Capital, said in a Bloomberg Radio interview on Monday. Many pensions are doing this, he said, with those in Canada being particularly aggressive in buying and investing in smaller companies.

Earlier this year, for example, OMERS hired Matt Baird from advisory firm Alvarez & Marsal to be its first Europe-based operating partner, according to the Financial News. Canada's Public Sector Pension Investment Board hired banker David Witkin from Goldman Sachs to help with its European private debt investments.

This trend is notable and has some significant implications. Until now, private-equity funds have enjoyed tremendous popularity because of their stellar returns, and they haven't had to cut fees as much as hedge funds. This will most likely change as more pension funds struggle to achieve returns that seem increasingly improbable and seek new ways to bypass asset managers. (It's not just pension funds, by the way. Family offices are looking to directly source private debt and even buy companies themselves as well.)

Also, this flood of cash has resulted in lower yields and higher corporate valuations, reducing future returns on private company investments. In the first quarter of the year, private-debt funds had estimated returns of 2.36 percent, down from 2.46 percent in the same period last year and 3.97 percent in the period in 2012, according to the Cliffwater Direct Lending Index.

But as they say, extreme times often call for extreme measures. And for pension funds facing some unpleasant math, those measures increasingly include morphing into the firms they have long invested in. Chalk another one up for the do-it-yourself crowd. But that means private-equity fees could soon be on the chopping block.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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