"Pension funds shouldn't be directed toward the private equity industry"

Don't force pension funds into the industry, says Merryn Somerset Webb, because the private-equity party is over

Yale wants to leave. Half of its assets were invested in illiquid markets four years ago, primarily in private equity. According to Bloomberg, the institution plans to sell about £6 billion worth of private equity (PE) assets this year, which represents 30% of the total in that industry and 15% of the fund's total assets (£41.04 billion). You are not alone. According to the Financial Times, Harvard is looking to sell £1 billion worth of PE assets, and some of China's largest funds, as well as Canadian and Danish pension funds, have been reluctant to contribute any new capital. For the third consecutive year, fundraising was lower overall last year.

Clearly, you can see why. Since the year 2000, PE has outperformed the SandP 500, and it has had a stellar couple of decades. When debt was cheap and private equity was relatively specialized, it made sense to purchase businesses with borrowed funds, restructure them (borrow more, cut costs), and then sell them for a fortune. This was also very profitable for investors and high-fee managers.

Now, however, valuations appear excessively high, and the "flog-on" component of the equation isn't working, as rates aren't going back to anything close to zero anytime soon and the economic climate is more precarious than it was. On the secondary market, nobody wants to sell their businesses for a low price. The few recent transactions were made at an average 10% discount to the declared net asset value (NAV). As the consulting firm Bain kindly states, there has been "persistent sluggishness in exit volume" over the past few years, and the number of unsold deals simply keeps increasing. It currently amounts to about £3 trillion.

Meanwhile, distributions made with money from sales are only around half of what they used to be. You could argue that this is unimportant, but in the realm of physical education, it is. Funds are insufficient for new deals in the absence of distributions, especially if the institutions aren't investing new funds, which they typically aren't. The "outsize capital flows the industry got used to before the pandemic are unlikely to resume in the near future," Bain says, which is understandable.

Whether they like it or not, pension savers are saving the day.

What will happen next? If the major investors are pulling out, will anyone else be joining? Perhaps you. PE closely monitors the retirement funds of regular Americans. The PE industry estimates that the £12 trillion in the sector could be used very effectively. They have Rachel Reeves on their side. According to her, pension funds from UK savers might also find contentment in PE. This week, 17 of the largest pension funds in the UK promised to invest at least 10% of their default funds' assetsthat is, your assets, to be clearin private markets, including unlisted start-ups. At least half of that amount, or about £50 billion, will be in the UK.

This might be completely voluntary. Given that they currently only have around 2 percent in PE, it's possible that the UK pension funds are lagging behind Yale and sincerely believe this is a good idea. Or perhaps the pension funds in the UK are soaring before being pushed. According to the FT, a "backstop plan" exists. Should the funds remain stagnant, Reeves will enact legislation to establish "reserve power" to force them to move.

A former pensions minister believes the British government should take a bold stance and mandate that at least 25% of all new pension contributions be invested in the UK, both in listed and unlisted companies. There is also increasing discussion about the same kind of idea being implemented more broadly.

Are you happy about this? To start, it's unclear exactly what private market investment will entail in this situation, but infrastructure projects are probably going to be included. Regardless, it is evident that a portion of your funds will soon be allocated to PE.

The second important point is that Reeves, the pension funds, and the PE funds believe you should be pleased with the plan. Here is Reeves' opinion on the subject: "I applaud this audacious move by some of our largest pension funds, which will release billions for promising start-ups, clean energy, and major infrastructure projects that will create growth, increase pension funds, and provide working people with more retirement security."

Thirdly, something is wrong. Since the asset class in question has made a significant portion of its returns due to circumstances that aren't returning (near-zero interest rates), Reeves should be aware that past performance is not a reliable indicator of future performance. According to consulting firm McKinsey, 61 percent of investment returns for buyout deals between 2010 and 2022 were driven by leverage and market multiple expansion, which is the process by which valuations increase due in part to low interest rates.

That's nice. However, what would happen if rates were not so low? If you look at the previous few years, you can see that PE returns in the first nine months of last year were 3point 8 percent (based on McKinsey figures once more), which is "well below the historical average of roughly 14point 5 percent since 2010." Over the next few years, UK investors will most likely be informed that PE is a necessary diversifier and has a far better performance record than listed equity. The possibility that its performance might not be repeatable in this setting is unlikely to be communicated to them.

Additionally, they won't be informed that, despite all the bluster, PE is really just equity with much higher fees, increased leverage, and less transparency. or that, at the very least, their funds are covering a void left by institutional investors. All things considered, if you're interested in equity, why not look for a pension provider willing to continue investing your funds in inexpensive, comparatively liquid listed companies at a cheaper cost?