Pension funds should grab 15% private equity opportunity – John Oliphant

Head of the R1.4 trillion  Government Employees Pension Fund (GEPF) John Oliphant has been in the news for the wrong reasons lately. Controversially suspended after being outspoken on broad Governance issues, five months after the event he still awaits a disciplinary hearing. Oliphant, who is highly regarded internationally, hasn't crawled under a rock. In this blog written in a private capacity for Biznews.com, he urges pension fund trustees to expand their horizons at a time when the country faces the prospect of stagflation and the search for yield is very much on. He reckons Private Equity is an obvious opportunity now that the law has changed to allow 15% of the funds' assets in alternative investments.  – AH  

By John Oliphant*

In a low return environment, investors need to find creative ways to generate sustainable returns. Depending on the risk appetite, one could explore a variety of strategies ranging from hedge funds to equity. But each option presents complexities for both trustees and regulators alike.

For the regulator, these complexities present challenges on many fronts. Firstly, the regulator will need to put in place mechanisms to ensure appropriate monitoring of risks both structural, and unique to each fund. Secondly, the trustees of pension funds will need to be sufficiently equipped to be able to make optimal decisions in a complex and multi-product environment.

It would be irresponsible to introduce complex assets into pension fund portfolios that trustees do not fully understand, or fully appreciate the risks being taken. But it is just as irresponsible to hide behind ignorance,  and forego learning about new opportunities that could enhance returns for members and pensioners.

In this regard, the Minister of Finance, as the custodian of regulations governing pension funds, amended Regulation 28 in 2011 to allow pension funds to allocate more funds to what is generally termed alternative investments ("alternatives").

These regulatory amendments ushered in a new era that allowed pension funds to invest up to 15% in alternative investments such as hedge funds and private equity funds. Previously this was limited to only 2.5%. As a result, most pension funds had minimal exposure to alternative asset classes prior to the amendments in 2011.

It also made sense at the time for trustees not to waste their energy in understanding these alternatives as they had "the other" 97.5%  to worry about. As such,  hedge funds and private equity were periphery to the agenda of most pension funds, and this is still the case almost three years since the amendments were made to Regulation 28.

So why is this the case? Are trustees simply ignoring these possible sources of additional returns? I submit that in a low return environment, ignorance will simply not be an acceptable excuse.

The search for higher yield should start in earnest, as the economy is on the brink of stagflation – that is high inflation and low growth – which is not a good combination for pension funds. As pension fund liabilities are linked to inflation, it is vital that their asset portfolios grow at rates higher than inflation. The economic environment therefore calls for a revisiting of investment strategies by pension funds. And in this regard alternatives should be given sufficient attention on the agenda of pension funds, as they offer diversification and additional sources of returns.

With an increased allocation to alternatives now allowable under law, it is imperative that trustees consider them. This offers pension funds an opportunity to build truly diversified portfolios by reducing dependence on traditional publicly-listed securities. Although the regulatory barrier has been lifted, there might be a number of other factors that could contribute to the slow take-up of the opportunity to invest 15% in alternative investments. Top of the list should be risk appetite, trustee education, liquidity and fees.

On the risk appetite, I believe it is mainly the risk of the unknown as opposed to the risks inherent in investing in these asset classes. I therefore believe it is the equal responsibility of all key players to dispel the myths that alternatives present much higher risk. Alternatives offer an opportunity to push an efficient frontier – optimal combinations of assets that yield the highest returns for a given level of risk – outwards, thereby increasing returns for pension funds for a given level of risk appetite. This, in a low return environment, trustees cannot afford to ignore. In this regard trustee education is critical in understanding the risks and opportunities. Trustees should take it upon themselves to learn more about asset classes such as private equity.

In my view, private equity is an important element of alternatives, because its long-term nature makes it stand out and as such is more suitable for pension fund investing. David Swensen, Chief Investment Officer at Yale Endowment and one of the longest serving institutional investment managers of all time, writes in his book "Pioneering Portfolio Management," that a well selected private equity holding contains the potential to make a dramatic contribution to portfolio returns.

In SA for example, the Riscura South African Private Equity Report indicates that Private Equity Pooled Internal Rate of Return for the 10 year period ending September 2013 was 22.2%, against the All Share Total Return of 20.8% for the same period. Although these are just averages, they do compare favorably. However, as Swensen indicates, the key is in selecting winners, as the difference between the top and bottom quartile in the private equity space is significant. This suggests that trustees must pay particular attention to the selection of managers in their private equity allocation.

Other issues that pension funds need to tackle include liquidity and fees. Liquidity is an issue especially for smaller defined contribution funds. The industry will need to develop in a manner that addresses this shortfall. But there are signs that the secondary market  is developing well in SA. If this trend continues, it will imply that funds will be able to sell their commitments in the secondary market if they need to liquidate their holdings.

I also see an opportunity for insurance companies to play in this space, by providing liquidity at a premium for example. With proper planning, pension funds could find optimal ways to manage their commitments to private equity while not introducing administrative challenges to the fund in respect of payout commitments.

Although there is greater alignment of interest because of the nature of private equity as an asset class, fees are still stubbornly high. This is certainly a barrier. But on the other hand, cheap is not always good. The right balance will need to be achieved. I believe market forces over time will determine the appropriate level of fees.

The search for higher yield has started and I believe this bodes well for alternative asset classes. I hope the industry will grab the opportunity and develop in a responsible way.

* John Oliphant wrote this article in his personal capacity. He was recognised as Africa's future leader of the year 2013 by Africa Investor, 2012 Pension Fund Industry Person of the Year – Principal Officers Association.