For many institutional investors, an Asset Liability Management (ALM) analysis forms the basis of their strategic investment policy. The investment policy is aimed at matching the growth in value of future assets relative to the growth of future liabilities. In that respect there are two important criteria: (a) the average expected investment returns should be high enough, and (b) the investment returns should be closely correlated with the development of the relevant pension liability structure.
The asset mix of institutional investors predominantly contains (traditional) equities and bonds, which satisfies (a) but not (b): during some periods investment returns are much higher than required, but during others they are much lower. The latter situation is illustrated in the following chart, which focuses on some extreme past periods. As can be seen, the most recent uncertain period between April 2000 and December 2002 is an example of a period in which due to the stock market crash, the shortfall (mismatch) between benchmark and required return is having repercussions on the strategic investment policy and investment risk profile of pension funds.
For a favourable value development, the investment policy should strike an optimal balance between sufficient return and acceptable risk. The goal should be to improve the risk/return profile of the existing portfolio. For investors with a longer time horizon of five to 10 years, extending the strategic asset mix by including a meaningful allocation to a longer duration asset class like private equity forms a logical extension to the current asset mix.
The percentage strategic allocation to private equity can be determined by quantifying three essential parameters: what superior return is realised and expected (private equity as return enhancer), how volatile is the private equity market (allocate as much as the risk tolerance permits), and the likely correlation with equity markets (perceived relatively low correlation).
As traditional asset classes become more competitive and therefore more efficient, private equity offers an alternative solution for achieving higher returns as shown in the underlying data.
Measured over variable investment horizons, the overall pooled (net) average annualised benchmark return of private equity for both the two largest sectors (venture capital and buy out funds) in the US has been attractive and superior to those of traditional equities. In Europe the relative figures are improving especially when taking the more recent investment periods into regard.

More stable returns
Rolling average private equity returns indicate that private equity returns are more stable than traditional equities, and that having a balanced approach by diversifying over regions and sub-styles makes sense. Private equity is outperforming listed stocks even in today’s turbulent investment climate.
Furthermore, due to the wide variation in individual fund returns and individual managers’ abilities, assessment and selection is nowhere more important than in private equity.
The spectacular private equity returns seen in the late 1990s and the negative returns in more recent quarters should not disguise the fact that the private equity industry in general historically has returned around 15% to 20% per annum to participating institutions.
As well as return figures, the short and long-term risk characteristics of private equity should be assessed. Prudent consideration should be given to the fact that as a result of accounting-based valuation techniques, infrequent valuations and the paucity of data (lagging effect), the short-term volatility of private equity returns and their correlation with public equity tend to be very low. A general observation regarding the low risk and low correlation of private equity is that this is inextricably linked to the relatively illiquid unlisted nature of this kind of investment. If private equity were to be traded on public exchanges, it is very likely that its volatility would rise substantially. One might therefore decide to make an educated guess as to what the “real” volatility and correlation of private equity ought to be. Alternatively, a longer-term volatility and correlation can be estimated from the available data. These numbers turn out to be significantly higher than the short-term estimates. Although the diversification benefits of adding private equity to a traditional asset mix are reduced based on these estimations, these benefits remain clearly positive. In other words, private equity does not only increase expected returns, but also reduces the volatility of a traditional asset mix.

Closer look
Looking more closely at the interrelationship between private equity and traditional equities, we find that the correlation is not the same in both rising and falling markets. Falling equity markets spill over to private equity much faster than rising equity market returns. Downward corrections in stock markets are followed by the private equity industry as it revalues its portfolios, as has also been the case in the most recent market crash. Furthermore, the over-all correlation with traditional equities has risen substantially during recent years relative to previous periods. The correlation between private and listed equity is therefore not constant under all market conditions.
Historically private equity has outperformed listed equities. There are two reasons for expecting this to continue in the future. First a liquidity premium can be expected on account of the relatively illiquid nature of private equity investments. Second, private equity is an imperfect market, characterised by information symmetry. Investors demand an extra premium for this.
The diversification benefits of private equity are also likely to remain, as private equity offers investors an exposure to other types of companies and which are driven by other economic factors than the companies that are listed on public stock markets.
In today’s market, pension funds may find themselves reaching the top end of their private equity range as their public equity portfolio has depreciated and distributions are taking longer than anticipated. This is an important concern for institutional investors, particularly those facing the possibility of large cash outflows. Why reduce one’s private equity allocation when the pension fund’s exposure limit is reached when private equity tends to outperform listed stock indices?

Having a liquidity budget
The ultimate consequence is that pension funds may be forced to reduce part of their private equity positions through secondary sales. It would be an alternative to find other assets to liquidate when such needs arise. In this context pension schemes should perhaps consider setting a kind of liquidity budget, a percentage of the investment portfolio that should remain liquid, which they can absorb in case of abrupt price trends. Given the long-term liabilities of institutional investors, a significant portion of the asset mix may well have an illiquid nature. Therefore, the oftentimes tight limits on the maximum acceptable allocation to private equity could very well be relaxed.
Institutional investors with no exposure to private equity at all as yet, or those who have just started their investment programme, may find today’s environment a good time to begin investing in private equity, further diversifying their commitments over time.
There are long-term performance cycles connected to private equity. Its historical outperformance and longer-term investment return justifies building or maintaining a strategic commitment (structural holding) to private equity, even in uncertain times. Pension schemes are going to need high returns if they are to pay for the growing retirement needs of fast-aging populations. High, absolute returns are needed to protect coverage ratios.
The above shows that even under conservative assumptions, private equity can considerably improve the risk/return profile of a traditional investment portfolio, and reduce overall volatility while increasing returns. Many pension schemes typically run a considerable degree of mismatch between their pension liabilities and their assets. A margin of a diversified private equity portfolio may decrease their risk (volatility) while simultaneously enhancing expected returns. One of the main lessons that even quite mature pension funds should take on board is that despite the stock market crash, private equity should remain a stable investment category in the overall portfolio and not become a more short-term oriented (forced) trading asset.
Ad van den Ouweland is managing partner at Robeco Private Equity in Rotterdam

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