In the middle of a private equity bull run, with money managers such as Canadian pension funds searching for superior returns outside traditional public markets, Andrew Ang is one of the few brave souls waving the caution flag.
Early in 2013, the professor and chair of finance and economics at Columbia Business School put out a prominent paper that suggested private equity returns aren’t as sexy as they seem. His research targeted large, long-term investors, such as university endowments and pension funds, which regularly cite their lengthy time horizons and deep pockets as key reasons to invest in private companies and infrastructure assets.
Because these funds often do not pay their beneficiaries for 20 or 30 years, they argue that they have the size and patience required to invest in illiquid assets that are thought to offer top-notch returns.
But Prof. Ang found that widespread biases inflate private equity returns. And even after adjusting for these, the gains often aren’t enough to justify the extra risk that comes with this type of investing. In a public market, investors can buy and sell at any time; in the private asset world, the market can quickly dry up.
“Many [funds] have these expected return targets that I think are unrealistic,” Prof. Ang said in an interview.
He isn’t alone any more. As private equity heats up, there are growing questions about the industry and its valuations. Even the Securities and Exchange Commission, the major U.S. market watchdog, has weighed in, with reports surfacing in April that an internal review found widespread compliance shortfalls that can affect the way funds are valued.
The questions come just as Canadian pension funds pile into private markets, searching for juicy returns many claim cannot be made from investing in publicly-traded securities. The Canada Pension Plan Investment Board, the investment arm of the country’s largest pension fund, now has 40 per cent of its portfolio in private assets, which includes privately held companies, real estate, infrastructure and securities such as private debt. Smaller rivals are following suit. OPTrust, the pension fund for Ontario public service employees, just signed its twelfth direct private equity deal in two years.
These pension funds are ramping up in what observers are calling an incredibly expensive market. Scores of private equity funds have emerged as the industry matured over the past two decades, boosting demand for a relatively fixed assortment of assets, and debt financing to fund takeovers is readily available thanks to the Federal Reserve’s post-crisis stimulus program. “There’s just a ton of liquidity out there,” said Jane Rowe, head of Teachers’ Private Capital, the private investing arm of the Ontario Teachers’ Pension Plan.
Undoubtedly, private assets can offer enticing returns. Teachers made boatloads by investing in Maple Leaf Sports and Entertainment, which owns the Toronto Maple Leafs and the Toronto Raptors, for instance, and Teachers’ private equity arm has returned 19.5 per cent, net of fees, since its inception in 1991.
But such outsized profits can also be outliers and it isn’t clear whether all of the country’s pension funds know what they are getting themselves into – specifically, how difficult it is to build a first-class franchise. Even Teachers, a widely respected private equity player, acknowledges that it stumbled badly in its early days. “It is a business where we had to learn to crawl, then walk, before we could really ramp up,” Ms. Rowe said.
One of the industry’s major drawbacks is the difficulty faced when trying to value private investments between their initial purchase date and the time of their ultimate sale. Unlike stocks traded frequently on major indexes, providing observers with regular updates on what the market considers a fair price, private assets change hands much less often. The average holding period in private equity is four years, and a lot can happen during that time; in extreme cases, a pension fund could buy a water utility and own it for 25 years. As a result, the valuation process is full of subjectivity.
“A valuation is an estimate. I don’t care if we do it or Goldman Sachs does it,” said Andy Smith, a principal at valuation specialist McLean Group in Virginia. “It’s an estimate, and you need to be asking questions.”
Because there is so much more subjectivity when comparing thinly-traded assets such as water treatment plants or highways, “if you’re valuing any asset, you’re always plus-minus 10 to 15 per cent,” Mr. Smith said. Annual performance metrics can’t always be trusted, and they are especially problematic when markets sour.
During the financial crisis, Harvard University’s endowment fund – then valued at $37-billion (U.S.) – famously lost 22 per cent between July 1 and Oct. 31, 2008, and university officials warned that even more value was destroyed after factoring in private equity and real estate, which could not be accurately priced in such a volatile market. Because the university did not have a clear picture, administrators were suddenly told to cut their budgets in dramatic fashions.