As for overall fund returns, Prof. Ang warns against relying on inflated data skewed by what’s called survivorship bias. Whenever poorly performing private equity funds fail, they stop reporting returns, and that means these portfolios are then excluded from further industry calculations.
To account for subjectivity and biases, auditors and valuation firms have developed code phrases such as “range of reasonableness” and “disparity in practice” – all of which are “code words for ‘fudging it,’ ” Mr. Smith said.
Global bodies such as the International Accounting Standards Board have become aware of the inconsistencies and laid out guidelines to standardize the valuation process as much as possible, including hiring external advisers to offer independent estimates. However, “it still is a subjective exercise by design,” said Colin O’Leary, the Canadian leader for valuation and business modelling at Ernst & Young.
“Many times when you talk to people on the deal side … they will give you this answer: ‘It only matters what happens when we get to the end of the investment,’ ” said David Larsen, a managing director at valuation and corporate finance advisory firm Duff & Phelps, which does work for the Canadian pension funds.
The valuation team at PricewaterhouseCoopers deals with the same issue. Clients “may struggle with the concept of ‘fair value’ when it differs from their expectations,” said Sean Rowe, a partner at the firm. “They may see the longer-term value, and not the immediate value.”
Advisers stress that mid-term checkups are incredibly important. Mr. Larsen, who was on the drafting committee for the U.S. Private Equity Valuation Guidelines, said funds have a fiduciary responsibility to know exactly what is going on, and constant valuations help to determine which asset allocation changes need to be made – should the manager put more money in private equity or less? Should the manager buy more stocks or fewer of them?
The issue is a hot one at the University of Toronto’s Rotman International Centre for Pension Management, which is run by renowned pension expert Keith Ambachtsheer. At this very moment the ICPM is doing research to find better ways to come up with mid-point valuations for illiquid, private assets.
These checkups are especially handy when material changes arise. This week, rating agency Standard & Poor’s downgraded the debt of Teranet Inc., which has a monopoly on land registration data in Ontario and Mantioba, and is owned by the Ontario Municipal Employees Retirement System. While the company’s business model is still solid, S&P says, it worries about how much debt has been added to fund acquisitions – which could ultimately affect the firm’s value.
When pressed about their private equity exposures, Canada’s pension funds often point out that their private asset portfolios are largely comprised of infrastructure investments, such as toll roads or water utilities. Because these assets are government regulated and are often essential to daily life, they are widely viewed as extremely safe alternatives that are bound to see their values rise in the long run.
Not everyone is convinced. Jim Keohane, chief executive officer of HOOPP, the pension plan for Ontario health care workers, stresses that these assets are still illiquid. “Liquidity can have tremendous value at certain points in time,” he said, adding that the risk premiums embedded in the values for these rarely traded assets often aren’t high enough. “From what we can see in pricing, it’s just not there.”
This doesn’t mean HOOPP is against all private deals. The pension fund has a sizable real estate portfolio, for instance. But Mr. Keohane worries that too many people have blinders on, especially with regard to government regulated infrastructure assets.
“I go to meeting after meeting, and I hear over and over again, ‘I just made this investment last year and the regulator came in and changed the rules on me.’ That happens all the time,” he said.
The Canada Pension Plan Investment Board, for one, recently invested in Gassled, Norway’s offshore gas pipeline system, and shortly after, the country announced major cuts to gas transportation tariffs, prompting the Canadian fund and its investment partners to sue, tying them – and their capital – to a lawsuit that could drag on for years.
There are ways to make private equity work for pension funds. Teachers has been investing in private markets for more than twenty years, and it is viewed as a global leader. But Teachers also has the luxury of being patient now that it has a sizable roster of investments.
“There’s no pressure to have to do a deal, and that makes Ontario Teachers different than a typical private equity [firm], or a younger pension plan that is trying to get money into a particular asset class,” Ms. Rowe said – especially in such a heated market.
“This industry has matured,” Prof. Ang said. “It’s always harder to get superior returns when there’s a lot of money chasing deals.”