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The Canada Pension Plan Investment Board 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.J.P. MOCZULSKI/The Globe and Mail

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.

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."

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