Public pension funds have been increasing their holdings of “alternative investments” in recent years. These assets fall outside the conventional investment categories of stocks, bonds and cash (and cash equivalents such as certificates of deposit and money market mutual funds). Alternative assets can include real estate and other tangible assets, as well as shares in private equity, venture capital and hedge funds.
The Georgia state legislature, for example, as of this writing, is considering a law that would allow the state’s pension funds to increase their allocations to alternative investments to as much as 10 percent. Some other state pension systems already invest a much greater portion of their assets in alternatives. For example, the Teacher Retirement System (TRS) of Texas recently reported that 14.5 percent of its assets were invested in private equity, 13.7 percent in real estate, 5.7 percent in “energy, natural resources and infrastructure investments,” 4.2 percent in “stable value” hedge funds, and 0.1 percent in commodities.
Most alternative assets are illiquid which means that they are more difficult to sell than conventional investments. While shares of stock can usually be sold immediately on an exchange or over the counter, alternative investments are not regularly traded. As a result, they are difficult to value. While it is normally possible to find a recent trade price for a stock or bond, no such market observations are available for alternative investments, so their values must be estimated.
Many alternative investments are shares in limited partnerships, such as private equity funds. Although these shares are securities, they are usually exempt from registration and disclosure rules set by the Securities and Exchange Commission (SEC).
The fund manager is not required to publicly disclose the contents of its investment portfolio, e.g., in the case of private equity funds, the list of companies the fund owns. However, the fund manager sends statements to investors that include performance information. These statements rely on estimates of fund assets, that are subject to substantial error given the lack of a liquid market for these assets.
For example, KKR & Company, a leading private equity fund manager, described its procedures for valuing private equity holdings as follows:
“… we generally employ two valuation methodologies when determining the fair value of an investment. The first methodology is typically a market comparables analysis that considers key financial inputs and recent public and private transactions and other available measures. The second methodology utilized is typically a discounted cash flow analysis, which incorporates significant assumptions and judgments.”
This reliance on assumptions and judgments can result in large discrepancies between valuation estimates and true value. Perhaps the most memorable example of a valuation error was the 2019 case of The We Company, originally named WeWork. Softbank, the fund that owned most of the company valued it at $47 billion in January 2019. When Softbank and its investment banks started preparing to sell shares of The We Company to the public, it became evident that the $47 billion valuation could not be achieved.
Before launching an initial public offering (IPO), a firm must issue a public disclosure with the SEC called Form S-1, which includes extensive details of the company’s operations and business plans. The We Company’s S-1 disclosure revealed that the firm was experiencing large losses and its CEO had major conflicts of interest. Investors were unwilling to buy shares based on a $47 billion valuation, or anywhere close to it. Ultimately, SoftBank had to cancel the IPO and infuse more cash into the struggling company. By November 2019, SoftBank valued the We Companies at only $7.8 billion and wrote down its own investment in the firm by $4.6 billion.
While this is a very extreme example, and no public pension fund invested in WeWork, this case illustrates the risk of private equity valuations not being realized when a sale is attempted. Other high-profile private firms including Uber and Lyft have been able to launch IPOs, but their market capitalization quickly fell below their private market valuations.
Additionally, academic research has shown that private equity fund managers exaggerate the reported net asset value of their funds when they are trying to raise additional capital.
Private equity and other alternative investments are attractive to public pension funds, because of the unusual large gap between risk free interest rates and investment return targets for pension assets. Recently, the 10-year Treasury bond was yielding around 1 percent while most large pension systems are assuming long-term rates of return between 7 percent and 7.5 percent.
Although the stock market performed extremely well in the 2010s, many investment managers believe that they cannot continue to rely on publicly traded equities to consistently achieve the outsize returns they require. These fears were confirmed in March 2020, when the coronavirus pandemic and bear market dropped the S&P 500 30 percent below its all-time high, which was achieved just a month earlier.
Consequently, they have turned to the alternative investment category, exposing public pension systems not only to the valuation issues discussed here, but also to high management overheads charged by many fund operators. For example, the California State Teachers’ Retirement System, CalSTRS, which has been a leader in providing the public with investment cost data, recently reported that the investments costs on its $19 billion private equity portfolio were 3.84 percent of assets in 2018. This was down from 5.21 percent in 2017, primarily due to a reduction in “carried interest,” which represents the general partner’s share of realized profits when funds sell their holdings.
A better alternative is for public pension systems is to accelerate the recent trend towards lowering their assumed rates of return, so that it becomes much less necessary to stretch for yield. Although this does require short-term pain in the form of greater employer and/or employee contributions, over the long-term this approach yields a much more stable pension system that retirees can rely on.