Why public pension systems invest in private equity, even when they shouldn’t

When targeting pension funds as potential investors, private equity groups adorn their brochures with stock photos of solemn hospitals, smiling firefighters, and technology renders. The pitch often combines the promise of outperforming traditional assets with the social upside of funding local developments. Why fund ExxonMobil when your pension system could earn higher returns by supporting a local trash-collection company?

Meanwhile, opponents of private equity entanglements appear to peruse the results of the Shutterstock images of “evil Wall Street businessman shaking hands” when picking the cover image for their commentaries. The reason for so much resentment? Private equity has no mercy. Skeptics argue that private equity’s scrupulous focus is on the bottom line, and unreasonable risk-taking is generally counterproductive to society, leading to unsustainable management and misallocation of capital. This exposes public pension funds, and as a byproduct, public employees and taxpayers, to much more risk than they prescribed—and often understand. 

Those who speak of the rise in private equity investments among institutional investors, particularly by pension funds and endowments, seem to believe it is either their salvation or a scam. Few venture into public pension managers’ shoes and consider the institutional arrangements that might have cornered them into such a position. 

The American Investment Council claims in its 2021 Public Pension Study that private equity provided higher return rates than any other asset class, with a median annualized return, net of fees, of 12.3% over 10 years. The Illinois State Board of Investment had the most success, with an estimated 10-year annualized return of 19.8%. 

​​Public pensions comprise 31% of all private equity investors’ funds and contribute 67% of their capital. Private equity now represents upwards of 13% of pension portfolio assets as of 2022, compared to just 11% in the prior year. 

Private equity firms offer pension systems a potential avenue to overcome the declining public market returns of the past decade with the added benefit of diversification and reduced volatility. Investing is always an unraveling of tensions, with parties doing their best to estimate risk and accurate compensation in public or private markets. Private equity is still equity, after all, with more tradeoffs.

Why private equity shouldn’t make sense to pension funds

1. Speculative returns v. certain liabilities

The U.S. Securities and Exchange Commission (SEC) released a “Risk Alert” warning in Jan. 2022 to investors that some private equity firms have been misleading investors about their performance track records. Since then, the SEC has proposed stricter rules requiring better disclosure of fee arrangements and investment allocation, aiming to facilitate accountability and legal disputes by pensions and endowments over investment decisions.

Since such assets are not marked to market, the actual rate of return is unknown until the end of the agreement, often years, if not decades, ahead. The record return rates claimed by the American Investment Council and similar proponents of private equity is annualized, unrealized, and, due to the nature of this business, often quite speculative. The legal certainty of pension liabilities puts into question the appropriateness of accounting unrealized speculated returns unadjusted for risk into the obligation estimates.  

2. Burden of fees  

Access to private equity is expensive. As frequently pointed out by the SEC, such funds charge a multitude of fees. Some opt for the traditional 2% on assets plus 20% of gains over a certain benchmark. Such fees can undermine gains and often transfer the market and fundamental risk to the pension funds, leaving the private equity firms flat—and the funds with a big burden: outperform the public market, accounting for the additional risk and fees.   

The price for such access can vary depending on the client. Juliane Begenau, in a Stanford Business School working paper, observed that negotiation skills or bargaining power materially impacted the fees charged to different pension funds. Such variation can affect the net risk-adjusted rate of return, potentially pulling smaller funds into arrangements that may not be as effective in promoting solvency as traditional investments.

3. Risk-adjusted underperformance

Many actively managed funds have found success by selecting and overseeing their private investments. Still, on aggregate, alternative investments such as private equity and real estate tend to underperform in longer time horizons. 

According to a soon-to-be-published study in The Journal of Investing, since 2008, U.S. public-sector pension funds realized a real negative alpha of approximately -1.2% per year, virtually all of which is associated with their exposure to alternative investments.

Private equity investments can be much riskier than they appear. It poses unique challenges, ones that are exaggerated by the asymmetry of information and illiquidity of private markets. Annualized rates can be misleading, and when accounting for risks, the realized returns often underperform. Such a reality could threaten the promises made to pension holders if the market unravels unfavorably. Still, private equity and alternatives continue to gain space in pension portfolios. Why?

Why it does make sense, even when it shouldn’t

It was not ignorance but rather cleverness that drove pension funds to private equity. 

Present accounting standards discount debt and project future assets based on the expected rate of return. This arrangement incentivizes risk-taking, as it does not account for risk when forecasting debt and assets. Public pension funds are under pressure to reduce the accumulating debt as much as possible and present an actual rate of return that matches estimates. Private equity offers both, though the promise rarely materializes. 

With most pension funds facing growing unfunded obligations, managers have been held under scrutiny to increase the funding ratio to honor the benefits promised. Unexpected falls in investment returns following the dot-com bubble and the great recession compounded a hole in pension balance sheets, which is forecasted to reach $1.3 trillion in 2022. 

Public pension fund managers have very limited tools to address underfunding. Only lawmakers can increase workers’ and taxpayers’ contributions to pension funds or reduce annuity benefits promised, leaving pension managers with only one variable in their control: the rate of return.   

This is not a story of managerial ignorance but of rational response to the present institutional arrangements for public pension systems. In the search for better returns, public pension funds found themselves with few options but to increase risk-taking, even if not always appropriately compensated for the genuine exposure taken. The benefit of a high return rate is two-fold: it increases projected assets and decreases the present value of liabilities. This lowers the infamous public pension debt, their unfunded liabilities, from both ends.

Even if too risky for what it is, private equity offers pension funds a theoretically high rate of return underwritten by a prestigious third-party, improving accounting optics. And against optics, rationality never stands a chance—until the day of retribution, of course.