Back in 2007, equity market volatility was extremely high, inflation was on the rise, and we wanted to look for an asset class that was uncorrelated from public equity. The Pictet Pension Fund board decided to diversify and invest in private assets.
Have private assets been helpful for our pension fund? Over nearly two decades, our private equity allocation has outperformed both the broader private equity industry and the stock market.Performance compared to Burgiss Global Private Equity and MSCI World indices, using quarterly data in Swiss francs, after fees.Furthermore, it has shown lower volatility, thereby optimising the risk/return profile.
US companies with revenues over USD100mn, % share of private vs public
Source: S&P Capital IQ, 01.2022.
Reasons to invest
Performance, therefore, is one reason why private equity appeals to investors, especially to pension funds. But there are other factors at play, too.
The opportunity set is much greater. In the US, for example, 87% of companies with revenues over USD100 million are private – and that share is growing. The number of listed companies in the US has fallen by over 40% in the past 30 years. So, there are fewer and fewer listed companies. What is more, those that are listed have been actively buying back shares, further shrinking the stock pool.
Another argument in favour of the asset class is that, increasingly, most of a company’s value accrues prior to it going public.
With businesses staying private for longer, the median value of a US company at the point of initial public offering (IPO) has increased to USD802 million in 2021, compared to USD132 million in 2000.
Private markets also offer greater potential for diversification. The MSCI World Index is a common proxy for global equity exposure and is ostensibly a diverse benchmark, yet 76% of its total market cap comes from North American companies. The figure is just 51% for our private equity allocation. That diversifies both our geographical allocation and currency exposure.
Then there is concentration. The top 10 companies in MSCI World account for 26% of the index; in our private equity allocation that share is 10%, so it’s a much broader set of companies, much more diversified. And the sector mix is also much more varied, with less of a skew towards tech. That means we are much less vulnerable to problems at any single company.
Company age and size at point of IPO
Source: Nasdaq Economic Research, Pitchbook. Age is the year of IPO minus the year of founding, valuation based on median pre-IPO valuation.
Lessons from experience
Based on our experience, there are four key considerations for investors looking to make an allocation to private assets.
Firstly, it takes time. Several years can pass between agreeing to invest and when capital is called. And even more time is then required to generate the returns. Investors need to make a long-term commitment to a private asset allocation.
Secondly, a clearly defined implementation plan is imperative. We set some rules from the start. We chose not to maintain a cash position to avoid incurring opportunity costs. Keeping money in cash would have prevented us from generating returns in other asset classes while we waited for our private equity commitment to be called; instead, we wanted our allocation to work and provide return. Capital calls are drawn from the fixed income sleeve for our first tranche, then from the equity sleeve for the second tranche. We decided to manage our allocation by target net asset value (NAV) as a percentage of the total portfolio, rather than based on commitments.
Over time, we also moved from investing in ready-made private equity funds to a dedicated mandate, allowing for more customisation and closer monitoring of cash flows. By 2026, we hope to achieve a mature portfolio, in which capital calls are matched by distributions, making our private asset allocation self-financing.
Thirdly, investors need diversification within their allocation. That includes diversification across vintages. It’s a bit like wine: there are good vintages, and there are less good ones. You have to choose the right manager, understand their philosophy and compare to a benchmark. The dispersion of returns across private asset funds is quite high: on every vintage there is a gap of around 15 percentage points in returns between the best and the worst quartiles.
Vintages take time to become fully invested, and each vintage features different companies. It’s not like public equity, where whenever you invest in MSCI World over the course of, say 20 years, you get largely the same companies. In private equity, each vintage is a unique set of opportunities. It is by adding these little Lego-like pieces that, in the end, you can really achieve portfolio growth.
Finally, investors need to allow for some flexibility on their target allocation. Private assets tend to be much more illiquid than public, so it is very difficult to get exactly to target. It is important to allow the allocation to periodically deviate from the target level. So far, we have never rebalanced our private equity portfolio simply because we were slightly above the target. We look at the future path of commitment and what would be the effect on our pension fund targets.
Co-investment and buyout
Where to invest within private equity? Whether investors want to enter private equity for the first time or ramp up their existing allocation, the secondary market can be an easy route. This entails investing in existing funds, which are more mature; they are already invested, and their holdings are known.
As our pension fund has grown, we have increased the share of secondary deals in our portfolio. We also have some co-investments – a structure through which private equity funds (general partners) offer select investors (limited partners) the opportunity to invest directly alongside them in a specific transaction. Co-investments tend to be deployed relatively rapidly, and can offer a higher target return than primary deals.
However, the majority of our allocation is to primary deals, in other words committing to new funds or vintages, which offer more diversification.
In terms of strategy, we focus on buyout, which is investment in mature companies with positive cash flows, often leaders in their fields. On average, the quality of their management teams is higher and the mix of return to risk is appropriate for us. But we also have some turnaround deals and some venture capital – investments where risk is higher, but returns can also be higher.
As a pension fund manager, you need strong insight from many, many colleagues. I feel like a chef d’orchestre, but I need very good musicians. With their help, our private equity investments have enabled our pension fund to diversify its equity allocation, reduce concentration risk and increase portfolio decorrelation.
