Pension funds investing in alternative assets
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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. Perhaps the most memorable example of a valuation error was the case of The We Company, originally named WeWork. 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 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. Although the stock market performed extremely well in the s, many investment managers believe that they cannot continue to rely on publicly traded equities to consistently achieve the outsize returns they require. 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.
This was down from 5. 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. Our monthly newsletter highlights the latest actuarial analysis and policy insights from our team. Thank you for your subscribing. When interest rates on year Treasury bonds slipped below 7 percent in , public pension systems floundered with their traditional investment strategies and leaned on their actuaries and investment consultants to help navigate complex alternative investment strategies.
Actuarial firms monitor past experience, calculate the current health of the fund, and report on what funds can be assumed to receive in investment returns in the future. If the plan falls short of this rate and does not make up for it by increasing contributions elsewhere, unfunded liabilities will increase. As of August , the weighted average assumed rate of return among state-managed public pension systems sat at 7. To make up for this underperformance and avoid increased taxpayer and member contribution requirements, pension boards sought out investment consultants who specialize in managing portfolios using alternative assets.
This pivot intensified after the financial crisis as tax revenue and paychecks began to shrink. The Challenge When a public pension board is forced to rely on investment consultants to navigate complex investment instruments on a multi-billion-dollar scale, the valuation and return of those investments must be as transparent as possible to avoid a surprise increase in contributions or ballooning debt.
Supporters of private equity firms routinely point to median annualized returns for public pensions coming in at upwards of But often the investment is in a limited partnership with a private equity firm operating as the general partner who buys and liquidates businesses. These liquidations, typically over 10 to 12 years, determine the true value of the investment. Until then actuaries use a value reported by the limited partner of these opaque assets to set funding policy and evaluate risk.
These investments are extremely sensitive to market conditions at the time of re-sale. If private equity firms hold onto assets until conditions improve, the plan will see zero realized return on that asset for an unknown amount of time. Because actuaries value public pension systems annually and pension boards base subsequent fiscal policies on those annual valuations it is even more important to assess what an accurate alternative asset assumed rates of return would be.
Simply put, alternative asset returns are hard to predict, especially for public pension boards, because of their structure. Even with full transparency, these alternative investments are the most challenging investments to value because they require assumptions about complex future cash flows and valuation multiples from future sales.
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