SHOULD RETIREMENT FUNDS ALLOCATE CAPITAL TO PRIVATE EQUITY?
This article is the first in a series of seven, exploring private equity investment.
Any retirement fund trustee who has served a retirement fund for a couple of years will be tired of hearing industry professionals trying to manage their investment expectations with warnings like “We are in a lower return environment and it may last longer than we hope.”
Unfortunately, double-digit returns are much harder to come by than in the past. The long-term effects of the money that was pumped into investment markets following the Global Financial Crisis continue to linger. The capital which was pumped into investment markets was in essence borrowed from the future, which debt is now being repaid. Coupling this with global geopolitical tension and uncertainty, e.g. the trade wars between the USA and China, does not give a clear signal for blue skies ahead.
These returns that are expected to be “lower for longer” have been discussed ad nauseam. However, one of the drivers of this phenomenon has remained under the radar. Numbers of companies listed on stock exchanges in London, the USA, and yes, South Africa, have dwindled significantly. These numbers have reduced substantially in absolute terms, resulting in severely lower per capita numbers. As an example, there were about 600 listed companies on the JSE in 1994, compared to about 300 now. There are many reasons for this trend, but suffice to say that more and more companies are accessing capital through private (unlisted) markets.
The result is that the opportunity set available through listed investments is constrained and some of the best investment opportunities can only be accessed through private market investments. The longer-term nature of private equity investment (typically 10 years) also leads to investors earning a liquidity premium – that is a return greater than that of listed assets in the long term – to compensate investors for leaving capital untouched for about 10 years.
Another important consideration is that South African companies have been forced to seek revenue outside the borders of South Africa, due to low growth in South Africa in the short- to medium-term past. As a result, more than 70% of earnings of the JSE All Share Index listed companies represent foreign (non-rand) income. Investing through the JSE is therefore not investing directly in our country any longer. Investing in South African private equity, however, provides much more control in terms of where the capital is deployed. This represents capital that hits the “ground” of our economy, which can bring growth, create employment, etc. On the other hand, investing in listed companies simply drives the share prices up, but the money doesn’t really reach the real economy.
So private equity enables higher expected returns, with a better impact on the local economy. In addition, the JSE provides access to a very concentrated investible universe, whereas private equity investment significantly increases that universe.
The question begs, why are retirement funds not investing more into private equity? The table below comes from the Registrar of Pension Funds Annual Report of 2017 and shows that private equity (invested) exposure is about 0.3% of retirement fund assets (excluding the Government Employees Pension Fund, which has an exposure of about 1%).
There are a number of challenges to investing in private equity, which we will unpack in a later article. The main obstacle, however, is the specialist nature of private equity investment research. The ability to do thorough due diligence and select the best funds to invest in is scarce. The capability to manage cash flows takes some effort and the governance budget required from trustees is large (time taken to approve allocations to these funds). When we delve deeper into these challenges, we will also show how funds of funds (and some interesting variations thereof) can take the burden off the trustees’ shoulders in a meaningful way and make these investments feasible.
The global trend towards alternative asset classes, and private equity in particular is unquestionable. However, South Africa lags behind. Members’ return hopes are restricted by challenges that may potentially be resolved.
It may be worth our while to heed the warning of the head of investments at CalPERS (California Public Employees Retirement System – one of the biggest global retirement funds), Yu Ben Meng, who considers the current 8% allocation to private equity sub-optimal and wants to increase it to 16%.
Willem le Roux
Principal Investment Consultant and Actuary