Wanna See A Train Wreck? Pension Funds Doing Deals

I must say, I almost hurled yesterday when I read Andrew Lee Sorkin's article on pension funds making direct investments alongside private equity (PE) firms in the Sunday NYT. Now I said to myself "I know that some pension funds have been doing this for years - and many haven't done very well at it. But there is now enough activity to warrant a story in the NYT?" I had that sinking feeling again and a premonition - of a train hitting a wall. A large, deep, sturdy concrete wall. The kind that makes the train look like an accordion when it is run into. This is the picture of pension funds acting like private equity firms. Train wreck. Ugly. Few survivors.

There are so many things wrong with this picture it is hard to know where to begin. As many of you know I find great comfort in lists, so let me use one here to help organize my thoughts:

1. You don't know what you are doing so why are you doing it (#1)? Of course, because you don't have to pay the customary fees for the honor of investing alongside your favorite PE firm. So, let me understand, you are more interested in saving fees than in making rational investments? Doesn't this seem like the proverbial tail wagging the dog? Stupid, stupid, stupid.

2. You don't know what you are doing so why are you doing it (#2)? Ok, so you've been invited to invest directly in a deal and you are going to save fees, great. But how do you know that the deal makes sense, the capital stucture is appropriate and that the payoff you expect to get on this deal is consistent with your risk/return targets for this asset class? Of course, BECAUSE THE PE FIRM SAYS SO. Oh right, so you are relying on their due diligence and judgement to get this deal done. So you are abdicating your fiduciary, due diligence responsibility to a third-party? Brilliant. Now I understand.

3. Aren't there just a few conflicts of interest here? So let's see, the PE firms don't have to reach out to their peers as much (and deal with issues of valuation, deal structure, covenants, etc.) because they can tap their LPs. And what are PE firms with abundant capital in a competitive marketplace incentivized to do? Push capital out the door with as little hassle as possible. And what of the pension fund managers? Some managers get carried interests in deals where they don't have to pay fees to third parties. So these managers, who aren't terribly well paid, get a chance for PE manager-type payoffs by making direct investments versus investments in a fund. So what is any smart, self-motivated pension fund manager going to do? Invest direct, baby. There is no better game in town.

4. Isn't your charter to be diversified? Isn't that why you invest in FUNDS in the first place? Right, diversification. So what do you call a handful of direct investment bets overlayed against a portfolio of diversified asset class investments? A crap shoot. And what happens in craps if you don't know what you are doing and play only a small number of times? Right, you lose. The volatility you have just added to the book across both risk and return parameters is potentially catastrophic, depending on how many chips you have chosen to bet. Are you getting this? This is pure insanity.

5. Aren't you a fiduciary who should be devoting resources to the things you can control - say, building an asset allocation strategy that is in concert with your payout requirements and risk/return objectives? What are you doing operating as a PE firm? Aren't you really breaching your responsibility unless you have a massive, well-compensated in-house PE team that treats this as a business and not a sidelight? If I was an interested party in any of the less-sophisticated pension funds engaging in this kind of activity I would scream bloody murder. "Stop wasting your time and my money and keep you eye on the ball, stupid!" Yeah, that is what I'd say.

Now, the pension fund that gets some play in the story, Caisse de Dépôt et Placement du Québec (the "Caisse" to those who have been on the Street for a bit), is a bit of an anomaly. They are extremly smart, extremely sophisticated, a long-time investor in alternatives and potentially one of the exceptions to the rule of "Pension Funds, Stay Away." That said, for every Caisse there are probably 200 San Diego Countys (nice town, crappy asset management practices, abysmal returns), so the odds of success aren't great. I know I've been really negative lately, but stories like this (or, more accurately, the trends underlying the stories) scare the crap out of me. People can and will get hurt when stuff like this happens. Come on, people. Just say no. Stick to what you know. And don't get charmed by the wonders of PE. Everything is cyclical, remember?

ADDENDUM

In response to some really good observations by reader Ian Spivey, I have decided to pen a short after-thought to this post. To me the biggest issue is less the concept of PE firms "luring" poor unsuspecting pension funds into direct investments, but that the pension funds are making direct investments at all. While Ian correctly states that certain pension funds do have the competence and staffing to invest in such a manner (like the Caisse and those mentioned by Ian in his comment to my post), my contention is that this is the ONLY circumstance in which these investments are appropriate. And in my experience, these exceptions are pretty few and far between. Here are some relevant links to help readers gain some perspective on both the empirical research and a real-world example of this practice in action:

http://www.time.com/time/magazine/article/0,9171,1004789-1,00.html - May 2003 - Retirement Systems of Alabama (RSA) makes a $240 million direct investment in US Airways. Story leads off with David Bronner, CIO of RSA, puffing on a big Cohiba cigar. Kind of remind me of that 1986 cover of David Wittig, a 30 year old M&A banker from Kidder Peabody, puffing on a big cigar on the cover of Fortune saying "I make $500,000 a year." And where is Mr. Wittig now? In jail.

http://sfgate.com/cgi-bin/article.cgi?f=/c/a/2004/09/14/BUGQ08OAVE1.DTL - September 2004 - US Airways is bankrupt for the second time in two years. RSA's investment is all but decimated. There isn't any cigar puffing noted in this particular story.

http://www.olin.wustl.edu/firs/conf/shanghai/PDF/024.pdf#search=%22pension%20funds%20investing%20in%20private%20equity%22 - December 2005 - A scholarly paper titled "The Return to Pension Funds Private Equity Investments: Another Piece to the Private Equity Premium Puzzle?" The punch line is that between 1995-2004, the study shows that pension funds' private equity investments have underperformend their public equity investments by 5% - per annum.

There is so much more that I could write but I just quickly dug these out to illustrate my point. We have seen the same phenomenon in hedge funds and venture capital as well. When a manager, even a pension fund manager, has a string of good luck, they tend to attribute fund performance to skill and not good fortune. This then leads to greater risk-taking and the peception that "I am so smart and my knowledge is so generalizable, I can conquer multiple asset classes and generate performance like Swensen at Yale or Meyer at Harvard." Wrong, wrong, wrong. So Ian, thanks for the comment. I agree that Sorkin's article, though topical, directionally correct and well-written, was a little thin on data. Hopefully you find these data points helpful.