Preqin: PE Managers Must Act After CalPERS’ Cuts

Private equity fund managers should take heed of the California Public Employees’ Retirement System’s (CalPERS) overhaul of its allocation to the asset class and focus on justifying the terms they present to clients, according to Preqin.

“CalPERS’ decision serves as an effective statement to fund managers on the importance of justifying fund terms.” —PreqinThe research firm was responding to last week’s announcement by CalPERS that it wanted to drastically reduce the number of private equity managers it uses in order to cut costs.

“The decision by CalPERS may not immediately result in a drop in overall commitments to private equity funds,” Preqin said in a research note, “but serves as an effective statement to fund managers on the importance of justifying fund terms, as well as the power of the limited partner.”

The research firm said CalPERS’ decision reflected a wider concern among investors that fees were the biggest challenge to their investment in private equity. Roughly 58% of respondents to Preqin’s survey of US public pensions said fees were their chief concern.

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However, appetite for private equity has not waned: the research showed that the number of US public pensions active in the sector rose in each of the past four years. Pensions’ average target allocation also rose in each of the past four years.

CalPERS has roughly 10% of its $296 billion portfolio invested in private equity. Preqin reported that this allocation included 444 funds and 298 active partnerships.

The $187.1 billion California State Teachers’ Retirement System (CalSTRS) is the second biggest public pension allocator to private equity in dollar terms, having invested $21.1 billion (11.3% of its portfolio) in the asset class. Texas, Oregon, Michigan, Washington, and Pennsylvania pensions have all allocated more than 10% of their portfolios, with the latter two investing more than 20%.

Alternative managers could continue to generate uncorrelated, strong risk-adjusted returns in 2015 if they focus on risk management, according to the Deloitte Center for Financial Services.

The firm argued investors’ concerns of hedge funds’ underperformance and record levels of private equity dry powder may be “overstated” as they have held steady performances over the long term.

“Alternatives have held true to their core value proposition of strong risk-adjusted returns and low correlation to the broader market,” Deloitte said. “The alternatives industry is still among the most nimble and adaptive sectors of the financial industry.”

According to the report, managers will need to take a more “proactive and strategic approach” to not only risk management but also managing their reputations with clients.

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“Firms understand that if managed correctly, risk management is a competitive differentiator and can be transformed into an asset that drives brand equity and provides a measurable, positive return in the form of increased asset retention and new asset flows,” the report said.

In 2015, alternative managers should strengthen their governance structures to put risk management “the very ethos” of their firms, Deloitte argued. It is also expected that firms will standardize risk reporting to evaluate and prioritize certain risks and bolster their ability to identify risk trends quickly.

In an increasingly competitive industry, the report added it would become more important for managers to not only anticipate tomorrow’s risk but also adapt and respond accordingly.

Deloitte also said the growth in non-US market investments could add significant operational risk that could take away from return on investment.

Managers would have to pay closer attention to tax, legal, and regulatory components to investing internationally and conduct proper due diligence on their financial impact.

“Alternative managers that spend a little more time up front to ensure that they have a true understanding of what they are asking the back office to do, and the risks they are taking on, are likely to do better in the long term,” the report said.

The firm also predicted more hedge funds and private equity managers would raise capital by “monetizing” or selling stakes in their companies to institutional investors. While this may open up opportunities for both managers and asset owners, Deloitte warned there may be corresponding technical and regulatory issues.