Oregon Still Struggling with PE

An investment staff review of the Oregon Public Employees Retirement Fund’s $14.6 billion private equity program says that returns have not been as robust as hoped the last decade and details multiple challenges the plan will face as it attempts to forge excess returns going forward.

“We need to do some things differently and evolve and be better,” said John Skjervem, the chief investment officer of the Oregon Investment Council. The council is the overall investment manager for the $77.1 billion pension fund, which became the first large institutional investor to make commitments to private equity back in 1981.

While investing in private equity typically requires institutional investors to lock up their money in funds that run from seven to 10 years, there was no illiquidity premium. The Oregon review found that the private equity program, “failed to produce excess returns over the benchmark (public equity + 300) over the past decade.”

Oregon’s private equity performance issues aren’t unique, and the plan is one of many wrestling with the challenge of maintaining strong private equity returns.

The two largest public pension plans in the US by assets—the $352.09 billion California Public Employees’ Retirement System (CalPERS) and the $231.5 billion California State Teachers’ Retirement System (CalSTRS), are each reviewing their private equity programs.

But percent-wise, the Oregon pension plan’s private equity portfolio makes up around 20% of the $77.1 billion retirement system’s overall portfolio, approximately twice the allocation of CalPERS and CalSTRS. This adds to the crucial role it plays in the system’s overall portfolio returns.

The Oregon public pension system, like others across the US, has not fully recovered from the great financial crisis. It has an unfunded liability of more than $24 billion.

The pension plan’s private equity portfolio returned an annualized 8.85% return for the 10-year period ending Sept. 30, 2017, compared to the 11.23% return of the system’s customized benchmark. That benchmark consists of the index return of the Russell 3000 stock index plus 300 basis points.

More muted private equity returns weren’t always the case.

Historically, over the long term, private equity investing has been a golden goose for the Oregon plan and other large institutional investors that followed its lead in investing in the asset class.

In fact, going back 20 years, even with the dampened results of the last decade included, the Oregon’s plan’s private equity program still had an annualized return of 11.2%, beating the 10.7% return of the system customized benchmark.

Skjervem aims to help returns by reducing fees. Private equity fees can be expensive. Institutional investors typically pay a 2% management fee and have to part with 20% of the profits, known as carried interest.

Skjervem said the Investment Council has reduced the number of private equity managers from 80, when he took over five years ago, to under 50 today. At the same time, he has upped the average private equity commitment to $250 million from $125 million.

He said the aim is to be a more valued partner with the private equity firm.

“If we are constantly more important that should accrue in many cases preferred economic terms,” he said.

Pension system data shows the Oregon plan paid $231.5 million in private equity fees and carried interest in the fiscal year ending June 30, 2017.

Skjervem said a quarter of the $3.265 billion in new fund commitments in calendar year 2017 was subject to negotiated fee discounts, although he would not go into details as to total potential cost savings.

Fee discounts, however, are hard to come by with private equity firms that have top-quartile investment returns because their funds are over-subscribed, said David Erickson, a lecturer at the Wharton School of Business.

Skjervem doesn’t disagree, saying negotiating fee discounts isn’t always possible because, “the power pendulum is firmly on the side of the general partner in this environment, particularly the GPs that have good performance records.”

Even as the Oregon Public Employees’ Retirement Fund receives fee reductions from general partners, private equity returns face an uncertain future at the Oregon plan and other institutional investors.

The Oregon private equity review details key issues that may make it difficult for the Oregon pension plan and other institutional investors to maintain the more recent level of private equity returns going forward.

It notes the use of financial engineering using leverage, for example, when private equity general partners take over portfolio companies, will be more difficult in the current financial environment.

“As long as rates are high and declining, you’ve got the wind at your back in terms of multiple ways to financially engineer a profitable [portfolio company fund] exit,” Skjervem explains.  

He said with rates hitting record-low levels, and now going up, the financial engineering levers are less available.

Skjervem said the Oregon pension plan is also exploring increasing private equity co-investments, in which a general partner gives a pension plan an additional opportunity to invest in one of its portfolio companies, often at a discount or at no additional fee.

Pension plan statistics show 6% of the Oregon plan’s private equity portfolio consists of co-investments.

But private equity co-investing is only about 10 years old and Skjervem said the results are inconclusive as to it helping to enhance returns.

“The early empirical studies of co-investments are pretty mixed; at this point, accordingly, we’ve been very careful,” he said.  “We haven’t jumped in with both feet.”

Other major pension plans like CalPERS and CalSTRS have been exploring expanding direct investments, in which a retirement system makes a direct investment in a portfolio company, without a private equity general partner. Major Canadian public pension plans have developed such expertise.

But for much of last year, Skjervem said, the Oregon pension plan had only one private equity staffer, having lost two other employees to money managers. Staffing is now up to three, but Skjervem said, even with two more planned employees, there would not be resources to consider the Canadian model.

“It’s off the table principally and pragmatically because we’ll never get sufficient resources to be able to pursue that strategy effectively,” he said.

One problem for the Oregon private equity program is that 40% of Oregon’s private equity portfolio originated before the great financial crisis and are in funds that originated in 2006, 2007, and 2008. They are still part of the system’s portfolio despite the funds extending beyond their normal seven to 10-year life, the review found.

“The exit strategies that [private equity managers] thought would be available to them when they underwrote these portfolio companies in 2007, all of that changed post-global financial crisis,” Skjervem said. “So, everything is taking longer, the restructuring and in some cases pivoting to new operating strategies. It’s all taking a lot more time and effort than everyone thought.”