Private Equity for Pension Plans? Evaluating Private Equity Performance from an Investor’s Perspective
Introduction Public pension plans, like many other institutional investors, have steadily increased their allocation to private equity investments over the last two decades. (Figure 1) This trend prompts an important question: do these investments enhance the investment opportunity set by delivering positive risk-adjusted returns, or are they merely high-cost vehicles for taking on risks similar […]
Arthur Korteweg is an Associate Professor of Finance and Business Economics at USC Marshall School of Business, Stavros Panageas is a Professor of Finance at UCLA Anderson School of Management, and Anand Systla is a Ph.D. Student of Finance at UCLA Anderson School of Management. This post is based on their recent paper.
Introduction
Public pension plans, like many other institutional investors, have steadily increased their allocation to private equity investments over the last two decades. (Figure 1) This trend prompts an important question: do these investments enhance the investment opportunity set by delivering positive risk-adjusted returns, or are they merely high-cost vehicles for taking on risks similar to those available in public markets? In the paper “Private Equity for Pension Plans? Evaluating Private Equity Performance from an Investor’s Perspective” we propose a new methodology to disentangle whether the rates of return associated with private equity (PE) investments represent meaningful outperformance, or just compensation for the risk embedded in these investments. We then apply the methodology to evaluate the returns obtained by public pension plans.
Our findings suggest that PE financed buyout strategies exhibit modest risk-adjusted outperformance, whereas venture capital and real estate funds do not. We also find that public pension plans tend to perform better in their private equity investments than other private equity investors, but this is mostly due to better access to private equity investments rather than selection ability. Finally, we identify a material correlation between a pension plan’s underfunding and the internal rate of return (IRR) of their private-equity investments; however, this correlation is driven by the fact that underfunded pension plans appear to be choosing comparatively riskier private equity investments, which command higher risk premiums.
