Pension Plans and Private Equity

Bloomberg reports on pension plans' enormous contribution to the recent boom in private equity. Three of the biggest investors in private equity are the state pensions of California, Oregon and Washington, which shelled out $53.8 billion in the past decade to private equity funds. In return they have recouped just $22.1 billion in cash by the end of 2008. One can easily assume that they've collected nada in 2009 as private equity-backed firms have done nothing other than go bust since the start of the year. In fact, the three pension funds haven't reaped a paper gain from funds formed in the past seven years.

According to the Bloomberg article, investments made in 2006 and 2007 are currently valued at $15.8 billion on the pension funds' books as of the beginning of the year. Whether those valuations, which are theoretically marked to market due to FAS 157, will bear out is anyone's guess, but I'll go ahead and try. My sense is that the equity in private equity deals struck in 2006 and 2007 is virtually worthless. The deals were all highly leveraged and done at ridiculous prices. Maybe not all of the companies will go bankrupt, but certainly very few of them will have any equity value left for investors. This might be why college endowments such as Harvard were punting their private equity holdings at 50% of their value. It's a very easy scenario to envision these investments going straight to zero, and Harvard has bills to pay.

Now that everyone expects a large V-shaped recovery, supporters of illiquid private equity investments for pensions and endowments are coming out of the woodwork claiming that a turn-around in valuations is now beginning. An Oregon spokesman is quoted as saying "The market is in a trough. The picture would've looked different at the end of 2007." Sure, it would have. Because back in 2007 everyone was marking all of their holdings way too high based on silly expectations for growth that turned out to be dead wrong. 2007 valuations weren't real. They were a mirage. And maybe we're in a trough, but it's also highly likely that valuations will go much lower. These are illiquid, highly leveraged investments.

Instead of pulling back from private equity deals as the bubble grew, pensions actually continued to raise their allocations. The three state funds more than doubled their buyout commitments in 2005 to $8 billion from $3.1 billion. Then they committed $18.7 billion the following year. Essentially, they invested most of their allocation towards the asset class at the very peak. A foolish choice that will certainly cost their retirees greatly.