State’s pension plan bets big on private equity
Washington’s investments are hard to value, and returns may be past their peak
Seattle Times business reporter
In the spring of 2008, as Washington Mutual was casting about for a financial lifeline, the giant thrift turned to TPG Partners, one of the world’s largest private-equity firms.
A TPG fund pumped $2 billion into WaMu. Among the investors in that fund — and among the losers after WaMu collapsed less than six months later — was Washington’s public-pension system.
The WaMu deal, one of the more spectacular flameouts in private-equity history, cost the pension system $41 million; another $6 million in WaMu stock held directly by the pension system was rendered all but worthless.
Though the WaMu fiasco isn’t typical, it points up the risky nature of private equity — a once-secretive and still-arcane corner of the financial industry with which Washington’s state-run pension system is deeply enmeshed.
A Seattle Times analysis suggests that the pension system’s returns from its heavy commitment to private equity may not be as lofty, or as firm, as reported, and that the days of truly big private-equity scores may be long past.
The system, on which 480,000 public-sector workers and retirees depend for much of their retirement security, has placed more bets in the risky realm of private equity than nearly any other public pension plan — more than $33 billion over the years.
At the end of 2012, nearly a quarter of the system’s $65.4 billion trust fund was invested in private equity, up from 14 percent as recently as 2004. According to Pensions & Investments (P&I), an industry publication, Washington’s concentration in private equity is nearly two and a half times the average among large public pension funds.
Most private equity involves either buying stakes in companies whose stock isn’t publicly traded, as venture capitalists do, or buying out public companies to take them private. Some private-equity firms also provide needed capital to public companies in exchange for ownership stakes, as TPG did with WaMu.
State officials say their private-equity portfolio is highly profitable and envied by other states.
“We’ve created relationships that other funds, quite frankly, couldn’t buy if they wanted to,” said Gary Bruebaker, chief investment officer of the Washington State Investment Board. “We’ve been able to get into investments other states couldn’t.”
“Bruebaker and other state officials note that private equity is the trust fund’s best-performing asset class over the past decade, with an average annual return of 12.5 percent. (The trust fund’s stocks, by contrast, have returned an average 8.2 percent annually, and its bond portfolio 6.5 percent.) .
If the pension system had only invested in traditional stocks and bonds, Bruebaker said, the pension system would have earned $6 billion less than it has.
But outside observers caution that private equity and other “alternative” investments are inherently riskier, harder to sell and harder to evaluate than stocks and bonds.
The Times analysis found, for instance, that the official figures include long-held stakes in companies whose value for reporting purposes is set not by any market, but by the private-equity fund managers themselves.
Of the $15.3 billion in the pension system’s total claimed private-equity gains over the past three decades, more than $2 billion consists of investments in nonpublic companies that are more than a decade old, according to The Times’ analysis.
Such old, illiquid investments are unlikely to ever be fully realized, experts say.
Outside stocks, bonds
In the investing world, “alternative” is something of a catchall that covers pretty much anything outside the stock and bond markets. Besides private equity, alternatives include hedge funds, venture capital, real estate and commodities.
Private equity has rapidly become commonplace among public pension funds. P&I’s survey of the 200 largest public pension plans found that, on average, they have 9.9 percent of their assets in private equity, up from about 4 percent a decade ago.
A February 2012 report by the U.S. Government Accountability Office cautioned that hedge funds and private equity “pose risks and challenges beyond those posed by more traditional investments.” Those risks mainly involved issues of liquidity — how easy it is for pensions to turn their investment positions into cash — and transparency.
Nonetheless, the report noted that among public and private pensions “the appetite for such investments is continuing to grow.”
That’s particularly true in Washington.
As of Dec. 31, $25.9 billion of the state’s pension portfolio was invested in various “alternative” assets. At nearly 40 percent of the total portfolio, that’s almost twice as high as the average in the P&I survey.
Besides private equity, nearly $8.9 billion, or 13.6 percent, of Washington’s pension investments are in real estate; the average is 7.5 percent.
Alternatives can, if chosen well, diversify away some of the risk in a pension plan’s overall portfolio. And because they operate over such long time frames, pension funds “are almost uniquely able to be patient investors, which opens up other investment opportunities,” said Diane Oakley, executive director of the National Institute on Retirement Security.
But almost all observers agree that the biggest attraction of alternatives is their purported ability to beat the public stock and bond markets.
“They want the returns,” said William “Flick” Fornia, a Colorado-based pension consultant specializing in public plans. “As the rest of the market gets more efficient, it’s harder to get good returns without looking at investments the average person can’t access.”
In 1981, Washington became the second state (after Oregon) to invest pension assets in private equity: a total of $6 million into two venture-capital funds. It eventually realized a $1 million profit, or 17.7 percent, though the state doesn’t say how long that took.
The state stepped up its private-equity activity in 1983 and has hardly stopped since. According to State Investment Board records, along with the $33 billion the state has invested in private equity over the years, it’s committed to kick in an additional $9.6 billion when called upon to do so.
By the end of 2007, near the peak of the boom in private-equity buyouts, the State Investment Board was the fourth-biggest private-equity investor nationwide by dollars, behind pension funds from much bigger states, California and Pennsylvania.
A typical private-equity buyout fund starts by getting several big investors — foundations, university endowments and wealthy individuals, as well as pension plans — to commit a certain amount of money to the fund.
The basic promise made by private-equity firms is that they can buy companies and run them better than the current managers. That could mean developing new products, expanding into new markets, merging with competitors, or laying off half the payroll and moving the work to China.
The typical buyout fund makes most of its deals in the first three to five years of its 10-year life. After doing whatever it can to make its “portfolio companies” more valuable, the fund starts selling them off and distributing the proceeds to its investors.
Until the portfolio companies actually are sold, though, they’re only worth what the fund managers say they’re worth.
“You don’t really know how well you’re doing until the day is done,” Bruebaker said.
Take legendary buyout firm KKR’s 2006 Fund, in which Washington’s pension system invested $1.67 billion. That fund bought stakes in companies such as for-profit hospital operator HCA, retailer Dollar General, and Texas utility company TXU (now Energy Future Holdings), at $45 billion the largest leveraged buyout in history.
HCA and Dollar General went public again a few years after their buyouts. According to the State Investment Board, Washington already has received $837.1 million in cash from the KKR 2006 Fund.
The rest of the state’s investment, currently valued at $1.29 billion, is still tied up in the fund’s portfolio companies, and will be until the stakes are sold off.
That may be a long time coming for some portfolio companies. Energy Future Holdings, for instance,lost $3.36 billion last year and is groaning under $40 billion in debt.
When TPG Partners came calling in 2008, the investment board — a TPG investor since 2000 — committed $750 million to the $19.8 billion TPG Partners VI fund.
The fund quickly pumped $2 billion into WaMu as part of a massive — and ultimately futile — rescue mission. But it has continued to make deals, most recently last year when it bought Par Pharmaceuticals for $1.9 billion.
Despite the WaMu deal, Washington’s investment in TPG VI is slightly in the black, at least on paper. As of Sept. 30, the pension system had put $543.6 million into TPG VI, gotten back $110.3 million in cash, and had investments valued at $491.6 million.
When calculating its total gains, the investment board follows accounting rules by including both the cash it has been paid and the estimated value of its remaining stakes.
But for funds that are past their “normal” liquidation date of 10 years, that may exaggerate the likely outcome.
Ludovic Phalippou, a finance professor at the University of Amsterdam who is skeptical about private equity, wrote in a 2009 paper that “poorly performing, old, and inactive funds report surprisingly high accounting values for their ongoing investments.” One reason is that their poorly performing deals are “rarely acknowledged by a write-down.”
The Seattle Times analyzed performance data on all 262 private-equity investments the state has made since 1981 (excluding a handful where the state has committed money but the fund manager has yet to make any investments). The most recent data is as of Sept. 30, 2012; since funds typically have a 10-year life span, only “mature” funds — those dating to the third quarter of 2002 or earlier — were examined in detail.
The 73 funds that completely wound up within that time period returned an average of $2.12 for every dollar invested. But 80 private-equity funds the state invested in before 2002 still had purportedly active investments, including one venture-capital investment that’s nearly 18 years old.
The investment board’s figures have those 80 funds returning $1.57 for every dollar invested. But only $1.37 of that was in actual cash; the other 20 cents, or more than a third of the reported gain, represented illiquid stakes in nonpublic companies.
Those investments aren’t necessarily worthless, though whatever value they may retain isn’t readily accessible. Inside the board, Bruebaker said, such deals are called “old dogs.”
He and his staff monitor the fund managers on those deals closely, Bruebaker said, adding, “If they’re holding them there’s some strategic reason why.”
As Bruebaker acknowledged, the biggest private-equity paydays came decades ago.
On average, funds launched in the 1980s and early 1990s regularly returned $2, $3, $4 or even more per dollar invested; funds launched since then have average capital returns in the $1.21-$1.49 range, according to the Times analysis.
Much of the reason for that decline, Bruebaker said, is that more pension funds and other institutional investors are following the trail laid down by Washington and Oregon.
“The more money you have chasing deals, the less money you’re going to make from those deals,” he said.
But other factors may limit private-equity returns going forward as well.
With banks less eager to lend than they were before the financial crisis, private-equity funds have to put up more of their own money to do deals.
Also, as institutional money poured into private-equity funds in the mid-2000s, prices soared for all kinds of assets — from the house down the block to corporations and office towers.
S&P data show that the cost of the average leveraged buyout rose from 6.7 times trailing pretax earnings, or EBITDA, in 2000 to 9.7 times EBITDA in 2007.
And like homeowners who bought at the height of the housing bubble, funds that bought companies in those years may have a long wait before their investments gain significant value.
A 2012 study indicates that at least in recent years, Washington’s added risk hasn’t been accompanied by greater reward.
The study, by CEM Benchmarking, of Toronto, found that the state system’s “asset risk” — essentially how much its returns can be expected to bounce up and down given its asset mix — was 14.5 percent as of the end of 2011. That was near the high end of the 191 U.S. pension funds in the study; the median asset risk of those plans was 10.1 percent.
However, Washington’s five-year total return, 2.6 percent, was in the middle of the pack, and its net value added over that span — a measurement that factors in investment fees and other costs — was negative 0.1 percent.
Theresa Whitmarsh, the State Investment Board’s executive director, said the CEM report “seems to be a bit of an outlier,” adding: “It’s the least favorable to us of any CEM report we’ve ever had.”
More recent, if less comprehensive, comparisons put Washington in a better light.
The Seattle Times examined 10-year performance figures for nearly three dozen plans with more than $10 billion in assets. As of Sept. 30, 2012 (the latest period for which most plans had reported), Washington’s 10-year return was 8.65 percent — better than all but four other plans.
But big bets on private equity and other alternative investments don’t seem to be essential for superior performance. Two of the top-four funds were heavily concentrated in alternatives (one even more so than Washington); the other two had less than half of Washington’s allocation.
Bruebaker said private equity still provides enough extra return to justify the risks.
“I’ve been in this business for 34 years, and I’ve been criticized for private-equity investments that didn’t look so good,” he said. “And I’ve never had those people come back to see me after they doubled their money.”
Drew DeSilver: 206-464-3145 or firstname.lastname@example.org