Even when these difficulties are tackled to come up with a reasonable assessment of the returns generated by a private equity firm, these are not far from those seen in publicly quoted equities.
“That tells you that much of value created by these funds comes from generating alpha,” Datta says. In other words, the secret to success is to select a private equity manager which will generate persistent alpha.
All the measures around adjusted performance lead an investor to conclude private equity has similar performance to publicly quoted shares with some additional alpha. Datta says: “An investor also has to keep the manager-specific and market risk in mind.”
More generally, the illiquid nature of alter native assets – not just private equity – makes it much harder to measure its true valuation as it is hard to mark to the market. This opacity can make it seem like these assets are less volatile and therefore less risky than more traditional asset classes.
“But once you adjust for these valuation difficulties, the risk profile is often not as good as it first appears,” Datta says.
Despite all of these caveats, Datta still thinks alternatives should play a role in a pension portfolio.
“But schemes need to ask the hard questions about the expected returns and the risks of a particular investment,” he says.
Different sizes, different problems
Trustees also need to ensure the risk characteristics of a particular investment are properly evaluated rather than looking at historic returns, which may not be adjusted to reflect to the problems with finding an accurate valuation for an illiquid asset.
Datta adds: “When all of these risks have been properly assessed, the investment might still be a good opportunity – alternatives still have the potential to make decent returns.” But schemes are going to be more reliant on manager skill than the standard returns of these assets, he adds. For once the outlook might well be brighter for smaller schemes.
Gatemore managing director Mark Hodgson says: “A large scheme has no choice but to opt for the larger deals which are both harder to find and face a lot of competition.”
In contrast, a smaller scheme has less capital to deploy and have more opportunities. Hodgson says: “There are fewer schemes chasing smaller deals and a larger number of companies looking for funding.”
The key to success is to find specialist fund managers. Hodgson says: “At the smaller end of the market, the trends are very different from those larger deals.” At this end of the market, spreads are still wide and the risk profiles are not being eroded.
And the opportunities for smaller schemes could improve further. “Pooling of local authorities and even a possible consolidation of private schemes will narrow the field of competitors even further,” Hodgson says. But the opportunities in smaller funds are not equal across all alternative asset classes. Hodgson says: “Many of the infrastructure projects are, by their very nature, large.” There are, for example, smaller funds operating in real estate, hedge funds and private debt.
Diversification remains vital. Hodgson says: “Smaller schemes need to ensure they pick a selection of funds in any asset class to ensure they avoid concentration risk.”
