For years, private equity investment has been relatively straightforward. Buy a company, turn it around and sell it at a profit. Today there’s blood on the streets in a changed market. Aggregate headline US private equity valuations may still be elevated, but the information is lagged and doesn’t tell the whole story, warned the Massachusetts Pension Reserves Investment Management Board (MassPRIM) investment team, speaking in a recent board meeting at the $92 billion asset owner.
IPO activity has slowed (only 74 companies listed in the US in 2022) and proceeds have fallen, resulting in a collapse in the exit market turning cashflows negative and leaving contributions outpacing GP distributions. Valuations have crashed, and financing has got more expensive for private equity buyers.
As the cost of capital has increased, bank lending has shut down for new LBOs: leverage loan volume is lower, spreads are wider, and the approval process is taking longer, doubling the cost of debt. It’s slowed the pace GP’s are investing; slowed fundraising and left many LPs with unfunded commitments (money committed but not invested) now reconsidering the amount they commit going forward.
“Many investors are finding themselves over allocated to private equity. Combined with the slowdown in distributions and reversal of performance, investors are going to be forced to make tough choices in 2023 and beyond,” said Michael McGirr, director of private equity at MassPRIM.
MassPRIM, however, is staying the course and continuing to commit to its best performing asset class. In line with a multi-year effort to slowly increase the allocation to private equity, it is adding an additional 1 per cent to its range (13-19 per cent) and continuing with current pacing, ploughing $2.2 to $3billion into new funds and co-investment opportunities this calendar year, convinced that opportunities lie beneath the market’s uncertain and volatile surface: valuations are becoming less expensive (particularly for tech companies) offering buying opportunities, and history shows that the best performance in private equity originates when other investors are cutting back.
But success will depend on a few key strategies. Vintage year diversification is essential, as is sticking to consistent pacing models that avoid increasing the allocation all at once.
Unlike many peers, MassPRIM can maintain pacing because its current allocation to private equity has remained comfortably within range. The average actual private equity weight from a sample of ten peer funds is 18.1 per cent versus an average weight of 15 per cent – based on available records, six out of nine pension plans are above their target weight.
As more LPs rethink their strategy, GP’s will increasingly seek capital outside their traditional asset bases. The tougher fundraising environment gives MassPRIM a chance to pressure GP partners on economic and governance contractual issues too. “We’ll be fighting these fights in the trenches. We will have successes to share, but don’t predict wholesale change in the structure of the industry,” McGirr told the board.
In a new strategy, the team will also focus on opportunities in secondaries, buying and selling fund positions from and to others for the first time in a bid to benefit from the change in the market. Elsewhere, co-investment alongside approved co-investment managers will remain a key strategy, a part of the allocation founded in 2015 that continues to grow in maturity and scale. “I expect to see deal flow in 2023,” said McGirr.
Risks
Widening the range holds risks, however. MassPRIM’s global equity and private equity allocation account for most of the risk in the portfolio which in private equity manifest particularly in write downs in valuations (growth private equity has been hit particularly hard) while distributions are also down because of weakness in the IPO market.
It’s left a heightened focus on the weight of private equity cash flow, and the liquidity profile, making the benefits of vintage year diversification particularly apparent. Combined, both private and public equity portfolios account for about 56 per cent of the market value of MassPRIM’s largest PRIT Fund and 80 per cent of the total risk. The investment team will look to cut the allocation to global equity if private equity goes outside the range.
Performance
The board heard how allocations to alternatives, hedge funds, private equity, real estate and timber have helped anchor the fund in the stormy environment. Looking ahead, risk adjusted, forward-looking returns appear more favourable given the welcome recovery in public equity and bond markets.
The investment team flagged the first signs of a reversal with data pointing to a cooling economy and moderation in inflation. Risks on the horizon include another spike in inflation and weak corporate earnings.
The economic picture is not deteriorating, and there is no expectation that the stock market will discount more than it has already. Other topics discussed include a mooted increase to US active public equity managers alongside growth managers in developed and international markets. Elsewhere the investment team have an eye out for credit opportunities and unique fixed income.
A market taker and unable to control geopolitics, pandemics or slowing economic growth, the only thing the fund can control is the design and composition of the portfolio. Diversification and low costs are key with risk, return and cost comprising the three essential pillars of MassPRIM’s investment programme.
MassPRIM is also poised to schedule the first board meeting of its newly convened ESG Committee. The pension fund has been working with partners at MIT Sloan on the Aggregate Confusion Project, an initiative to improve ESG measurement in the financial sector.
MassPRIM, which prides itself on having one of the leanest headcounts in the country compared to the size of the investment programme, is adding a deeper bench of talent. Staff will be added to help build the diverse manager programme, enhance reporting and oversee the ESG initiative, amongst other things.
