Friday, September 21, 2012

Private Equity and Conservative Canadians

Now that our favorite Uncle Ben has promised the investment world the Fed will  mainline MSB purchases into the system until the unemployment rate reaches 7%, we are deeply conflicted.  In a surprising display of one-upsmanship,  Minneapolis Fed President Kocherlakota suggests using a threshold unemployment rate of 5.5% before the quantitative easings are unwound.  So, the hard-working, responsible saver faces a long horizon of low investment returns. 

Folks looking to build up balances for college tuitions or retirement are facing a trifecta of low returns, rising taxes and, eventually, rising inflation.  Meanwhile, we see political commercials for the supposed evils allegedly inflicted on coddled union workers by Bain Capital and other private equity firms.  Here we go again, Two-Face!

What's an institutional investor to do?  Really, public pension funds have no choice but to increase their allocation to alternative assets.  Otherwise, they should meaningfully decrease their expected rate of return on plan assets, thereby putting pressure on state and local taxpayers to make up the contributions to the gold-plated, public pension funds.  This would make taxpayer-voters pretty mad, unless the headlines are buried beside the obituaries in the paper.

Our conservative and circumspect Canadian neighbors to the north are planning to step up their allocations to alternative assets, according to a Royal Bank of Canada survey reported in the Globe and Mail.  According to the survey,

"Of those funds looking at boosting alternative asset holdings, 45 per cent said they planned to increase their real estate holdings, 34 per cent are looking at infrastructure, 14 per cent are planning private equity investments and 7 per cent are planning more hedge fund investments.

Mr. MacDonald said large public sector pension plans have had better performance in recent years due to their investments in alternative assets, and smaller plans increasingly want to emulate that success"
There is no doubt that public pension funds face challenges in matching the alternative asset class performance of funds such as the university endowment funds of Harvard, Yale and Columbia.  Smaller funds don't have the capabilities in-house to structure the right deals, and brokers often lead them astray.  Larger funds, like CalPERS are able to structure better deals, but even they have conflict of interest issues and other inefficiencies which come with a public organization. 

Bringing the capability entirely in-house, where the group actually finds, values and structures private equity investments for a public pension fund is something that is being tried by one large Canadian fund.  Even if it works for a time, the issue of compensation and culture will weigh on retaining that group for any length of time.

So, like our brown-suited Two-Face, we have to rail against the distorted, artificial low return environment in which Uncle Ben has trapped the economy.  Poor retail schmoes will face a limited set of expensive, unproven options for alternative investments. We can also posture for the press about the bogey-men of Wall Street, particularly in an election year.

At the end of the day, however, an investor has to find a way to reach for higher return, which means more risk.  Our chalk-striped half is outraged by the 2/20 fee structures and by the tax treatment of carried interest , but the alternative investment class should offer higher expected returns than the liquid asset classes of stocks and bonds looking forward in this surreal rate environment.  It makes a person's blood boil!

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