Is private equity a public financial hazard?

Private equity—ownership stakes in businesses that are not traded on an exchange—has become a favored asset class of U.S. public pension plans. It promises extraordinary returns and added diversification of the investment portfolio. Allocations continue to grow, currently comprising about 13% of public plan assets. And it’s a two-way street, with public pension plans in the U.S. and abroad providing 35% or more of the capital invested in private equity. But private equity investing has its challenges.

Contrasted with publicly traded equities, private equity funds have higher fees, lower regulation, and more restrictions on selling shares. Private equity funds lack clear return and risk metrics, making it difficult to assess performance before investments are redeemed, often a decade or more after the initial investment. These difficulties imply a responsibility for trustees and investment officers to ensure that: (a) private equity provides something not attainable with publicly traded stocks and bonds, and (b) investing in private equity is prudent and consistent with plan officials’ fiduciary obligations.

The recent rise in market interest rates after years at depressed levels creates new challenges, especially for existing holdings. Higher interest rates make it more difficult for private equity portfolio companies to service their often-significant debt. High interest rates also decrease the discounted present value of each dollar of future profits, lowering the value of portfolio companies.

All these factors should give investors pause. Higher interest rates, the increasing use of nontraditional transactions to return investor funds, and an ever more crowded field of investors are signs that the highly touted extraordinary returns in the past may not continue. In his 2012 letter to Berkshire Hathaway shareholders, Warren Buffett talks about “extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices” in warning that “[w]hat the wise man does in the beginning, the fool does in the end.”

Read the full brief: Is private equity a public financial hazard? Answering questions on the impact of private equity investments on public pensions

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