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Pension funds expect 11% returns from the asset class

Pension funds anticipate private equity returns over the next three years to be 38 percent lower than managers’ expectations. However, pension funds’ desire to invest in the asset class remains high.

Pension funds believe private equity returns will not outperform other assets due to demands for better transparency and the problems in the credit markets in contrast to managers’ expectations, according to a report by accountant KPMG and UK researcher CREATE-Research.

Pension funds:
Seeking 
11% returns.

The report surveyed globally 61 pension funds and 239 alternative and long-only managers combined.

Pension funds expect private equity funds to produce returns of 11 percent as opposed to managers which expect clients to demand 18 percent. Managers believed private equity would be the strongest performing asset class, while pension funds believed quantitative funds, long-only high alpha funds and infrastructure funds would do better with an average performance of 12 percent.

The disparity can partially be explained by different reactions to the ongoing problems in the credit markets, according to the authors of the report, KPMG partners Jon Mills and Anthony Cowell.

However, another reason for investors’ lower expectations of private equity is the increase in outsourcing to help firms comply with complexity in regulation and to improve the quality of firms’ estimates of returns, the authors said.

The UK industry’s compliance with its planned attempt at self-regulation, the Walker report, will mean more outsourcing, Mills said.

“There is a demand for a second set of eyes rather than the manager performing all valuations. Pension funds are keen to justify the methodology of valuations in funds they invest in and they want simple products they can understand.”

Despite the prospect of diminishing returns, 45 percent of institutional investors canvassed said they would commit to private equity over the next three years. This lagged funds’ demand to invest in real estate at 60 percent, infrastructure at 50 percent and equities at 50 percent.

The authors of the report were also told pension funds are sceptical about the tendency of private equity firms to innovate beyond their core competence.

Permira, a firm regarded conservatively by many investors as a European buyout house, recently made its first two investments in Asia. It bought Japanese company Arysta LifeScience for ¥250 billion ($2.2 billion; €1.5 billion) last week, and it backed casino Galaxy with a HK$6.5 billion ($840 million) for a 20 percent stake. This innovation has impressed many in the industry and is fully in line with Permira’s fund mandate, according to a source at the firm. Yet the authors of the report have been told pension funds are sceptical about the tendency towards such novel investment strategies.

Cowell said: “There is a significant concern amongst institutional investors that innovation is a con trick, as it is a way for managers to increase fees. Investors would like far more transparency and simplicity to make their investments easy to understand.”