TERMINATOR

At a press conference in San Diego last month, Arnold Schwarzenegger, the governor of California, declared that the state's public pensions need major reform. Standing in front of an armoured vehicle, the Gubernator said: “Right now, our treasury is like this armoured car with the doors kicked wide open. The money is just flying out and it's bleeding the state dry”.

Add Schwarzenegger to the long list of enemies of defined-benefit pension plans, vast pools of capital that have supplied billions to private equity funds and are most responsible for the spectacular recent growth of the asset class.

Schwarzenegger would like to see CalPERS and CalSTRS, two major backers of private equity funds, become defined-contribution plans, meaning pensioners would have control of their own retirement accounts and how they are invested, but no guaranteed payout upon retirement. By contrast, traditional defined-benefit plans give workers no say in how the pool of capital is invested, but guaranteed pay-outs at retirement. Foes of defined-benefit plans say they put tax payers on the hook for pension deficits. Schwarzenegger pointed out that in 2000, the state's pension obligation was $160 million, but this year the figure is closer to $2.6 billion.

If the governor gets his way (does he ever not?), the state pensions will be turned into systems resembling America's 401(k) individual retirement accounts. But where would private equity figure into this new system?

The question is a crucial one because it applies not just to California but to many more states: public pensions in Florida, Montana, Ohio and South Carolina have already adopted some form of defined-contribution plan; similar changes are being considered in at least eight more states, including California.

In theory, if retirement dollars flow into stock-and-bond focused individual accounts, there will be less capital for long-term, illiquid commitments to private equity funds.

It is unclear what the real demand is for defined-contribution plans where workers are given the chance to switch over. In Florida, members of the state's retirement system are now given a choice between a defined-benefit and a defined-contribution programme (California's governor is proposing a similar system). To date, fewer than 10 percent of public employees eligible for a defined-contribution account have chosen it. In 2001, when the issue was being hotly debated across Florida, backers of defined contributions predicted that between 40 percent and 50 percent of pensioners would make the switch.

That level of migration may yet take place, albeit gradually. And it may happen across all 50 states, which would mean fewer dollars available for the private equity industry, as we currently know it. “Even if Schwarzenegger is successful, the immediate impact would be small – CalPERS would still be managing a defined benefit plan”, says Kelly DePonte, a partner at San Francisco-based placement agent and advisor Probitas Partners. “But the effects in 20 years could be dramatic”.

Private equity existed before public pensions got involved, and it will continue to exist if they leave, but it's a lot more fun having giant LPs with $8 billion allocations to alternatives, as does CalPERS. If a significant percentage of CalPERS contributions go towards defined-contribution accounts over the next several decades, general partners will need to look for new sources of capital if, indeed, private equity is to continue its expansion.

As is well known, overseas LPs and funds of funds have emerged as increasingly important backers of US private equity funds. But in their efforts to capture a sliver of the mindboggling trillions that flow to retirement accounts, capital-hungry GPs will have to be more creative.

In 2001, The Carlyle Group and mutual fund giant Fidelity briefly joined forces to come up with a way to package private equity for the 401(k) crowd, i.e. a type of security that would feed Carlyle's growing family of private funds, have liquidity options and be made available to unaccredited investors. Many in the industry describe this concept as “cracking the code”, allowing, say, a Carlyle private equity product to be listed as a choice in an individual retirement account application alongside, say, gardenvariety “aggressive growth” or “balanced growth” options.

Those talks were eventually called off, but the desire to “crack the code” remains strong in certain pockets of the US private equity market. Witness the mad rush last spring to launch business development companies, perhaps seen as initial steps toward public sources of capital.

The issue of defined contribution goes well beyond the state level – if George W. Bush gets his way (does he ever not?), America's social security system will be transformed into one resembling the defined-contribution plans of the private sector. Social-security dollars being funneled into private equity vehicles? Dare to dream.