Public pension plans’ private equity portfolios are overexposed to valuation risk, according to an industry watchdog.
The notoriously opaque methods used to value private equity, real estate and other private asset classes could pose a threat to the pensions of public employees across the US, the group argues.
Public pension plans in the US invest in private market funds that use varying methods to value their underlying assets. Equable Institute, a nonprofit that provides educational materials about public pension plans, claims that the lack of transparency into these practices could put LPs at risk of portfolio losses and ultimately impact payouts for public employees.
As US public pension plans have increased their investments in the private, illiquid asset classes, their exposure to risk associated with private investment managers’ overestimated valuations has grown exponentially—from 9% in 2001 to 34.1% at the end of 2022, according to a report from Equable.
In general, GPs determine asset prices in various ways. The market approach, for example, values a private company using comparable public companies. In contrast, a discounted cash flow model estimates a company’s revenue, expenses and profit to project its worth over time.
Fund managers report the valuation projections to a pension plan, which then uses that information to report the value of its portfolio. The valuation method typically isn’t included in reports disseminated to the public.
Some implications of misvalued assets are particularly specific to pension plans. The reported value of a pension’s assets is used to determine beneficiary contribution rates, which means that an incorrect valuation of portfolio assets could impact beneficiaries.
Anthony Randazzo, executive director of Equable, said that in the past unfunded liabilities—the difference between the pension’s assets and the amount it owes to its beneficiaries—were higher than recognized and contribution rates should have also been higher.
While the intricacies of these valuation processes aren’t outlined to the public, they undergo rounds of close scrutiny by the pension’s investment committee and auditors. Public pension plans’ investment teams address valuation risk during the manager selection process, said Nicholas Tsafos, who advises private equity firms as an audit partner at EisnerAmper. When considering investing with a private fund, the pension’s investment team typically questions the prospective GP about its valuation policies.
“It’s not just about the valuation model. It’s about the policies and procedures the private managers have in place,” Tsafos added.
What’s more, PE firms and independent services follow valuation guidelines from industry groups like the International Private Equity Valuation board and the Institutional Limited Partners Association.
Tsafos said that there’s a reason why private market assets undergo different valuation processes compared to the public market: Private market assets have a longer investment horizon, which makes calculated projections necessary.
Evidence of risk
Regardless of valuation methods, public pension plans’ PE portfolios are losing money. For example, Calpers’ PE portfolio logged a -2.3% return for the period between March 2022 and March 2023 and CalSTRS’ PE investments returned -0.9% over the same period.
Losses are rampant at the fund level as well. PE funds’ rolling one-year horizon IRR fell 51.3 percentage points in Q2 2022 from its Q2 2021 peak, according to PitchBook data.
While the asset class saw a slight recovery from this rough patch in Q1 2023, PE fund performance’s one-year horizon IRR remained in the red at -1.2%, a product of high financing costs and portfolio valuation reviews, according to PitchBook’s latest Global Fund Performance Report.
“The losses that private equity funds are experiencing right now are the manifestation of the downside of valuation risk,” Randazzo said.
The backdrop
Many institutional portfolios found themselves overallocated to the asset class in fiscal year 2022 as a result of the denominator effect, when a decline in public equities shifted the balance of returns toward the private market portion of pension plans’ portfolios.
The widespread overallocations meant the investment portfolios of many of the largest public pension plans in the US were overexposed to the risks inherent in private market asset classes.
Still, today, these large public investors are in a relatively stable spot. State and local public pension plans generated an average 5.6% return in 2023, a significant improvement from 2022’s -5.9% average investment return, the report said.
Related read: PE’s portfolio markdowns show no signs of letting up
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