As this blogger has said for many months, pension risk management trumps a return-only focus. Few care about the risks associated with the upside. It's the extreme tail of a price distribution that gets people's attention. When low frequency (read DIRE) values occur, watch out. The dominoes crash into other, the structure crumbles and someone is left picking up the pieces. Is that happening now? You betcha! Any problems with investments, heretofore put into neat asset buckets, spill over into other parts of the portfolio, forcing major decisions about asset allocation, liquidity and cash requirements.
A November 16, 2008 New York Times article makes my point. (See "From the Valley Comes a Warning.") Writers Jeff Segal, Lauren Silva Laughlin and Rob Cox explain that the California Public Employees' Retirement System (Calpers) has to now decide whether and how to rethink its strategic asset allocation to alternative investments. Originally meant to be about 10 pecent of its overall portfolio, equity sector losses have apparently pushed the giant public plan's relative exposure to hedge funds, venture capital, private equity beyond its limit, to about 14 percent of its asset holdings. Worse yet (from a strategic asset allocation orientation) is that a market downturn may now accelerate calls for capital from the private equity and venture capital funds in which Calpers is invested, forcing an even higher allocation. (The idea is that some portfolio companies need more money now because their respective revenue projections cannot be met as corporate spending contracts. Private equity and venture capital fund managers - and their investors - can either lose everything they have invested in the portfolio companies or try to help them stay afloat, by giving them a cash lifeline sooner than anticipated. Hence, the need to accelerate capital calls.)
Calpers is not alone. We've heard from plenty of plan sponsors that the "stay the course" or bid adieu to alternatives (some or all) is at the top of their decision list. The problem is that exiting a particular private fund may be costly, so much so that the plan sponsor is made worse off in the short- and intermediate-term. Additionally, plan sponsors seldom have the legal right to turn down a request for additional capital from private equity fund X or venture capital fund Y. According to private investment fund attorney John Brunjes, a partner with Bracewell & Giuliani, "in a private equity or venture capital fund is a contractual relationship. Except for fraud or duress, pensions are on the hook to write a check when the alternative fund manager comes calling."
If true, that some plan sponsors are "stuck" for the foreseeable future (i.e. must meet their capital commitments to alternative fund managers) AND their losses continue in traditional equity land, participants may take it on the chin in the form of reduced benefits. Taxpayers and/or shareholders may be asked to make up the difference. From the mail and calls we get at Pension Governance, Inc., there are a lot of individuals who are beyond unhappy about what they see as their diminished future due to rescinded benefits, disappearing plans, sponsor insolvencies and so on. (While our company focus is on plan sponsors and their service providers, our web presence encourages communication from plan participants.)
With respect to investment fiduciary duty, will members of the investment committee be held liable for not having properly assessed correlation patterns over extreme data ranges? When things go south and investor flee to quality, "contagion" is not uncommon. This means that bad news impacts the performance of multiple asset sectors, even those thought to move inversely or independent of each other. The "one world - one market" phenomenon translates into lower diversification benefits.
Will investment fiduciaries be held accountable for not better measuring liquidity or assessing transferability restrictions or the legal implications of capital calls? What is the role of consultants and fund of funds managers in evaluating risk factors beyond the numbers themselves? Are there some private funds deemed to have done enough to vet the suitability of alternatives for their institutional investor clients.
I'll be writing much more about the changing relationship between institutional investors and private funds. What do you want to know more about in these areas? Drop me a line.
- On January 4, 2007, I wrote: "Contagion itself is dangerous but when you consider what some describe as an inevitable convergence towards one global market, with trading that occurs 24/7, the potential for serious harm is real. Continued technological advances, international deregulation and investors' willingness to go offshore promote lightening speed information flow. When bad news hits, it's the shot heard 'round the world. Having worked on three trading desks during volatile times, I know firsthand how quickly things can change." (See "Pension Contagion - Should We Worry?")
- The Calpers website reports that, as of September 30, 2008, its current allocation to alternatives is 12.2% versus a target of 10 percent. For more information, click here.
- Here is the link to the slide show that has Silicon Alley shivering in their boots. Essentially famed venture capital firm Sequoia Capital told entrepreneurs to watch their cash and acknowledge that the funding party may be over, at least for awhile. See for yourself. Read "The Sequoia: 'RIP: Good Times' presentation: Here it is" by Eric Eldon, Venture Beat, October 10, 2008.