Is leverage in private equity funds ok for pensions?


I’m troubled by a question we got from Stephen Timms at the WPC meet in November. Timms asked if we knew of any other areas in which the pension market could be facing liquidity risk. I was going to put my hands up and say “private markets and in particular leveraged private equity”. In this piece in today’s “unhedged”, Robert Armstrong directly addresses the question of whether pension funds need the liquidity they may not get this year from most of their private market holdings. He is sanguine, I am still nervous, though I cannot see the liquidity event (other than insurer’s demanding cash not in-specie assets).


Armstrong kicks off with a chart that he published last year.

The chart shows the performance of six more-or-less similar real estate investment trusts. The five whose returns are bunched together are priced by the market; the outlier (Blackstone’s Breit) is private, and priced by accountants in the employ of the trust. I leave it to readers to assess, in their own word or words, the accuracy of Blackstone’s paid-for marks. Breit investors have reached their own conclusions. Many of them looked at the fund’s valuation and asked for their money. Some of those were told they could not have it.

Dan Rasmussen of Verdad Capital, who has been quoted in this space several times, points out in the FT today that this phenomenon is not restricted to Reits. It’s a private markets issue. He uses the example of venture capital:

Technology investors faced a sharp reversal this year. By the end of June, Nasdaq was down 29.5 per cent and the Goldman Sachs Unprofitable Tech index was down 52 per cent.

Yet one corner of the tech market was strangely unaffected. The US Venture Capital index compiled by Cambridge Associates was down only 12.5 per cent through the end of June (the last available data).

It’s the same unsurprising story again. When asset managers get to price their own assets, they go mighty easy. This distorts the market in unfortunate ways (as Unhedged has pointed out several times). We might sum up the issues as follows:

  • Institutional investors like private capital because soft marks give the (mostly spurious) appearance of low volatility, which leads to better risk-adjusted reported returns
  • Institutional investors also like private capital because the fund managers can use loads of leverage to improve their results, which the institutional investors cannot do directly, because that would look too risky
  • As a result, mountains of capital have flooded into private capital, diminishing returns. The private equity industry, for example, has not beaten the S&P 500 over the past decade (see here), despite using mountains of leverage. Big fees eat up the extra returns provided by the leverage.
  • It is probably regrettable so many assets are flowing into private markets, where it is harder for some investors to own them
  • The fees paid to private capital managers is largely wasted
  • Institutional investors are likely to be disappointed by private markets over coming years

The idea that private markets are a distinct and superior asset class, relative to public markets for the same underlying asset types, is now mostly bullshit. I say “now” because private captial returns used to be great, before all the low-hanging fruit was eaten; I say “mostly” because I have a totally unproven view that private funds’ complex debt structures and clever lawyers could make high leverage less risky. Rasmussen and I are of one mind on most of this, I think. But there is an area where we disagree. He thinks that private markets could be heading for a financial crisis:

[T]here are three ingredients to a financial crisis: consensus optimism, leverage and illiquidity. And private markets exhibit all three characteristics. Illiquidity may be fine on the way up, but, as investors in the Blackstone Real Estate Income Trust are discovering, it’s not ideal when market conditions change . . .

[A]fter the dotcom bubble bursting, it took all the way until the end of 2014 for the VC index to regain the high water mark it set in early 2000. If the current listed equity market downturn persists, marks will eventually converge nearer to reality, leaving institutions nursing very real and illiquid losses.

I agree that high purchase prices, high fees, high leverage, and glue-huffing mark-to-model prices are probably a formula for losses. But losses, even big ones, do not a financial crisis make. In a financial crisis, losses are transmitted promiscuously from bad, mismarked assets to sound, rationally priced ones. No one knows what anything is worth, and all prices fall together.

What I picture happening in private markets is something more like this:

Pension manager: Could I have my money back, at the suspiciously high net asset values you published in your last quarterly report?

Private capital fund manager: No. [Marks assets way down over a period of months or years]. OK now you can have the money.

PM: These are bad returns.

PCFM: My bad [flies private to St Moritz].

No one on either side of this unpleasant exchange desperately needs to sell stocks or treasuries or whatever to raise cash to meet pressing liabilities (HT bold).

It is also worth noting that rational pricing is starting to take hold in at least some corners of private markets. PitchBook’s 2022 Global Fund Performance Report notes that VC funds globally reported negative quarterly returns in first two quarters of 2022. One-year rolling internal rates of return, having gone nuts in 2021, are headed back to earth:

Kyle Stanford of PitchBook writes, with bracing plainness:

“The relative inability to exit in the current market and the decline in capital availability are circumstances that will lengthen hold times at best or lead to portfolio markdowns and possible down rounds …

With part of VC fund performance being attributed to the growth of private, not-yet-realised valuations, we expect venture performance in the near term to hinge on the fortunes of this group. The top of the late-stage valuation market has more quickly corrected than other areas of VC, leaving these company valuations exposed with revenue multiples from 2021 and no clear path to realise those values for investors”.

I told Rasmussen that I didn’t see much chance of a private market crisis. He thinks institutional investors (“limited partners”) might get into a mad rush to sell their private market positions:

Fire sales are really the hallmark of a disorderly crisis. The question is, once the writing is on the walls that there need to be big markdowns, do LPs start trying to fire sale their LP interests? Given that this is coming from their illiquid buckets anyway, presumably the answer is “no” but if the consensus swings from thinking these are amazing to needing to reduce exposure from 40 per cent to 20 per cent, then things could turn ugly as there’s no easy way to exit.

I very much doubt this is going to happen. I see the LPs just waiting around, praying that things get better.

My gut tells me that if the only way you can get a bang out of private equity is by borrowing , then leveraged PE funds are no different than leveraged LDI. The difference is all in when you need the money or the hedge.

Borrowing’s all very well until it isn’t.


About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to Is leverage in private equity funds ok for pensions?

  1. Byron McKeeby says:

    There seems to be a possibility that any gearing is considered to be a bad thing in days of “cowardly capitalism”.

    Yet listed equity managers who are market index agnostic and seek instead to invest in good businesses with low gearing at valuations which offer margins of safety are not usually such a bad thing. The same may be said of unlisted private equity managers who use gearing sparingly.

    I’m less convinced of real estate managers or some infrastructure investors who may use gearing at higher levels, but other commentators on here may disagree.

    And always don’t forget the “gearing” levels of governments who borrow through their gilts markets, while Corporate “bonds” also form part of corporate gearing.

    Shouldn’t all bonds (and gilts) be re-named “debt” to remind investors what they’re buying or holding?

  2. John Mather says:

    John Burn-Murdoch’s article entitled “Britain’s winter of discontent is the inevitable result of austerity”
    The closing remarks:-

    “Lives lost, earnings lost, years lost. Unlike Trussonomics, austerity is a slow and silent killer. For the best part of twelve years, the Conservatives sowed the seeds. This year they’re reaping the harvest.”

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