Recently I had the opportunity to be a speaker at Aspire. Aspire (http://www.chapmanhext.com/dallas-leadership-events-aspire/) is a speaker series hosted by our affiliate Chapman Hext & Co. P.C.
As part of my speech I briefly touched on the amount of excess capital available in the alternative assets space. In this case alternative assets are primarily made up of investments in hedge funds and private equity funds. As I mentioned in my presentation, in 2015 private equity had a record $1.3 trillion in “dry powder”, which is industry lingo for available money to invest. This dry powder inherently creates competition between funds to invest or buy solid companies. In essence there becomes four to five qualified buyers for every one private company looking to sell. As you can imagine with this war chest of cash and competition between funds, purchase price multiples have gone up to historic levels. The question then becomes, where did this money come from, and will it last?
A significant amount of the dry powder has come from pension funds. As you can see from the chart below, the percentage of pension fund’s portfolio in alternative assets has doubled since 2008, going from 9% of the overall assets to 18% of the overall assets.
Why has this portion of the overall holdings doubled in just 8 years? It’s a combination of decades of low government contributions, investment underperformance (interest rates at nearly zero) and growing obligations to the beneficiaries of the pension fund. Sprinkle in a recession or two and you can see why the investment boards of these large pension funds are looking at a scenario where the assets are growing slower than the liabilities coming due. Estimates of this short fall, or unfunded liabilities, range from $1.6 trillion to $4 trillion.
The solution, invest in riskier non liquid investments that promise a higher return. According to the Public Plans database, a decade ago alternative assets represented 7% of the holdings at the biggest 150 US pension funds; in 2016 alternative assets make up 26% of the holdings.
Has it worked? Well many economists are starting to sound the alarm bells, that no in fact it has not worked and we are in for a world of trouble. A prime example is the crisis brewing at CalPERS. CalPERS is the California Public Employee’s Retirement System which manages pension and health benefits for more than 1.6 million public employees in California. Recently Steve Westly, former California controller and CalPERS board member, stated “The pension crisis is inching closer by the day. CalPERS just voted to increase the amount cities must pay to the agency. Cities point to possible insolvency if payments keep rising but CalPERS is near insolvency itself. It may be a reform or bailout soon.”
Although CalPERS may be the largest US public pension fund, they are not alone. According to Danielle DiMartino Booth, total unfunded liabilities in state and local pensions have grown 5x in the last decade. According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs.
So what’s next? California, Kentucky, Texas have all made moves to reduce the assumed rate of return in their actuarial calculations. That doesn’t change the amount coming due to beneficiaries of these funds, and so local governments can expect pension costs to jump some 50-60% in the coming years. In Dallas for instance, four years ago the local pension reported being 100% funded. As we have all read in the news, turns out these risky real estate investments didn’t turn out and thus the fire and police pension fund borders on insolvency. The realistic solution, double the municipal tax rate. Not a very popular or easy thing to do, but all solutions are bad ones at this point.
What we do know is the music will stop eventually. Be it through Federal government intervention and a tax payer bailout or some other means. It is safe to say that the dry powder, and the allocation to risky non liquid investments won’t be in the cards when big brother takes over. And so, as the war chests are emptied and private equity starves for fresh cash, will they continue to pay up to purchase or invest in private businesses? My guess is no.
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