Are U.S. Public Pensions Hiding Funding Risk by Allocating More to Private Equity and other Alternatives?

Posted on 04/22/2022

Partially thanks to quantitative easing, markets have been on a positive run since 2009 and deeper cracks are showing in 2022 as central banks have to deal with rampant inflation. Couple this news as private markets fundraising reaches all-time new highs from the doldrums of 2009.

Both U.S. public pension funds, university endowments, and sovereign wealth funds, in the aggregate, have increased asset allocation targets to private equity dramatically since 2003. The adoption of private equity is manifold. Private equity investments tend to perform well when there are exit opportunities and this happened when the Federal Reserve, Bank of Japan, and European Central Bank printed vast amounts of money during the COVID-19 pandemic and lockdowns. The first factor are strong IPO markets (rising stock market). The second factor is the cheapness of money (low or near-zero interest rates). The third factor are finding capable buyers (listed companies, secondary firms, other PE investors, sovereign wealth funds and pensions). The fourth factor is finding a way to jettison certain assets or find riskier means of going public such as a SPAC (blank check company).

Private equity risks, and to a greater extent – venture capital investments, are on the risk horizon as various stock markets are being jolted by a wide range of factors including rampant inflation. In addition, Western central banks are on a shaky path to increase interest rates, which is a boon for banks and bad news for cheap money (depending on how far central bankers raise interest rates and cut QE). The only factor that appears to benefit private equity investments are the buyers and there are far more buyers of private assets than ever before. Private equity purchase multiples, alongside price-to-earnings multiples in the public markets, have kept rising and are now higher than pre-2008 global financial crisis levels. However, so far in 2022, there is a buckling in technology company’s P/E ratios. The private equity giants are also ready for a downturn as their distressed arms and private credit units have greater access to data to recycle companies and assets, while generating external management fees along the way. Furthermore, with the excess dry powder, more private equity firms and co-investors have opportunities to take listed companies private whose stock prices may have been negatively impacted. For asset owners, the important questions loom, “How long will central bankers raise rates and how long will they allow pain in public markets?”


Over the past decade, public asset owners have been able to mask the volatility of their investment portfolio by investing more in private equity and venture capital. Why? Private equity firms are the main one’s valuating their portfolio companies. Private equity firms, venture capital firms, and other financial companies are required under Generally Accepted Accounting Principles (GAAP) to “mark to market” the value of their underlying company holdings on a quarterly basis. Private equity firms value their holdings and communicate changes to their investors. Listed companies are valued by the market. The challenges of “fair value” will be heightened as liquid markets experience more volatility. The result of permitting PE fund managers and other holders to mark their private investments is the unrealistic smoothing of investment returns. Furthermore, it could materially misrepresent the risk of the private equity holdings.

For venture capital, VCs value their startups by taking the last round company valuation in the private market and assigning that value to the firm’s ownership in that company. What happens if the easy money train ends? An example of the risk of this type of valuation are the well-documented stories of Solyndra, Theranos, and WeWork. Many of the young VCs today were still in school during the dot-com bubble in the United States.

Some of the largest U.S. public pension fund investors in private equity by amount
California Public Employees Retirement System
Washington State Investment Board
California State Teachers Retirement System
Teacher Retirement System of Texas
Florida State Board of Administration
New York State Common Retirement Fund
Oregon Public Employees Retirement System
Virginia Retirement System
New York City Retirement Systems
New York State Teachers Retirement System
Michigan Office of Retirement Services
Source: Sovereign Wealth Fund Institute (SWFI) – Data analysis does not include private credit or private infrastructure as those are separate main asset classes.

The Milliman 100 Public Pension Funding Index (PPFI) estimated funded status of the 100 largest U.S. public pension plans increased from 83.9% at the end of September 2021 to 85.5% at the end of December 2021. Milliman calculated the deficit between the estimated assets and liabilities decreased to US$ 833 billion at the end of December 2021, down from US$ 919 billion at the end of September 2021. Cash-rich sovereign wealth funds, academically referred to as permanent capital, will likely have much longer holding periods versus public pensions that have to start paying a growing pool of retirees. Defined benefit pensions that have closed to new participants are the most at risk if they are heavily allocated to private equity, if there is a downturn in that asset class.

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