Thursday 28 Mar 2024
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This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on August 15 - 21, 2016.

 

Pension funds, which tend to invest in safer asset classes, are venturing into riskier alternative investments such as private equity. Malaysia’s largest retirement funds — the Employees Provident Fund and Kumpulan Wang Persaraan — discuss the benefits and challenges of adopting this strategy.

Global investors, including sovereign wealth and pension funds, are increasing their exposure to alternative asset classes such as private equity to increase returns and escape market volatility and sluggish growth. 

A combination of demographic changes, early retirement and longer life expectancy has placed pension funds under greater pressure to achieve investment returns so as to meet their growing liabilities, especially when equity investments are underperforming due to market volatility. Low bond yields have ensured that returns from even government securities remain low. 

The Employees Provident Fund (EPF) and Kumpulan Wang Persaraan (Diperbadankan) (KWAP) are among the local players jumping on the private equity bandwagon. And as the challenge of getting good returns grows, this asset class will likely attract more pension funds globally, say industry observers.

While their exposure to private equity remains low at under 5%, EPF and KWAP — whose primary mandate is capital protection — have generated earnings from this segment. However, the two pension funds do not discount the possibility of increasing their exposure to this asset class, which has potential for high returns and portfolio diversification. 

Private equity used to be seen as a way of taking advantage of companies in need of financial backing during economic downturns or financial crises. However, over the years, these investors have gradually shed their image as predators. Now, most of them invest in distressed companies to turn them around and help them go public.

In the early days, private equity investments were not for the faint-hearted as they entailed high risks, arising from limited information on the financial health and operating track record of investee companies, among others. But this has changed in the last decade. Now, investors can lower their risk by putting their money in private equity funds instead of the investee companies directly. 

In private equity funds, the fund manager (known as the general partner) utilises the pool of funds to invest in portfolio companies for a fee and a share of the investment profit. This strategy has contributed to the relative success of private equity investments as many firms have been able to turn around underperforming companies or help them achieve their expansion goals. 

Nevertheless, investors looking to capitalise on private equity must be willing to keep their money in the fund for 7 to 10 years. This illiquidity, however, is often offset by superior returns. This makes it an almost-perfect asset class for pension funds seeking high and steady returns over the long term. For them, illiquidity is not an issue. 

This alternative asset segment has grown dramatically in the past decade. Investor allocations, the outperformance of private firms versus public companies and market appreciation have seen global private equity assets reach US$3.65 trillion, excluding venture capital, says research firm Deloitte Touche Tohmatsu Ltd in its Private Equity Growth in Transition report.

According to the report, private equity has outpaced other asset classes in the last 10 years, with a robust compound annual growth rate (CAGR) of 13.7% since end-2005. Investments are anticipated to reach US$4.66 trillion by 2020, representing a CAGR of 5%. 

In March, South Korea’s Public Officials Benefit Association — a pension fund for government officials — boldly announced that it would allocate US$200 million to private equity vehicles. The allocation represented a whopping 100% increase from its allocation last year. 

On Aug 5, Kenya’s National Social Security Fund announced that it was looking to private equity and other investments abroad to boost returns. The country’s retirement guidelines, which were released last year, allows pension funds to invest as much as 10% of their assets in private equity and venture capital to diversify their holdings.

Meanwhile, EPF — Malaysia’s largest retirement fund — is looking to expand its exposure to real estate, infrastructure and private equity investments to between 8% and 10% of its total assets under management over the next five to seven years.

In an email response to Personal Wealth on its private equity investments, EPF stresses that the asset class provides “long-term diversification benefits” from the perspective of risks and returns. The fund, which has RM681.7 billion under management, says the illiquidity of the asset class, among other empirical evidence, indicates that private equity assets give investors better returns than equity markets. 

With the current spread of 5% for the segment, EPF says its minimum target, or internal rate of return from private equity investments, stands at 20%. However, the retirement fund has invested only 2% of its allocation, 88% of which are parked in foreign funds and 12% in the domestic market.

As private equity investments require thorough due diligence, EPF has kept it exposure minimal since 2008 while working on improving its internal capabilities to assess the segment. 

“The investments must pass EPF’s highly stringent investment parameters even before we decide to review the opportunity. Then, the investment proposal will go through multiple approval processes, including our investment committee and investment panel, before we decide to invest in the opportunity. After the financial close, we will have a dedicated Post-Investment Management (PIM) team that closely monitors our private equity investments,” says a spokesman for EPF.

“As a retirement fund, we need to be prudent in our investments. We only invest when we are comfortable with the risk level. Track record and due diligence are pivotal to our assessments.”

EPF has invested in funds based in India, China, Japan, South Korea and Australia as well as in Southeast Asia, North America, Latin America and Europe. It directly invests in large funds and employs services such as funds of funds — an investment strategy of holding a portfolio of other investment funds — to further diversify its private equity investment portfolio into primary, secondary and co-investments.

“The largest co-investment deal was the delisting of QSR Bhd — the franchise holder of KFC and Pizza Hut in Malaysia. Apart from that, we are invested in Colombia Asia Sdn Bhd, the country’s leading community healthcare provider,” says the EPF spokesman. 

 

Catalyst For Growth In Low-Yield Environment 

KWAP, which manages the pensions of the civil service, says pension funds are still struggling to make up for the investment losses seen in the 2008 global financial crisis. “Interests rates, corporate earnings and gross domestic product growth are low. People are seeking higher returns. So, I think many [are turning] to private equity,” KWAP CEO Datuk Wan Kamaruzaman Wan Ahmad tells Personal Wealth in a recent interview.

“More and more investors are trying to allocate more money to private equity funds. It is a global trend nowadays, searching for yields. This can be seen particularly in North America, where there is a sizeable presence of private equity funds. University endowments and pension funds there are moving a lot of money into private equity, with some of them investing more than US$50 billion.”

About 90% of KWAP’s assets are allocated to equities and fixed income. “The remaining 10% is allocated to private equity, real estate/property and cash. We keep cash even though we do not have any liabilities at the moment as this allows us more opportunities when there is volatility in the market,” says Wan Kamaruzaman.

The country’s second largest retirement fund, with RM120 billion under management, dipped its toe into private equity less than a decade ago, says the CEO. Like EPF, its infinitesimal allocation to the segment has been governed by its lack of familiarity with the asset class and the attempt to build the internal capabilities of its fund managers to oversee its private equity investments.

“KWAP’s overall asset allocation to private equity has not exceeded 2%. Right now, we are closer to the 2% of the money committed. But the drawdown is around 1.1% to 1.2%, which is slightly more than RM1 billion,” says Wan Kamaruzaman.

“We have invested in 23 funds focused on growth, buyouts, infrastructure, the secondary private equity market and real estate segments. Investing in private equity funds is part of our diversification strategy and we actively seek co-investment opportunities, where we co-invest with a private equity fund and have a direct stake in the [investee] companies.” 

The bulk of the pension fund’s private equity investments are in Australia and Asia. But it also has exposure to European and North American markets. 

“In terms of fund structures, we do not have any with exposure to just Malaysia. But we have exposure to Southeast Asia, and there are a few funds like that,” says Wan Kamaruzaman. 

In Malaysia, KWAP’s private equity undertaking has been more in the form of co-investments. In 2014, together with private equity fund Tremendous Asia Partners Group, it bought a stake in snack food maker Munchy’s Group. The group’s brands, such as Oat Krunch, Lexus, Muzic and Captain Munch, are distributed in 45 countries. 

“We have 15% exposure in Munchy’s. The private equity fund also took up 15%. Previously, we were invested in Malakoff Corp Bhd, but we exited at the pre-IPO stage,” says Wan Kamaruzaman.

   
   
Cover Story: The private equity lure for pension funds (Pt 2)

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