Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Political pain awaits super’s private markets push
Private equity is controversial again. That’s mostly due to the confusion that persists around how private equity assets are valued and the apparent smoothing of returns that goes on behind the scenes. But as big super funds increase their allocations to private equity and internalise their private equity teams, the problem might be in another area entirely.
The concerns that private equity managers express publicly and privately are basically the same: super funds will have a hard time attracting top-tier investment staff unless they’re willing to pay them what the average superannuant would consider to be an exorbitant amount of money – their money. What changes when that concern is expressed in private is their estimation of the scale of the problem. In public, it usually comes with the caveat that funds are doing all the right things – setting up offshore offices, working with good general partners. In private, the skepticism is overwhelming.
As PE investors, pension funds come with all sorts of agency problems that PE managers don’t have in the same helpings. For example: they’re being paid out of the money they’re managing on behalf of their members, making anything but the most frugal use of that money a potential political flashpoint. That’s been the case with everything from sporting sponsorships to… well, more sporting sponsorships.
PE managers are fond of pointing to the case of the Ontario Municipal Employees Retirement System (OMERS), a Canadian public pension fund that, from 2013 to 2021, had maintained a separate compensation scheme for its internal PE division that was designed to mirror market rates by allowing them a cut of profits from the deals they sealed, so long as those deals achieved an annualised eight per cent return over the course of their life.
However, OMERS later changed the terms of the agreement several times by cutting the share of profits from 10 per cent and (allegedly) amending it to require an eight per cent return every year rather than cumulatively. They then ditched that agreement altogether in a move that (allegedly) saw eight employees resign and one of their top dealmakers file a $US52 million wrongful termination suite when he was (allegedly) let go after he refused to agree to the new plan. OMERS says that it had a right to modify the compensation scheme because of its fiduciary duty to its half a million members. The whole thing was simply too expensive.
Executive pay among super funds is relatively restrained compared to what would be on offer in for-profit funds management businesses. It might become somewhat less so when super funds are trying to compete in a very expensive asset class, and that’ll doubtless be a problem in what sometimes seems like the most politicised pension market on earth.
One point that PE managers concede – and super funds gladly take – is the possibility that funds will be able to attract mission-driven investors who don’t mind foregoing multi-million dollar pay-packets for the opportunity to make somebody’s retirement better and contribute to society (a calling that the ruthless LBO ‘managers’ of 1980s classic Barbarians at the Gate would no doubt have viewed as something like charity). The counterfactual to this is that you tend to get better performance from people who are better paid.
In Paying for Performance in Public Pension Plans, researchers Yan Lu, Kevin Mullally and Sugata Ray
found that “higher paid CIOs outperform their counterparts by 47 – 60 basis points per year, largely through increased and superior investment in private equity and real estate” – generating an additional US$74.91-US$95.63 million in economic value”.
“We interpret our results as indicating that higher CIO compensation, at least in the long run, would lead to better performance outcomes that generate economic value for plans,” the researchers wrote. Such performance increases would likely mitigate the underfunding experienced by some public pension plans.”
Outraged by Compensation: Implications for Public Pension Performance, a paper by researcher Alexander Dyck, Paulo Manoel, and Adair Morse, has a similar finding – concerns over the politics of compensation leading to funds hiring cheaper (and potentially less skilled managers) with a deleterious effect on returns.
So, a tough choice awaits big super – pay up for talent and potentially face the wrath of the usual political hitmen. Or forego the heavy hitters and hope you can attract reformed ‘barbarians’ with hearts of gold.
