Why Pension Funds Are Hooked on Private Equity

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JASON REED / Reuters

President Barack Obama delivers remarks on the budget alongside acting Director of Office Management and Budget Jeff Zients, in the Rose Garden of the White Hose in Washington, April 10, 2013.

When President Obama unveiled his budget last Wednesday, it rekindled a debate over taxation of the private equity industry. Many executives in the private equity business (as well as the venture capital and hedge fund businesses) pay the capital gains rate on their earnings rather than the higher rate paid on ordinary income. Even though these industries make most of their money from the appreciation of assets — the definition of “capital gains” — the President, and many others, believe it is unfair that employees of these funds are able to pay the capital gains rate. After all, these execs are getting paid to manage these funds, not for risking their own capital.

Of course, the private equity industry isn’t going to take such a tax hike lying down. According to Politico, the Private Equity Growth Capital Council recently sent a white paper to the House Ways and Means Committeer extolling the benefits of private equity for America’s pension funds. According to the paper:

“Since the 1980s, pensions’ investment in private equity funds has grown. According to Preqin, a provider of data on the private equity industry, pension funds have been the largest contributor of capital in private equity investments during 2001-2011 . . .  pension funds make up 43% of capital invested, of which public pension funds comprise almost 30%.”

(MORE: How Bad Is America’s Pension Funding Problem?)

Indeed a recent report in the Wall Street Journal provides further evidence that private equity and pension funds are increasingly reliant on one another. Writes the Journal: 

“Numerous pension funds are still struggling to make up investment losses from the financial crisis. Rather than reduce risks in the wake of those declines, many are getting aggressive. They are loading up on private equity and other nontraditional investments that promise high, steady returns in the face of low interest rates and a volatile stock market.”

More and more, pension funds are allocating their resources towards alternative investments like private equity. But is this a good idea? At first blush, it may seem dangerous for pension funds to invest in risky, illiquid assets like private equity funds. In fact, on average, private equity has outperformed the broader market. In 2012, economists Robert  Harris, Tim Jenkinson, and Steven Kaplan studied private equity returns and found — to their surprise — that private equity funds beat the S&P 500 by an average of more than 3% per year.

In a telephone interview, Kaplan hypothesized that private equity’ relative success could be attributed to the fact that many private equity firms have robust operations teams that are, on the whole, good at turning around underperforming companies. But success in private equity requires patience. Investors in private equity funds must commit to keeping their money in the fund for a period of months or years. Private equity’s superior returns can also be interpreted as compensation for iliquidity.

(MORE: Are We Lying to Ourselves About Our Pension Problems?)

Since pension funds are inherently concerned with the long-term, this illiquidity is less of a problem than it might be for another type of investor. So it make sense for pension funds to attempt to capture the higher returns provided by private equity.

So the real worry shouldn’t be that pension funds are overinvesting in private equity, but the fact that pension funds are chronically underfunded — the state of affairs which presumably motivates pensions’ interest in alternative investment vehicles. As my colleague Michael Sivy has pointed out, pension funds, both in the private and public sector, are trillions of dollars short of what they need to maintain their promises to workers over the long haul.

So while private equity will probably continue to use their track record of bolstering returns for pension funds as an argument for why Congress shouldn’t fiddle with this success by closing the carried interest loophole, the real problem in the pension gap. Congress shouldn’t bend over backwards to hand out breaks to an industry just because it helps mask the symptoms of such a serious problem.

MORE: Can We Handle the Truth? Public Pensions Are Short on Cash