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Private equity angst at Oregon

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At $26.4 billion and 28 per cent of Oregon Public Employees Retirement Fund’s total assets under the management, the pension fund’s private equity allocation is at the very top end of its target range.

Not only is the exposure stubbornly high, lacklustre M&A deals and “anaemic” exit activity; a slowdown in fundraising and deployment and market volatility creating benchmarking havoc have also conspired to cause consternation for the Oregon Investment Council (OIC).

“We are still in a phase of markets digesting what has been a wild ride since COVID,” said Michael Langdon, director of private markets at OIC, who charted how unprecedented stimulus in 2020 led to record deal activity; inflation and tightening ensued, and now a disconnect between private equity and volatile public markets continues to thwart performance.

Bias to larger funds but smaller funds do best

In its Annual Review of the asset class, the private markets team told the investment council that OPERF’s large program is skewed to allocating to larger funds – yet smaller funds have significantly outperformed. The team have now begun a “manager by manager” analysis to dig down into “why this has happened” although they noted “actual, crystalized IRR” confirming smaller fund outperformance, remains unproven.

The size of the program means OPERF can only access a narrow selection of the manager universe because small managers can’t take large commitments. Of the 5000-odd funds in the asset class composite from 2013-2022, only 352 raised $3 billion plus of committed capital – during the same time period 50 per cent of OPERF fund investments by count and 71 per cent by commitment went to funds with $3 billion or more of total commitments.

Positively, large commitments enable OIC to negotiate more favourable fees.

Cash flow negative

In another challenge, the slowdown in distributions means the private equity allocation has turned cash flow negative for the first time in a decade. In 2023, the portfolio processed capital calls of $2.9 billion and distributions of $2.4 billion leaving net contributions of $518 million.

“2023 was the portfolio’s first negative cash flow year since the GFC,” state board documents.

Moreover, it’s difficult for LPs to model how fast distributions will show up to ease the crunch of negative cash flows. “We control what we commit, but we can’t control how fast managers invest,” the board heard.

The team has also been unable to use the secondary market to pull forward distributions because of challenges around execution. Still, looking ahead, improved pricing in the public market will feed into the secondary market, helping OPERF generate more strategic liquidity.

Pacing and fewer GP relationships

OPEF has a strict private equity pacing commitment of $2.5 billion total annually. But this has also caused challenges to appear in the portfolio because it has led to an underweight in vintages that have performed well. It has created a drag on OPERF’s relative performance due to the strong, early performance from recent vintage years where OPERF is underweight, say board documents.

Around 60 per cent of OPERF’s fund investments in mature vintages are ranked below median as compared to other funds pursuing a similar strategy in the same vintage.  “Fund size continues to have an outsized impact on quartile rankings, particularly with respect to OPERF’s core allocation to North America buyout funds,” say board statements.

The pension fund will keep its pacing range of between $2-3.5 billion while there is a slowdown in distributions.

OPERF is currently “lighter” than it wants with some 30 GPs on its roster rather than a preferred 40. In a catch-22, the team will only add managers as the pacing allows, and given the team will stick with the existing roster unless “the manager gives reason not to reup” it means scant opportunity for new GPs. Since 2015 the program has sharpened manager selection, reducing the number of managers from 70.

The OPERF portfolio has buyout, venture and growth equity. An overweight to buyout and North America has served the fund well. In contrast, the struggle to retain the target weight to venture has been a detractor. In another trend, the investment team expect to tilt more to developed markets in America and Europe because of the challenging geopolitical landscape.

Shifting dynamics

The board heard how the dynamics behind private equity are changing. Since 1981 – when Oregon was one of the first US pension funds to invest in private equity – interest rates have steadily fallen. It means rates have been falling for the entire time the fund has invested in private equity, bolstering the allocation as well as bidding up all risk assets.

The new interest rate environment means that fundamentals and earnings growth will now be the most important contributors to returns in excess of the market. Moreover, if returns are muted on a real basis by inflation, every single basis point is important.

Other market trends include inflated valuations in the tech sector. GPs hunting for capital for their next fund are under pressure from LPs to sell assets but because valuations remain inflated, buyers are cautious. Still, technology is unaffected by cyclical ups and downs. In contrast, PE opportunities in healthcare and services are buffeted more by macro trends, while investors in consumer brands do best focused on the luxury segment and from digitization trends.

The current market is also characterised by an uptick in demand for and availability of leverage from direct lenders.

The board heard concerns about the rising cost of leverage, with the team counselling on the importance of paying close attention to OPERF’s ability to serve the cost of leverage so as not to impact cash flows. Many GPs didn’t hedge interest rate exposure heading into rising rates and worryingly, a fair amount of debt has come due, requiring refinancing across the capital structure.

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