Pension funds have always been considered to be conservative investors. This means that pension funds have generally been associated with low-risk instruments such as bonds. However, over the past few years, pension funds started aggressively investing in privately listed equities. As a result, they were able to generate a fairly high return as compared to their peers.

Also, since interest rates have fallen considerably over the years, pension funds have been encouraged to take on higher risk. The end result is that pension funds have started investing in riskier assets in their quest for higher returns.

The private equity market is one such asset class. The end result is that pension funds have ended up becoming the biggest financiers of private equity funds.

In this article, we will have a closer look at the pros of cons of pension fund investments in equity markets.

Advantages of Pension Fund Investments in Private Equity Markets

There are obviously many advantages which make private equity an attractive investment option for pension funds. Some of the main reasons behind this have been mentioned below:

1. Diversification: The first and foremost reason that pension funds invest in private equity markets is for diversification.

   The assets which are acquired via private equity market do not have a high correlation with the other asset classes held by pension funds. This added diversification helps pension funds in ensuring that their returns remain stable even in periods of economic downturns.

2. Higher Returns: Private equity funds have historically provided higher rates of return as compared to other asset classes. Since pension funds have been compelled to take risks because of lower interest rates, investing in private equity does not seem like a far-fetched idea.

   When pension funds invest in private equity, they are able to invest in cutting edge businesses. Also, they are able to enter these businesses when the valuation is very low since the investments have not become available to the general population. Theoretically, this creates the probability of very high returns.

   Even if the high failure rates of private equity investments are taken into account, it is possible for pension funds to earn a significantly higher rate of return as compared to other investment options.

3. Longer Holding Period: Private equity investments need time to grow. Since the investments are made during the early stage of the company, it takes a few years for these investments to start producing positive cash flow.

   Pension funds typically have a long-time horizon. Hence, they are best suited to make private equity investments. It is for this reason that almost 20% of all private equity capital raised in the United States comes from pension funds. This makes pension funds the largest contributor of capital to private equity organizations.

Disadvantages of Pension Fund Investments in Private Equity Markets

There are some obvious disadvantages of investing in private equity markets as well. Some of these disadvantages have been listed below:

1. High Costs: The success of private equity investors is highly dependent upon the skill of the fund manager. There are many funds which have been able to consistently earn more than 16% return over an extended period of time. However, there have been many other funds which have not been able to beat the index for several years.

   The problem with choosing private equity funds is that they charge very high fees and commissions. These fees and commissions eat into the overall rate of return provided by the investment. This often makes it unviable to invest in private equity in the first place.

   Many pension funds have started designing their investment contracts to be more performance based. This will ensure that the incentives of the private equity partners are aligned.

2. Lower Transparency: Private equity funds are under no obligation to disclose their investment strategies. In fact, most of these funds actively prevent sharing of information. On the other hand, pension funds need to report in a transparent manner.

   In most cases, pension funds are required to update the daily valuation of their assets to regulators. As a result, there is a lack of transparency when it comes to investing in such funds. This can be problematic for a pension fund since they need to have very clear understanding of their assets and liabilities.

3. Lower Liquidity: The biggest problem with pension funds investing in private equity is the fact that pension funds offer lower liquidity. The investments made cannot be sold to a third party on the market. Hence, the funds cannot be immediately liquidated when the pension fund needs to do so.

   It may be possible to sell the investment over the counter after using the services of an investment banker. However, that may be an expensive proposition and may also end up taking a lot of time.

   The lower liquidity is a significant impediment to pension funds and is one of the reasons that pension funds reduce the quantum of their exposure to private equity.

The bottom line is that pension funds are now comfortable with investing in private equity as an asset class. This is because there are certain significant advantages to doing so. However, at the same time, there are significant financial deterrents which do not allow pension funds to invest a significant portion of their asset base.

The fact of the matter is that private equity will continue to remain a fringe asset class for the foreseeable future as far as pension funds are concerned.