March 12, 2014
Interviewed by: David Snow
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Defined Contributions and Private Equity

Transparency and liquidity is needed if defined contribution pension plans are to deepen their relationships with private equity, says Michael Riak, Principal – Head of Defined Contribution with Pantheon Ventures.

Transparency and liquidity is needed if defined contribution pension plans are to deepen their relationships with private equity, says Michael Riak, Principal – Head of Defined Contribution with Pantheon Ventures.

Defined Contributions and Private Equity
With Michael Riak of Pantheon Ventures

David Snow, Privcap:

Today, we are joined by Michael Riak of Pantheon Ventures. Michael, welcome to Privcap.

Michael Riak, Pantheon Ventures:

Thanks, David.

Snow: Let’s talk about the fact that you are now with Pantheon Ventures, a private equity-investment firm investing in many different funds and other activities. Yet, your background is defined contribution. Private equity has become a huge component of defined benefit pension plans, a major allocation, and gave birth to the private-equity industry. Yet, if you look in defined contribution plans, there is basically zero product that looks like genuine private equity. Why is that?

Riak: It is funny. You would think that, because private equity has been such a successful asset class for DB plans, there would be more of it in DC plans. There are, but there are significant challenges to be overcome in order to have private equity in a DC plan. It starts with the way the whole DC industry has been set up with daily valuation and daily liquidity. People like to go on the website of any other record keeper fidelity and see how their balance is doing on a daily basis. You have to be able to have liquidity so people can move in and out of those accounts on a daily basis. It is not mandated legally that you do it that way, but it is how the industry has been set up. So, there are five big issues that have to be solved in order to have private equity in a DC plan. One is you have to be able to get the money in the ground quickly. In the private equity industry, it has grown up around the DB plan, where you could wait to get that private equity in the ground. You could wait one, two, three to five years to make a commitment to invest in private equity and then take time as capital calls come in, you invest the private equity. It does not work that way in a DC plan. You have to get the money in the ground quickly, and that is something the firm I work for, Pantheon Ventures, is known for—being able to get money in the ground quickly by investing in a private equity secondary transaction. So, that would be the initial seating.

Snow: Right, where the capital is already in the ground because—

Riak: It’s existing portfolio. The second thing that has to be done is daily valuation. There are really no standards for doing it. Pantheon had to come up with the methodology for being able to value a private-equity portfolio on a daily basis. At a very high level, Pantheon looks at things such as valuation methodologies. It was really codified in 2007 with FAS157, and fair valuation methodologies. Looking at proxies, because you do not have the ticker symbols for these companies or the PNLs. Look at it on a daily basis—you look at industries, and you look at economic events. Also, you have to look at the cash flows that happen with a private-equity portfolio. Those are so important; at a very high level, that is what you have to be able to look at to daily value this. The third is liquidity. How are you going to provide that liquidity? The whole DC industry has grown up around, “You will be able to move your money in and out on a daily basis.” The fourth thing is an operational backbone. You must have systems in place to be able to track that valuation and the liquidity, to monitor it, and to make sure you are producing reports on a daily basis. The program has to be transparent, it has to be consistently applied, and it has to be audit-able. On a daily basis, you must be able to show your auditors and planned sponsor that this program can be audited—it is very important. The fifth thing is communications. There is a lot of fear among plan sponsors as to how you communicate a private-equity program. It is not that difficult.

Snow: Of the five challenges you mentioned, what was the toughest nut to crack or what remains the toughest nut to crack?

Riak: The toughest nut to crack is convincing plan sponsors that you have an accurate valuation methodology, that daily valuation is something they would be comfortable with. “Accurate” does not mean “exact.” Even other asset classes, daily valued U.S. equity funds, international funds, emerging market funds—there are some estimates in there, especially in international. You have lags, you have multiple pricing services with some bond accounts. It does not have to be exact, but it has to be close. That is what we are talking about.

Snow: You mentioned that it is not necessarily a regulation that they provide daily pricing—it is just the way the industry works. Is there a fear that some underlying investor moves his money out of a private-equity vehicle and, the next day, an underlying fund has a huge IPO or a huge exit, and there is a sense that he got robbed of that value because they did not know?

Riak: It is no different from what’s going on in the public-listed markets. That can happen also. You could move out of a fund the day after some major event happens with a publicly listed stock. Same thing with a bond—you can move in and out at a time when, suddenly, interest rates may have a major change. Private equity are still companies, even though they are not listed on the stock exchange. They react the same way as companies do in the listed markets.

Snow: Talking to people you know in the DC world, do they concede that, or is there still the perception that this is an inherent weakness of private equity, that you cannot have a credible daily valuation of what are completely illiquid securities?

Riak: Actually, when you talk to them about it and explain it—especially when you talk about daily valuation—they get it. In private equity, there was a thought that they are smoothing, because you had quarterly valuation. You did not have that daily valuation volatility. That goes away when you are daily valuing your account. You have the volatility that you have still on the listed markets, so private equity in a daily valued scenario is not for diversification and volatility smoothing, because it is daily valued. It is for alpha generation, for helping people improve the performance of their accounts, their target day funds, their balance funds, and their managed accounts.

Snow: For many defined benefit plans and other LPs in private equity, private equity has been a strong outperformer and the portfolio has enhanced the overall performance of the portfolio. Are DC plans aware of this? Do they feel that, by not having private equity in some of their products, they have suffered as a result?

Riak: There is a lot of education that still must go on in the DC market; even planned sponsors we have spoken to who have been doing this for years still have to be educated on what’s going on with this type of portfolio. Yes, there is a constant understanding that private equity outperforms in most cases, especially if you are picking high-quality managers in private equity. It will outperform the public markets, which is what we are trying to do. That is why it has become so prevalent in the DB industry, just dealing with those issues, getting the money in the ground quickly, daily valuation, liquidity, communications. Once planned sponsors get comfortable with that, they will see this is an asset class that can really help.

Snow: A final question for you about the communications challenge you mentioned, particularly communications to the underlying investors who might only think of private equity as something Mitt Romney did that was evil back in the day. As you see or as you imagine the product rolling out, what kind of communications effort will have to go to the underlying investors saying, “Good news, guys, there is now private equity in your portfolio”?

Riak: It is not much different than communicating other alternatives in a plan or even standard U.S. equity products. A description has to go out there that, again, if it’s a standalone option, it is a much more extensive description because they could choose that option. But, if it is just an allocation in a balance type fund, a target date fund, the description does not have to be that vast. We have drafted this stuff, sent it for legal review and asked around, “Do you understand it? Will people understand it?” It has been reviewed; that is the key thing—getting something out there that gets people to start looking at it, getting comfortable with it. It is not that difficult to do. I have done these types of communications for more than 10 years at a large planned sponsor; once you start making those drafts and you start getting it and having people review it they say, “This is not that difficult. We can do it, we can update our documents. We can send out communications to participants in emails and letters.” It is not that difficult.

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