September 30, 2022

Alternative investments proved to be the top-performing sectors in the wild ride of a fiscal year, but bad news is coming when managers report their actual June 30 returns this fall, industry insiders said.
The rosy numbers are not expected to hold. Most investors report alternative investment returns as of a quarter earlier than the rest of the portfolio, and consultants and managers anticipate the actual June 30 data and beyond to reflect significant write-downs across private markets.
For example, real estate investors expect total returns to plunge to 4.4% in calendar year 2023 from an estimated 8.8% in 2022, according to the results of the Pension Real Estate Association’s third-quarter consensus forecast survey of the U.S. commercial real estate market, released Sept. 13. The appreciation return of the NCREIF Property Index, reflecting property values, is expected to plummet to 0.1% in 2023 from 4.7% in 2022.
The issue all stems from an anomaly in the reporting. Many institutional investors close their investment books for the fiscal years ended June 30 in July, months before their alternative investment managers have turned in their returns for those periods. So, investors’ fiscal-year returns include returns from alternatives — ranging from private equity and private credit to real estate and infrastructure — that are lagged behind by a quarter while still reporting public markets as of June 30.
With stocks and bonds taking a beating in the second half of the fiscal year, alternative investments actually reported as of March 31 looked pretty good. But industry executives warn that private markets assets are not invulnerable to the downturn in markets.
“One piece of bad news” is that private market assets will be repriced, Allan Emkin, San Diego- based managing principal of Meketa Investment Group, told CalSTRS’ investment committee on Aug. 31.
In the next three or four quarters, there will be write-downs in private market assets to reflect what has happened in the public markets “because they are not immune to what happens in the general economy or to the capital markets at large, and that has not yet been reflected in the portfolio,” he said.
And alternatives are a big part of CalSTRS’ portfolio, with 16.3% invested in real estate, 15.7% in private equity and 5.4% in inflation sensitive, which includes infrastructure, as of June 30.
The June 30 numbers for alternative investment portfolios will be included in the pension fund’s financial statements, said Christopher J. Ailman, CIO of the $311.7 billion California State Teachers’ Retirement System, West Sacramento, during the same meeting. Staff will bring the first draft of the full financial statements to the board in November.
CalSTRS earned a net -1.3% for the fiscal year ended June 30, outperforming its -2.2% benchmark. The three best-performing sectors for the fiscal year were private market asset classes: real estate returned 26.2%, underperforming its benchmark of 27.3%; private equity at 23.7% internal rate of return, slightly outperforming its 23% benchmark; and inflation sensitive at 17.5%, well above its 12.9% benchmark. The returns for all three asset classes are as of March 31.
“We know the assets are going to be written down, but by how much?” Mr. Ailman said.
Endowments and some pension plans will go back and restate their June 30 private markets performance with a “trued up” figure for June 30 later in the year, he said.
“It’s confusing because there are two sets of numbers,” Mr. Ailman said. But those June 30 numbers will be captured in next year’s returns, he added.
The difference between the reported fiscal-year returns for a pension fund’s private market asset classes and when those returns are “trued up” later in the year can vary, said Mindy Selby, CalSTRS spokeswoman, in a Sept. 13 email in response to questions.
The private market returns are “derived from the estimated projections performed using a public market index,” she said.
CalSTRS’ investment book of record is closed by early July, a standard practice for private assets that report on a lag, Ms. Selby said.
“To be consistent, we ensure that four quarters’ valuation are captured over a reporting period,” Ms. Selby said.
However, CalSTRS’ financial statements — its comprehensive annual financial report — “capture the best estimate for the June 30 values,” she added.
For the $444.4 billion California Public Employees’ Retirement System, Sacramento, the annual comprehensive financial report to be released sometime later this year will include private market performance figures through June 30, said spokesman Joe D’Anda in an email. “If this leads to a material difference in the fiscal year returns, it will be noted,” he said.
The fiscal-year returns reported by CalPERS in July are preliminary, he said. But the returns in the financial statements are official and used as the basis of employer valuations and contribution rates, Mr. D’Anda said.
As of June 30, CalPERS had 15.8% invested in real assets, 2.8 percentage points above its target allocation, and 12% in private equity, 4 percentage points above its target.
CalPERS returned -6.1% in the fiscal year ended June 30, exceeding its -7% benchmark.
The Oregon Investment Council, which oversees the $93.3 billion Oregon Public Employees Retirement Fund, Salem, was also overweight private equity — 8 percentage points over its 20% target as of June 30, boosting its returns, said Paola Nealon, managing principal at the council’s general investment consultant Meketa, at the council’s Sept. 7 meeting. However, she cautioned that OPERF’s returns do not reflect potential write-downs in the private markets given the quarter lag. The pension fund earned a net 6.3% return for the fiscal year ended June 30, outpacing its -0.7% benchmark. It is the highest public pension fund return Pensions & Investments has reported out of 70 plans.
Greg MacKinnon, director of research of the Pension Real Estate Association, said he wasn’t surprised that real estate market participants in the most recent consensus forecast survey “are expecting something of a drop-off in performance next year.”
“Multifamily and, especially, industrial, had stellar years in 2021 and continued to be strong through the first half of 2022,” he said in an email. “It would be hard to repeat that performance for another year, especially given macro conditions.”
With the Federal Reserve raising interest rates at a quick pace to combat inflation, the economy is in worse shape than it was at the beginning of 2022, he said.
And real estate, across all sectors, is tied to economic growth, Mr. MacKinnon said.
“So, one should expect returns to be more muted than they have been over the last 18 months,” he said. On top of that, the outlook for office usage is uncertain, which is gradually being reflected in market valuations, Mr. MacKinnon said.
The result is “you get lower overall return forecast for 2023 than for this year,” he said. Although he added total returns are expected to start to pick up a bit in 2024, Mr. MacKinnon noted.
Even so, the annual return for the four years ended 2026 are expected to be more than 2 percentage points below the 2022 return, PREA’s survey shows.
“Real estate as well as the broader capital markets have been on quite a ride,” said Scott Dennis, Dallas-based CEO of Invesco Real Estate, a division of Invesco Ltd.
The real estate industry is coming off a period where the NCREIF Open-End Diversified Core Equity index returns were running in the high 20% range, Mr. Dennis said.
“That’s been great … from a return perspective, but that is not sustainable,” he said.
While the real estate investment trust market had dropped 20% right away this year, the private real estate side has not yet reflected the markdowns due to a lag in valuations, which are done by third parties, Mr. Dennis said. If the markets continue as they are with rising interest rates, there will be valuation markdowns in the third and fourth quarter of 2022, going into the first quarter of 2023, he said.
Private equity returns are also expected to be lower when the June 30 numbers are revealed, consultants say.
“Private equity valuations tend to follow the public markets,” because one method for valuing private investments are public market comparisons, said Adam Bragar, New York-based head of the U.S. private equity practice of Willis Towers Watson PLC.
But not all sectors will fare the same, he said. Greater declines are expected in certain areas such as venture capital, particularly later-stage venture capital in which managers depend on initial public offerings for exits. With public markets softening, there is less likelihood venture capital-backed companies will go public. This will negatively affect valuations because if a company cannot go public, it will have to raise another round of financing, which is likely to value the company at flat or lower than past financing rounds, Mr. Bragar said.
Mega buyout investments will likewise be more negatively affected because there are few alternatives to an IPO exit for these very large companies, he said.
Potential buyers for mega companies are more limited than for smaller companies, Mr. Bragar said. There’s a lower likelihood of another private equity firm having the capital required to acquire the company, he said. What’s more, other large companies that might have been potential buyers in the past may not want to make the acquisition when their own valuation is down, Mr. Bragar said.
However, Willis Towers Watson focuses on the lower end of the middle market and “companies in our portfolio continue to perform relatively well,” Mr. Bragar said.
That is not to say that private equity valuations won’t go down.
“I don’t think any of our clients are … not expecting markdowns across their (private equity) portfolios,” Mr. Bragar said. “Those adjustments in valuations will be more muted than the public markets … none of the market write-downs have been greater than what has happened in the public markets.”
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