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September 07, 2009

Private Equity Pain for Education and Public Workers

The article below, by Will H. Rogers, originally appeared in the Fall 2009 Update of the Committee on Political Education of the Texas State Employee Union, Local 6186 of the Communication Workers of America, AFL-CIO.

In June, workers at Harvard University were told that 275 of them would be laid off and 40 would have their hours cut.

Weeks earlier in Texas, retired state employees and retired teachers learned that they wouldn't be receiving long overdue pension increases. Those still working for the state learned that they would be paying higher contributions to their pension fund and new state employees would have their pension benefits cut.

The layoffs at Harvard, the higher pension contributions and lower benefits, and the lack of pension increases are collateral damage from what Harvard President Drew Gilpin Faust called "a set of extraordinary financial challenges."

What were these "extraordinary financial challenges? There was really only one: the precipitous decline of investment assets that help pay Harvard's operating expenses and fund pensions for Texas teachers and state workers.

The value of Harvard's endowment fund, which pays more than one-third of the university's operating expenses, has dropped 30 percent since June 2008.

Texas' two main public pension funds, the Teachers Retirement System and the state workers' Employee Retirement System, in March reported losses of 32 percent and 28 percent respectively.

Harvard's financial losses and subsequent job cuts are largely due to its over commitment of funds to private equity investments and other alternative assets.

In Texas, returns on private equity investments have been disappointing, but TRS and ERS remain committed to increasing their investments in private equity and other alternative investments.

Harvard's Problems

Harvard was one of the first large institutional investors to jump into the alternative asset market. Private equity is one type of alternative asset; others include real estate, commodities, and hedge funds.

By 2008, 35 percent of Harvard's endowment investments were in alternative assets instead of stocks and bonds, the more traditional investments.

The strategy worked well. Over a ten-year period, Harvard's private equity holdings generated a 28 percent return on investment.

But in 2008, the bottom fell out of the private equity market, and Harvard suffered huge losses. Steve Davidoff, who teaches law at the University of Connecticut School of Law and contributes frequently to the New York Times Deal Book blog, estimates that the value of all of Harvard's private equity investments dropped by 40 percent between June 2008 and March 2009.

Layoffs and pay freezes for staff and faculty followed.

Why the sudden downturn in private equity investments?

Private equity investments work like this: A private equity company sets up an investment fund and solicits commitments of capital from big institutional investors like pension funds and endowments and from large private investors.

The company uses the committed capital to partially fund deals such as leveraged buyouts of publicly owned companies, the purchase of corporate bonds and securities selling for less than their face value, and venture capital investments.

Generally, private equity investments are speculative in nature. They rely heavily on borrowed money--according to Barron's private equity companies in the mid-2000s borrowed nearly $1 trillion just to finance leveraged buyouts--and are sold when the investment becomes worth more than the original price.

The profits from these deals are shared with investors as are the losses. During the mid-2000s some private equity funds were generating returns of 50 percent or more. The norm was 25 percent.

But these profits were unsustainable because they were fueled by huge amounts of debt. Leveraged buyouts, the main private equity deal of this decade, saddled companies acquired in these buyouts with heavy debt burdens.

As long as revenue remained constant or grew, most of these companies could pay their debts. If there was a problem, cheap and easy credit for refinancing debt was always available.

But when the recession hit, revenues dropped and cheap, easy credit dried up. As a result, many of these companies were unable to make debt payments forcing bankruptcies and near bankruptcies

One of the Teachers Retirement System's private equity investments is illustrative. Back in 2007, TRS decided to commit $300 million to Colony Investors VIII, an investment fund set up by Colony Capital, a Los Angeles private equity company that specializes in real estate deals.

At the time, one of the deals that Colony had in the works was the purchase of Station Casinos, a gaming company that owned about a dozen mid-level casinos in Las Vegas.

Despite some reluctance, TRS agreed to this commitment after a private consulting firm estimated that the commitment would generate an annual return on investment of nearly 19 percent.

Unlike many private equity ventures that are speculative in nature, this one was to be a long-term investment. Colony in partnership with Station's managing partners, the Frettita brothers, Frank and Lorenzo, bought out company stock holders, took the company private, and planned to use land already owned by the company to build new, high-end casinos.

Colony and the Frettita brothers borrowed about $3 billion to buy stock from shareholders at about $90 a share, increasing the company's debt load to more than $5 billion.

The deal was done in November 2007, but by December 2008, Station was in trouble. The recession caused revenue to drop sharply, and for the final quarter of 2008, Station reported a net loss of $3 billion.

By January 2009 it was unable to pay interest on bonds coming due, the first in a series of defaults.

In February, the company announced that it would file for bankruptcy and asked bondholders to accept payments of between ten and 50 cents on the dollar for their bonds.

Since then, the company has been in pre-bankruptcy limbo as it tries to negotiate a pre-packaged bankruptcy deal with bondholders who didn't like the original offer. (Update: Station filed for bankruptcy in July.)

Investors who committed capital to Colony have taken a beating. Whitehall Street Global Real Estate Limited Partnerships 2007, a Goldman Sachs investment vehicle, reported that its $139 million investment in the Station deal was now worth $31 million.

As for TRS, its investment in Colony Capital Investors VIII has dropped 77 percent in value since 2007.

Illiquidity: Another Problem for Investors

There is another problem with private equity investments that wasn't anticipated when returns were high. These investments are highly illiquid. That is, if something goes wrong and you want to get your money out of the investments, it's difficult to do so.

When an investor like Harvard, TRS, or ERS commit capital to a private equity fund, they do so for a certain period of time, usually ten years. The private equity company draws on these commitments as needed.

Investors pay the private equity company a management fee of on average 1.5 percent of committed capital. Investors become limited partners with little say in how the capital is invested.

When Harvard's private equity investments turned sour, their illiquidity amplified Harvard's problems. The university tried to get out of some of its commitments, but Harvard's private equity partners were hemorrhaging money themselves and wouldn't let the university do so.

Harvard tried to sell some of its private equity investments to other investors, but the offers it received, estimated to be about 20 cents on the dollar or less, were so low that it decided not to sell. Instead, it froze salaries and laid off staff.

Although not as hard hit as Harvard, Texas state workers' Employees Retirement System has run into problems caused by the illiquidity of its private equity holdings and other illiquid investments.

ERS staff recently told the system's Board of Trustees that its monthly cash flow excess of $10 million would shrink to $5 million by 2017 because of its private equity and real asset commitments and because the return on investment outlook for these investments was bleak.

It seems likely that this predicted decline in cash flow was partially responsible for the higher contributions that current state employees will be making to the pension fund, the cuts to the benefits of new employees, and the lack of a pension increase.

TRS and ERS Stay Committed to Private Equity

ERS's and TRS's private equity and other alternative assets have so far been disappointing. TRS's private equity one-year return on investment was -25 percent. TRS investment staff isn't expecting much improvement.

A recent report to the TRS Board of Trustees said that, "distributions (from private equity investments) will continue to be lower than normal levels over the next 12 to 18 months." Other alternative assets such as real estate had equally disheartening returns.

But unlike Harvard, which has begun to divest itself of some of its private equity holdings and will be less aggressive investing in alternative assets, both Texas public pension funds plan to increase their alternative investment holdings.

Under pressure from state leaders to increase investment returns so the state would not have to increase pension contributions, TRS in 2007 decided to increase its allocation of alternative asset investments from 5 percent to nearly 30 percent over a three to five year period.

TRS remains committed to making this transition.

ERS is also planning to increase its holdings of alternative assets. Today ERS's alternative asset holdings are less than 5 percent of its portfolio, but it plans to increase these holdings to 21 percent.

One reason that TRS gives for increasing its holdings is that alternative assets including private equity have performed better than its stock market investments.

In March, TRS issued a report saying that these results are proof that its alternative asset strategy is sound and that it will continue to increase its alternative asset holdings.

Time will tell whether this bet pays off. If it doesn't, 1.4 million Texas teachers, state workers, and retirees whose pension benefits are administered by TRS and ERS could be facing the further benefit cuts.