The booming US private equity market could be heading for a crash as interest rates rise and hedge funds, desperately seeking higher returns, pour money into the sector, the chief investment officer for the biggest US pension fund warned today.
"The biggest one (asset bubble) I'm afraid of at the moment is private equity," Mr Mark Anson, CIO for the California Public Employees' Retirement System (CalPERS), told the International Fund Management 2005 conference organised by ICBI.
"The current overhang of leveraged buyouts committed but not invested is $182 billion (end-2003 figure). A lot of money is chasing high yield. Hedge funds are competing with buy-out managers and that convergence scares me," Mr Anson said.
Calpers has $175 billion in assets and Mr Anson has complete responsibility for all assets in which the pension fund invests, including domestic and international equity, global fixed income, high yield, real estate, corporate governance, currency overlay, securities lending, venture capital, leveraged buyouts and hedge funds.
The pension fund has $20 billion in private equity assets. Mr Anson said the skill sets deployed by hedge funds and buy-out firms are very different, with the funds using their trading abilities to quickly spot and act on mispricing opportunities in markets, whereas private equity companies look to build value long-term in their target investments.
Many private equity deals are also highly leveraged, with buyers borrowing money to magnify returns just as the US interest rate cycle ticks higher with the Federal Reserve raising rates.
If too much competing capital pushes down returns in long-term locked-up deals, at the same time as the price of money increases, then there is a danger investments will go sour as investors' calculations are thrown off track.
Hedge funds, which attracted $129 billion in global inflows in 2004, double the previous year, have turned to private equity in the face of falling returns in other markets.
The average returns of funds of hedge funds, the less risky chosen investment route for many institutions, last year was between 4 to 8 per cent. These returns were concentrated in November/December as global equity markets recovered after the US presidential election and were little different from what could have been achieved using index tracker funds at much lower fee levels.