Private Equity and Passive Investors Are on a Collision Course

(Bloomberg View) -- In what can only be described as a perverse role reversal, mom-and-pop investors have piled into passive investments, hoping for decent valuations that produce stable returns at ultra-low fees. Moody’s projects that passive products’ market share of U.S. bonds and stocks will hit 50 percent as soon as four years from now, from 30 percent today.

Meanwhile, private equity, which made its bones producing outsize returns by moving in for the kill when there’s blood in the Street, is raising record sums even as valuations press historic highs. If anything, the Street is paved with gold, which presents a challenge to deploying the record $1.5 trillion in dry powder, or investable funds, private equity firms are holding globally.

Call it the latest in a long line of unintended consequences thanks to interest rates being held too low for too long. For those keeping count, this is the third time in 30 years that a Federal Reserve easing cycle has stretched so long that it catalyzed market distortions. While the culminations of the Nasdaq and housing bubbles have left scars, most are hoping this time will be different, which appears to be the case. For now.

In the meantime, commercial real estate and bond market valuations are at record levels, while stocks are a relative value bet; they’re not as overvalued as they were in 1999 based on price-to-earnings multiples, though they are at a record in relation to U.S. gross domestic product.

The dearth of bargains begs the question of how these two huge market players will behave even as risky assets stretch into the second-longest rally in postwar history. Many strategists have begun to debate how loyal these two highly distinct types of investors will be to their respective mandates.

In theory, passive investors are in it for the long haul, assured that over time, being agnostically exposed to market indexes in some form will produce steady returns, albeit with bumps along the way. Recent gyrations in technology stocks, however, suggest that passive investors will liquidate first and ask questions later. The human instinct to take profits off the table has been exacerbated by the automated trading systems "running" many of these invested funds. Momentum to the upside could take a vicious turn when powered into reverse.

Private equity’s vast treasure chest of funding presents a challenge in and of itself. The more money these managers have on hand, the greater the temptation to buy into pricey deals simply to deploy assets on which huge fees are being collected. You need to look back no further than the last time history was being rewritten, as private equity-firms built record piles of dry powder from 2006-2007. The Fed’s unconventional policies kept capital markets open, effectively bailing out many pricey private equity deals made the last time markets peaked.

“This time around, the Fed may not have the same levers to pull to save the bad deals struck,” according to the Lindsay Group’s Peter Boockvar. “Rule No. 1 of investing is the price you pay dictates the returns you get. If private equity is now deciding in the ninth year of a bull market that it’s time to bulk up, then we have to assume their future returns will be really poor.”

The implication is that these “poor returns” will shake the same cohort sideswiped by the rapidity of passive investing’s reversal, the baby boomers. A recent Gallup Analytics report found that as a generation, boomers “have above-average rates of stock ownership.” Even so, according to the Insured Retirement Institute, one in four boomers have no retirement savings to speak of; it’s likely that many of those with little to no savings are relying on a pension to fund their living expenses.

So many boomers are overexposed to stocks, while at the polar opposite of the spectrum, millions of them sleep peacefully knowing they are covered by their pensions. Little do they know how very intertwined their fates are.

It’s no secret that the state of Illinois is at risk of being downgraded to junk by the credit rating firms. Foundering pensions lie at the core of the state’s fiscal misfortunes: The combined funding of the state’s five pensions is 39.2 percent. As perilously weak a position as the pensions are in, judging by where we are in the market cycle, things could take a turn for the worse.

A recent Pew report found that to offset what the pensions are not generating in investment returns, managers have piled into alternative investments, including private equity funds that carry outsized fees. Take the example of the Illinois Teachers Retirement System; almost 38 percent of the fund’s assets are invested in alternatives.

Broadening out to the rest of the country, Pew found that the pensions with recent and rapid entries into alternative investments reported the weakest 10-year returns. Desperation apparently begets desperate maneuvers.

How telling, against this backdrop, that Harvard University is looking to jettison $1 billion in private equity and venture capital investments and $1.6 billion in real estate funds from its endowment.

As reported by Bloomberg, a number of these stakes will have to be sold at deep discounts, “because they date back almost a decade and are expected to only deliver single-digit annual returns.” This move is a repeat for Harvard, which sold off more than $1 billion of private equity investments at steep discounts in the aftermath of the financial crisis.

The perception of ‘safety’ in pension checks and passive investing is likely to be severely stress-tested as both valuations and the longevity of the rally get stretched to their historic bounds.

“If passive money just flees after the next big correction, then it will end up having been just a momentum strategy for many,” Boockvar said. “As for private equity, investors can sell their stakes. The private equity firms benefit either way from the fees they collect on assets under management.”

At least one clear winner will emerge, regardless of the direction markets take.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of "Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America," and founder of Money Strong LLC.

To contact the author of this story: Danielle DiMartino Booth at Danielle@dimartinobooth.com.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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