It sounds like a win-win for public pensions. By allocating an outsized portion of their private-equity allocations to home-state firms, they not only harvest high risk-adjusted returns but also give an assist to their local economies.
But a fresh study by Yael V. Hochberg, assistant professor of finance at Kellogg School of Management at Northwestern University, and Joshua D. Rauh, an associate professor of finance there, suggests the approach is a costly one. The in-state private equity investments made by public pensions, the researchers found, “perform significantly worse” than those that they make outside their home states.
The paper, “Local Overweighting and Underperformance: Evidence From Limited Partner Private Equity Investments,” takes a look at 18,828 investments by 631 different investors (public pensions, corporate pensions, endowments, foundations) in 3,554 private equity funds, including venture capital, buyout, and real estate funds, with vintage years spanning roughly 1980 to 2009.
Several caveats attend the results: The March 29 paper is marked “preliminary and incomplete,” the authors lack complete data on investment sizes, and they didn’t look into whether state economies benefit from the local infusion of money.
In their paper Hochberg (co-author of an earlier, influential paper, “Whom You Know Matters: Venture Capital Networks and Investment Performance”) and Rauh first establish that investors of all flavors tend to favor local private-equity shops. However, public pension funds do so more than other categories. On average, the study found, public pensions overweight in-state funds by about 10 percentage points, relative to their share of the total population of funds in the United States. Massachusetts LPs in the study, among the heaviest overweighters, make more than 40 percent of their PE investments in-state; for an unbiased portfolio the percentage should be more like 18 percent.
For other endowments, foundations and other types of investors the range of overweighting is in the 3 to 7 percentage point range.
Intriguingly, only public pensions seem to be hurt by their in-state favoritism. According to the study, the in-state private equity funds backed by public pensions underperform the out-of-state funds they back by 5.5 percentage points of IRR per year on average. Those same in-state investments also underperform investments made in the pension funds’ home states by LPs located outside of the state by 3.1 percentage points. Public pensions that have especially high overweightings toward in-state funds tend to have even worse luck with those funds, the study found.
So what’s going on? The study looked at one possible cause—that investment officers at public pensions are exposed to political pressures, via Economically Targeted Investment programs and similar efforts. The authors did find that public pensions with higher levels of corruption (used as an imperfect proxy for political pressure), using established corruption benchmarks, tend to favor in-state funds more heavily. By contrast, they found no similar correlation for other kinds of investors, such as public endowments and foundations. However, somewhat counter-intuitively, the more corrupt the state, the better the performance of home-state investments by public pensions; for other types of investors, the performance of in-state investments does fall as the level of state corruption rises.
As for the cost to public pensions, the study estimates that the relatively poor in-state fund selections they make cost the public pensions in the study some $1.3 billion per year. The overweighting—the fact that public pensions would do better by investing more money out of state—costs them another $500 million per year.