OREANDA-NEWS. Pension funds risk squandering their gains during the bull market if they pin their hopes on a hike in interest rates and abandon the search for growth beyond the stock markets. That's the stark warning from Cambridge Associates, the global investment advisor, which is monitoring the valuations of the major institutional investments.

Although pension funds have seen their assets rise during the bull market, their liabilities have been growing too, with pensioners and future pensioners projected to live longer than ever before. The average funding level of the schemes in the UK's Pension Protection Fund's 7800 index currently stands at 84 per cent. According to Cambridge Associates, most UK pension funds typically need to ensure that their assets grow two percentage points faster than their government bond yields.

Some pension fund trustees have been hoping for an interest rate rise that would reduce their liabilities. Cambridge Associates calculates that a one per cent rise in interest rates would reduce liabilities by as much as 20 per cent. But with the Greek debt crisis continuing to cast a shadow over the global economy, Cambridge Associates is warning trustees that they need to continue the search for new sources of real asset growth.

Public Equity Markets Are "Unattractive"

The usual sources of growth are no longer so attractive for pension funds that are serious about outpacing the growth of their liabilities. Alex Koriath, head of Cambridge Associates' UK pensions practice, said: "The public equity markets are not an option because valuations are so unattractive."

He pointed to CA research showing that the price/earnings ratio for US large-cap stocks was 23 at the 31 March 2015. Fair value, based on historical norms, should be 16.3. If there were to be a correction to fair value, there would have to be a 29.1 per cent drop in prices or a most unlikely 40 per cent increase in earnings.

The Vast And Diverse Private Markets Do Have Opportunities For Growth

Mr. Koriath said there remain significant options for pension funds in the vast and diverse private markets -- if they look hard. CA tracks 18,285 private investment funds, of which only 3,450 are traditional buyout funds.

The historic record looks attractive. Over a 10-year period to September 2014, the CA U.S. Private Equity Index grew by 14.1 per cent compared with the S&P 500, which grew by 8.1 per cent.

Yet, according to Mr. Koriath, "Valuations are getting frothy even for traditional private equity funds. A blanket allocation to traditional buyout strategies is not compelling at the moment." According to the most recent data, the average purchase price was 10x -- which matches the purchase prices last seen in 2007 on the eve of the financial crash that triggered the global economic crisis.

Despite the current frothy valuation environment for traditional leveraged buyout strategies and the impact on returns, the long-term median net return to investors has held steadfastly to approximately 10 per cent, with half of the field outperforming that threshold. 

But Mr. Koriath highlighted three relatively untapped private investment strategies:

1. PE Sector Specialists. As the private investment space continues to mature, the field is separating more clearly between generalist funds and specialist funds. On average, specialist funds, including healthcare, consumer, and technology-focused private equity funds, are more likely to deliver more than 2x the invested capital and less likely to deliver less than 1x the invested capital than generalist funds.

2. Co-investment Opportunities. Over a 10-year period, these opportunities -- where investors invest directly into portfolio companies alongside a private equity fund at the invitation of a fund manager -- outperformed the CA Global Buyout Funds Index in five out of 10 years. For those who invested in 2004, their investment had risen by 80 per cent by the end of 2013 -- twice the percentage for the index. The growth was further amplified by the fact that co-investments command lower fees.

3. Direct Lending - Following the credit crisis banks, particularly in Europe, have materially scaled back their corporate lending. This has created opportunities for specialist fund managers to step in the void and lend directly to middle market companies. Expected returns in the range of 8 - 10% have made this an attractive opportunity for many pension funds.

An Opportunity for Most Pension Schemes to Increase Private Allocations

To have a meaningful impact on the growth trajectory, the most successful pension funds allocate ten per cent or more of their assets in private markets: approximately ?25m for a typical ?250m fund. "Most pension funds are still investing more liquid than they need to and they are not fully exploiting the opportunities private markets can offer for a long-term investor," says Mr. Koriath.