Japan's public pension funds: Sleeping giants

The numbers associated with Japan's $1.2 trillion Government Pension Investment Fund (GPIF) - the largest pension fund in the world - are mind-numbing. The most recent data published by Towers Watson, which ranks the world's largest pension funds, shows that GPIF is bigger than top five North American pension funds combined.

It dwarfs the likes of California Public Employees Retirement System (CalPERS), California State Teachers Retirement System (CalSTRS) and Canadian Pension Plan Investment Board (CPPIB).

With assets under management (AUM) roughly equivalent to the GDP of South Korea, it is no surprise that the prospect of even a slither of this immense wealth making its way into private equity has GPs worldwide salivating. In theory, if GPIF was to put just 1% of its capital to work in alternative assets tomorrow, there would suddenly be $12 billion available for allocation.

GPIF has already taken a first step in this direction, forming a partnership with Development Bank of Japan (DBJ) and Ontario Municipal Employees Retirement System (OMERS) to jointly invest in infrastructure assets earlier this year. It has earmarked JPY280 billion ($2.7 billion) - 0.2% if its assets - for the scheme. Shortly before that it hired Noriko Hayashi, a veteran private-equity manager from Sony Life Insurance, and moved several existing staff into an investment group dedicated to the asset class.

There is no longer any doubt: the world's largest pension fund is getting serious about private equity. But this is more than a $1.2 trillion question.

The argument goes that greater participation from GPIF could not only offer private equity a new source of capital but also potentially precipitate a shift in sentiment in a country where institutional investors have historically been more conservative than their North American and European counterparts. While many GPs are excited by this prospect, it remains to be seen when they expect to the see the benefits and who in the industry is most likely to reap the rewards?

"Overall the signal is that investors are moving in the private asset direction. GPIF is gigantic, so naturally everyone - public pensions and corporate pensions - is monitoring its next movement," says Tuck Furuya, a partner with placement agent Ark Totan Alternatives. "When we meet with pension funds now, private equity is the topic that they will always bring up."

Demographic bottleneck

Of course, these changes are not limited to GPIF; it is one of a number of Japanese public pension funds affected by a government review of their assets allocations. The process - which formally began two years ago - also includes: the National Public Service Pension Fund, the Local Government Official Employees Fund and the Public School Employee Pension Fund. Individually, they are a fraction of the size of GPIF, but collectively they control around $606 billion in assets.

The fundamental problem faced by the pension funds stem from Japan's demographics. The population is projected to fall by 30% to below 90 million by 2060; the proportion of those aged 65 or older will have almost doubled from 2010.

Fewer people are paying into public pension plans at a time when more people are retiring from work, which places increased pressure on returns. Add to this a succession of economic crises that have afflicted the country and it is clear that pension funds can no longer stick to their notoriously conservative strategies of old.

GPIF has been singled out by virtue of its size and less-than-stellar performance. The fund's portfolio currently comprises 60% domestic bonds, 12% domestic equities, 11% foreign bonds, 12% foreign equities and 5% short-term financial assets. While the most recent data shows it returned 10.2% in the 2012 financial year, in two previous years it returned 2.3% and -0.3%.

Taking Japan's pension funds as a whole, the picture is much the same. As of last year, 51% of assets were deployed in domestic and foreign bonds. While this represents a marked improvement to a decade ago - when bonds accounted for 71% - public equities have taken up a larger piece of the pie, leaving other assets on a paltry 6%.

The industry began to address the prospect of change in 2012 when GPIF launched a feasibility study on alternative assets. A government panel was also put together to address the issue.

As expected, the conclusion - which came through last November - was that GPIF that should reduce its reliance on bonds and invest in different asset classes, including private equity infrastructure, real estate and venture capital. It also outlined a proposal to overhaul the governance structure of the funds whereby the investment committee - currently part of the administrative arm of the funds - would report directly to a board of directors, independent of the CEO.

It is still unclear how this development is likely to affect smaller pension funds, and there are other factors to consider. Joji Takeuchi, CEO of PE advisory Brightrust, echoes Furuya's sentiment that investors are looking closely at what GPIF does, but he also points out that pension funds have already been hit hard by the fall out that the AIJ scandal in 2012.

The hitherto unknown Tokyo asset manager found itself at the heart of one the largest-ever financial scandals when it was discovered to have falsified performance records relating to around $2.4 billion in pension money. A total of 84 pension co-operatives representing 880,000 employees lost money as a result of the fraud.

The number of smaller pension funds has since dropped dramatically as investors fled to the security of big name providers, but just as importantly, the scandal galvanized public opinion against high risk investments.

"At the moment that is impacting the number of potential investors from the pension sector committing to alternative investments," says Takeuchi. "However, institutional investors and financial institutions are coming back in general, and that will have more immediate implications for GPs."

The incumbents

The best way to gauge the broader change in Japanese investor sentiment is to look at those who currently invest in private equity. According to Preqin, primary LPs - not including fund-of-funds managers and secondaries managers - made around $1.3 trillion of commitments worldwide last year. Of this, around $26 billion - 2% of the total - came from Japanese institutions.

To date, the most prolific investors are banks and corporates, with insurance companies, private sector pension funds, asset managers and investment companies accounting for smaller portions.

In general, industry participants report an improvement in sentiment towards the asset class among Japanese investors. Many put this down to the wider economics reforms brought in by Prime Minister Shinzo Abe - the Abenomics package comprising "three arrows" targeting monetary, fiscal and structural measures.

"During earlier periods of recession, many investors were risk averse and putting money into alternative assets was a challenge because the mentality then was that the economy might deteriorate," says Yasufumi Hirao, CEO of fund-of-funds manager Alternative Investment Capital . "Now, people are expecting more inflation and for corporate performance to improve so the risk is more affordable, which means there is capacity for alternative investment."

In terms of where this capital is going, the same Preqin report show that around 45% of the Japan-based banks include buyout vehicles within their investment strategy, while only 4% of corporate investors consider this fund type. Meanwhile, 87% of banks and corporate investors will consider venture fund opportunities. In terms of geography, 70% of banks will only invest in the Asia, but 79% of corporate investors are willing to back private equity funds focused on markets outside of Asia.

Pensions, on the other hand, are likely to take different approach, favoring low risk, low return strategies. While large funds and insurance companies might set a target return of around 15%, pension funds are more likely to be happy with a single-digit IRR.

The government advisory panel recently recommended that GPIF should aim for yearly returns of 1.7% plus the rate of wage growth, which implies 4.2% in total. This rate is lowest among the pension funds to which GPIF compares itself. CalPERS, for example, seeks an annual return of 4.75%.

A number of industry participants have declared that GPIF should do more to target higher returns. Yasushi Ando, CEO of New Horizon Capital and an adviser to the ruling Liberal Democratic Party on pensions, went on record earlier this year to say that the fund should deploy $95 billion into the asset class. Whether GPIF can be convinced to take on more risk is another matter.

"Pension funds don't pay much attention to financial institutions or sophisticated investors' behavior because the pension funds know right from the start that their understanding and capabilities do not match those of an experienced LP,' says Ark Totan's Furuya, "So even if they see insurance companies investing into private equity, it doesn't mean much."

Follow the leader

As such, pension funds are more likely to take their lead from GPIF. The co-investment vehicle it recently set up with DBJ and OMERS could therefore be an indicator of how others proceed.

The unit trust structure will be managed by Nissay Asset Management and invest in infrastructure opportunities identified by OMERS, which will co-invest alongside the vehicle over its five-year investment period. Areas of interest include power generation, electricity transmission, gas pipelines, and railways. DBJ, for its part, is contributing $100 million to the fund.

No performance target has been disclosed for the vehicle, but GPIF earlier pointed out that OMERS returned an average 11% annually between 2009 and 2013 through such investments.

GPIF's Hayashi explains that the partnership represents an ideal starting place because it not only offers exposure to relatively low-risk alternative assets, but also affords GPIF much needed access to sophisticated investors in the shape of OMERS and DBJ.

"As a background to that program, we do expect to learn from experienced institutional investors, and we have already started to accumulate a knowledge base, better industry relations and more experience,' she says "This has been an important starting point as we seek to build our own resources."

This underscores the key challenge facing Japanese pension funds in that many lack the resources to run and effective private equity program.

Kazushige Kobayashi, managing director with Capital Dynamics, says the issue for many pension funds will be whether they have sufficient human resources to participate. A fund typically has only one or two professionals who handle all investments and they have to spend a lot of time on public equity and fixed income, given these account for the lion's share of portfolios. Accordingly, this has opened up opportunity for funds-of-fund and other gatekeepers looking to fill the knowledge gap.

Ark Totan is one such example, having been set up in 2010 with the specific intention of targeting pension funds. Based on his interaction with the pension fund community, Furuya explains that many are looking outside of Asia when making commitments.

"Up until now whenever pension funds invest in private equity it is more likely to be foreign funds as opposed to domestic funds," he observes. "One of the reasons for that is the number of quality foreign funds that are available."

This implies that pension fund strategies are as much to do with investing in experienced managers as they are to do with investing in mature markets. Preqin found that 49% of Japanese LPs will not invest with first-time fund managers, while 29% are willing to back such managers provided they are spin-outs from existing firms and therefore have the semblance of a track record. Only 22% said they would invest in a first-time GP, no strings attached.

Baby steps

Furuya's point is endorsed by Yuka Hata, executive director with advisory and fund-of-fund manager Nomura Private Equity. "Japanese LPs normally like to start by investing in the US or Europe, they will not jump into Asia," she says. "We recommend they start with global fund managers, then once they start to construct their portfolio hopefully the client can be persuaded to put money to Asia."

At the same time, Hayashi says GPIF that it will not take a regional focus but rather maintain a diversified portfolio with a long-term perspective. However, since no other announcements have been regarding GPIF's future, industry participants can only hazard a guess as to the eventual impact of the asset allocation review. Progress will remains slow but many in the market remain optimistic.

"I think Abenomics has changed people's mentality." says Noumura's Hata. "It didn't happen right away, but after a while investors started thinking that they might want to take the risk. It was quite a surprise to see that as it is something the Japanese market has not seen in a long time."

This view is shared by Capital Dynamics's Kobayashi, who expects to see greater clarity in terms of GPIF's intentions in the near future. The wider pension community will then follow suit. However, progress - when it happens - will be incremental.

"GPIF is a big entity and if they invest, the amount would be relatively large," he says. "They have to select a manager for those programs and it will take a long time, maybe six months to a year or more, but we hope they can start that program sometime next year."

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• Topics
• LPs
• North Asia
• Japan
• LPs
• Government Pension Investment Fund (Japan)
• Capital Dynamics
• Nomura Principal Finance
• Brightrust