Allocations by institutional investors to alternative investment classes have risen substantially during recent decades. By 2010, the 1,000 largest sponsors of public pension funds allocated on average more than 17% of their assets to alternatives, including 9% to venture capital and buyout funds and 6% to real estate. At the average university endowment, alternatives in 2010 made up more than a quarter of the portfolio, approximately half of which was venture capital, buyout and real estate.
Yael Hochberg and Joshua Rauh—the authors of the study “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments,” which appeared in the February 2013 edition of The Review of Financial Studies—contributed to the literature by examining the allocation to, and performance of, investments by institutional investors serving as limited partners (LPs) in buyout funds, venture capital funds and real estate private equity funds, a class collectively referred to as private equity (PE).
It’s been well-documented that investors, both individual and institutional, exhibit “local” bias, meaning they invest more in stocks close to home. It’s also been shown that state pension plans overweight local companies in their holdings of public equity—and that bias negatively impacts returns.
Given the home-state preference, and the increasing allocation to PE by public pension funds, an important question is whether local bias impacts performance. Hochberg and Rauh examine institutional investor allocations to home-state and out-of-state PE funds, as well as their performance on those investments.
The authors’ study covered the period 1980 through 2009 and included 19,092 investments by 632 unique LPs investing in 3,199 PE funds. They found:
- Public pension funds in the sample overweight home-state investments by 16.3 percentage points relative to the overall state share of investments and 16.5 percentage points relative to the state’s share of all out-of-state investments, both statistically significant at the 1% level.
- Average overweighting by private pension LPs is approximately 8 percentage points.
- Average overweighting by endowments is also about 8 percentage points.
- Average overweighting by foundations is 9.6 percentage points.
- Public pension funds most overweight in-state venture capital investments and real estate investments. They overweight in-state investments in the “other” category and in buyout funds to a lesser extent.
Hochberg and Rauh note: “The overweighting of public pension LPs in local investments is particularly striking when one considers that risk management incentives should give public pension LPs a strong motivation against local concentration. If the performance of local investments is correlated with local economic conditions, then declines in the value of these local investments will come at times when state revenues have declined and raising revenue for pension funding is most costly.”
No Information Edge
The explanation they offer for this overweighting is that public pension funds may believe they are able to exercise local connections, networks and political access to gain better information on the prospects of funds located in their home states than out-of-state investors, or to gain access to better funds in their home state. An information advantage would be expected to be especially strong in the realm of PE, a setting characterized by substantial asymmetric information.
Unfortunately, the authors found evidence to the contrary: