Friday, March 26, 2010

Private Equity's Unwelcome Intruder?

Hester Plumridge reports in the WSJ, Private Equity's Unwelcome Intruder:

The Ontario Teachers Pension Plan has just beaten European buyout firm CVC Capital Partners to the chase to buy U.K. lottery operator Camelot Group. While the £389 million ($576.4 million) deal may be relatively small, it could be the start of a wider trend. Pension funds such as Ontario Teachers are bypassing secondary funds to take charge of equity investments themselves. Their offers of longer-term ownership, and the potential for paying higher prices, could give them an edge with vendors.

Pension funds traditionally invest in companies via secondary vehicles: specialist-mutual, private-equity, sector or index funds. But Ontario Teachers, which manages $87.4 billion of funds, claims to be changing the industry model. Well over half of its $34.9 billion equity investments are made directly in companies. Benefits include eliminating hefty external manager fees, as well as retaining greater control over holdings.

Other funds are following suit. The California Public Employees' Retirement System, the largest U.S. pension fund by assets with $200 billion, will invest directly up to a third of the $1.3 billion earmarked for infrastructure investments this year.

In theory, pension funds have several advantages over private-equity managers. Pension-fund liabilities, and therefore their investment time frames, stretch to decades, rather than years as is the case with private equity. The promise of long-term ownership swung the Camelot deal for shareholders. Pension funds also may have a lower cost of capital than private equity, as they don't require a liquidity premium to reflect the cost of locking up money. That may enable them to outbid private equity or run investments with less aggressive capital structures. Escaping private equity's hefty fees also boosts returns.

Of course, direct investment requires in-house expertise that is both resource heavy and hard to build up, which is why so few pension funds are doing it. But Ontario Teachers notes that returns on its portfolio of in-house investments have exceeded those from external managers.

Private equity should keep its fingers crossed that the idea doesn't catch on.

I strongly doubt this idea will catch on because most pension funds do not have the in-house expertise to engage in direct investments. And I would caution readers that the big private equity funds still source the big deals, allowing pension funds to co-invest at lower fees (they still need in-house expertise to co-invest alongside PE funds).

The press release on Teachers' website offered a few more details on this deal:

The Ontario Teachers’ Pension Plan (Teachers’), the largest single-profession pension plan in Canada, announces that it has agreed to acquire Camelot Group plc, which has an exclusive licence to operate the UK National Lottery, for an estimated consideration of £389 million. Details of the transaction were not disclosed.

Teachers’ will acquire the shares from Camelot’s five shareholders: Cadbury Holdings Ltd., De La Rue Holdings plc, Fujitsu Services Ltd., Royal Mail Enterprises Ltd. and Thales Electronics plc. Completion of the transaction is conditional upon approval from Camelot’s regulator, the National Lottery Commission.

Wayne Kozun, Teachers’ Senior Vice President, Public Equities, said: “As a pioneer in direct investing, and with an excellent global investment track record, we look forward to partnering with management to realize the full potential of the Camelot business over the remaining licence term and into the future.” Mr. Kozun added that, as a pension plan, the fund has a long term time horizon, as it can be 70 years or more from the time a teacher‘s career begins until the last survivor pension payment is made. “We’re known as a patient investor,” he said.

The acquisition is made on Teachers’ behalf by its Long-Term Equities division, which is focused on direct investments that have steady cash flow and growth potential over a long-term horizon.

“We believe that Camelot is a world leading lottery operator and we are delighted to be involved with such a company which presents a unique, long term opportunity to earn attractive risk-adjusted returns,” said Lee Sienna, Vice President Long Term Equities. “As a significant shareholder or sole owner, Teachers’ Long Term Equities division works actively with the board and management of portfolio companies to develop strategies and policies that build businesses and create long-term value. Camelot is an excellent example of a first class business with long term potential and we look forward to making further investments to grow the company.“

Dianne Thompson, Chief Executive of Camelot Group plc, said: “We welcome Teachers’ commitment to The National Lottery’s ongoing success, and look forward to the opportunity of working with them to continue our progress in developing the business and delivering even more money for the Good Causes.”

Teachers’ already has a successful history of direct investments in UK companies, including Acorn Care and Education, Bristol International Airport, Birmingham Airport, Scotia Gas Networks, InterGen and Thomas More Square Estate, as well as substantial shareholdings in a variety of publicly listed companies. It has offices in Toronto, London and New York.
Of course, things don't always go Teachers' way. Earlier this week, Australia's Future Fund, the country's version of a sovereign wealth fund, said it wouldn't back Ontario Teachers' Pension Plan and Canada Pension Plan Investment Board in its attempt to buy control of toll road operator Transurban.

Both Teachers and CPPIB are heavily investing in private equity and infrastructure deals, which carry their own set of risks. While I welcome the shift towards direct investments, I also know that most of these deals are co-investments alongside big PE funds to bring down fees. It's no panacea and these investments still need to be properly benchmarked to reflect the risks the pension fund managers are taking.

***Feedback***

Here are some comments I received:

"The partners of Private equity firms usually are serial entrepreneurs who have their own substantial amounts of money in the fund AKA skin in the game and hard knocks experience. The EMPLOYEES at a pension fund have neither. I am not a big fan of private equity as the valuations are suspect. But if I had to chose one to manage my money I know which one I would pick because in private equity realm fees are usually a rounding error. They either win huge or go bust."

and this one:

"I think it is still way too early to pass judgment on these deal as only time will tell if pension fund are discipline enough to play this role- I hope they are but it is a tall order

I just hope it sends a signal to the GPs that possibly pension funds are dead serious about reviewing the economic arrangements of these business model with the 2 and 20 plus fee. Something is sure I believe that the Canadian pension funds are going to antagonize the community of GPs and may be this is a good thing

The board of these pension funds need to be ready to pay their deal makers just like the other side of the table and let these deal makers have real skin in the game and have downside risk as well as the compensation structure today is insane."

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