Thursday, August 25, 2011

AIMCo vs. CPPIB: Diverging Views on PE?

Wellington Financial posted an interesting comment on their site, AIMCo’s take on PE marks stark contrast to CPPIB:

Diverging views – that’s what makes a market!

Thanks to the good folks at AltAssets, we have some new insight into what AIMCo CEO Leo de Bever sees in the world of private equity buyout these days. AIMCo manages $70B of assets for various Alberta-based public pension plans. You’ll notice that his take on the PE situation is markedly different than what we’re seeing at CPP Investment Board. Not that there’s anything wrong with that, but if you are a member of both plans, you could be forgiven for wondering why you appear to be on both sides of the trade, so to speak.

Here are some relevant highlights of the interview:

What is the current appetite for private equity investment amongst your clients?

Our clients bought into the asset class during the 2005-2008 period at too high a price and a very high external fee structure, a side effect of a limited internal management budget prior to AIMCo’s creation in 2008. Net returns had been disappointing, so some clients are doing some soul searching as to whether they want to keep investing in private equity.

To give you a better idea of our starting position, the average ongoing private equity management fee burden was over three per cent, largely because the money committed in 2005-2008 was less than half invested. Initially, I was getting client pressure to rush and fill the remaining private equity allocation. However, filling asset class buckets only makes sense if there are good opportunities. Private equity only has good returns when one can improve the performance and value of a company by strengthening the management and capital structure or improving the economics of the business.

We are still of the view that if you do this well, have patience, and keep management costs in line, you can do better than the public market by five per cent after costs, but you have to work for it. There is considerable pressure on pension funds and endowments to perform well and that is why our clients raised their allocation to [direct] private equity. It is not radically high, and is remaining steady while we try to find the right assets.

How have your GP relationships and strategy changed since you have come on board in 2008?

The initial 46 private equity fund investments were unwieldy. How can you manage 46 relationships? My team cut that to 15, a number we feel we can work with.

Small allocations to 46 firms meant that any views we may have had were not heard. We were told politely that we didn’t matter. I never liked that. Even a ‘limited’ partner should be able to have a discussion that can help the relationship along. With 15 or fewer relationships that becomes possible.

We are working through a big J-curve issue due to the rising allocation in the years between 2005 to 2008 and we are also controlling costs by bringing the skills in-house that allow us to go more direct. The direct deals are out there, and of course we are part of it.

But like anything else, we will only do things ourselves if we have the skills. Unless you have the expertise this is a case of ‘don’t try this at home’. GPs are now starting to provide better terms, often in the form of co-investment opportunities, which brings down our average management costs.

When we look where to invest, we start at the original premise of private equity, which is not high leverage or financial engineering, but taking a company out of the limelight of quarterly earnings to help it create more value for shareholders. Pension funds have the required cash and patience because of their long time horizon.

Those are pretty strong views, which won’t come as a surprise to anyone who has heard Mr. de Bever speak at an industry conference. Like Michael Nobrega of OMERS, Mr. de Bever has considered opinions, and he thinks it is his job to share them as a steward of capital.

If you’ve been following this space over the years (see representative post “How are we doing on SunGard after 5+ years?” April 13-11), you’ll understand what I mean when I point out that if Mr. de Bever ran CPP Investment Board, things would be dramatically different at that $153B entity. Under the watchful eye of CPPIB EVP Mark Wiseman and the now departed John Breen (see prior post “Dust off your resume: CPPIB’s hiring” July 15-11), CPPIB committed C$21.8 billion to third party private equity funds between 2005 and 2008. The period of time that Mr. de Bever says was marked by “too high a price and a very high external fee structure”. With an average commitment of C$272 million across 80 different funds during that timeframe, CPPIB definitely has more say than AIMCo when it comes to negotiating deal terms and side letters. But our ultimate return experience shouldn’t be any different if those vintage years are as poor as Mr. de Bever anticipates.

The fact that CPPIB has committed to just ~10 additional private equity funds since the beginning of 2009 (the 20 funds a year pace is now just 4/yr) may well mean they are starting to come around to Mr. de Bever’s point of view. But it could also reflect the fact that by the end of 2008, CPPIB had found all the global managers they intended to partner with over the coming years.

If CPPIB is right, and global buyout is the place to be (see prior post “Doubling Down on Private Equity at CPP Investment Board” Feb 20-09), then AIMCo beneficiaries may well be missing the boat. If Mr. de Bever is proven correct, then Canadian taxpayers are in for many more years of net flat returns, at best, in CPPIB’s C$29 billion external private equity program.

I recommend my readers carefully go over AIMCo's 2010-2011 Annual Report. On page 12, you'll notice all the benchmarks AIMCo uses for its public and private investments. AIMCo’s total fund return was 8.2% for the year ended March 31, 2011, marginally better than the AIMCo Total Fund Benchmark. Most listed assets earned a higher than market return, but that was offset by lower than market returns in unlisted assets. The return on pension and endowment assets was 10.3%.

Indeed, Private Equity returned 9.2% for FY2011, underperfoming its benchmark by 3.4%. On page 30 of the Annual Report, this explanation was given:
AIMCo inherited a globally diversified private equity portfolio that had generally underperformed its peers and was operating at a loss as at December 31, 2008. It was composed of approximately 70% funds, 12% fund-of-funds and 18% co-investments, by net asset value. Since that time, a new private equity team has been formed to execute a restructuring of the program. They have been transitioning it toward more opportunistic direct and co-investments, a cost-efficient and flexible platform, while maintaining a smaller, select relationship-oriented fund portfolio.

Given the illiquid nature of private equity, this transformation will occur over the next five years. Last year’s results have been impacted by the $35 million cost of selling some underperforming fund investments to free up capital for direct placements and save $16 million in annual fees.

In 2010/11, we also expanded the portfolio to target the growing number of pre-IPO start-ups that are trying to capitalize on disruptive innovation in energy, materials and agriculture. Our investments in this area have been focused on clean and renewable energy companies that are well along the path to grow to commercial scale.
Mr. de Bever is very cautious. He knows things can get out of whack in both public and private markets. He warned people on my blog last October to watch out when the music stops. He was underweight equities in FY2011 and it cost him some return but he probably made it all back in the last few weeks as markets sold off.

As far as the Wellington article above, I agree that CPPIB has too many fund stakes but they're huge and still they've landed some home-runs in private equity, including the Skype deal in FY2011. Of course, no pension fund in Canada publishes its direct investing results relative to fund investments, so we don't really know how to interpret those overall performance figures. All I know is that public equities lead private equities, and as long as stock markets around the world remain weak, you can forget about strong PE returns. Will Fed Chairman Bernanke rescue public markets and PE on Friday by injecting more liquidity into the system? Stay tuned.

UPDATE: A senior pension fund manager shared these thoughts with me:
For the sake of long term credibility, AIMCo should identify the performance of the run out of the old assets separately from the new, so we can accurately measure the view of the 05-08 vintage and the new concentrated bet approach. The reality is the leadership won't be around to see either opinion actually proven out. So, nothing to learn here, other than how institutions fail in the short term, fire some people, and start over again, without much consequence to the institution. This is why there should be many medium sized pension funds, and lots of diversification of management, rather than large mega pools of capital.
Someone on Twitter (follow me @PensionPulse) reminded me "just cause you have a pool of capital that qualifies you for PE involvement, doesn't mean you have brain/method suitable for same."

That reminds me of Tom Barrack's famous quote when he got out of real estate right before the crisis hit: "There's too much money chasing too few good deals, with too much debt and too few brains."

At the time, I sent out an article to PSP's senior managers, I'm Tom Barrack and I'm getting out, pissed off our head of real estate (good!!!) and I was castigated for being "too negative." The rest as they say, is history. -:)

Finally, watch this interview below with Holland Balanced Fund President Michael Holland who doesn't expect much from the Fed and argues investors should not be concerned with the market's recent volatility.

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