Tuesday, May 14, 2013

Canadian Model Full of Hot Air?

Alec MacFarlane of Financial News reports, Canadians continue UK push with Civica buyout:
The private equity arm of one of Canada’s largest pension funds has fended off bids from two of Europe’s largest buyout houses to buy UK software provider Civica from 3i Group, amid an increasing drive by Canada’s main pension funds to invest directly in the UK.

Omers Private Equity, the private equity arm of the Ontario Municipal Employees Retirement System, saw off the rival bids to buy Civica from 3i for an enterprise value of £390m.

3i, which bought Civica in 2008 in a £109m public to private transaction and has since completed 10 add-on acquisitions for the company, has generated total proceeds of £228m and a 2.1-times money multiple from the deal, according to a statement from 3i.

The business provides software systems, cloud-based IT services and technical outsourcing, primarily to public sector organisations such as local government, education, social housing, healthcare, and emergency services in the UK and around the world.

Private Equity News, a sister publication of Financial News, reported last week that Civica had also attracted bids from buyout firms Cinven and Apax Partners. Bain Capital, which expressed an early interest in Civica, earlier dropped out of the running, according to two people familiar with the matter.

Omers Private Equity said it will support the management team as they seek to capitalise on organic growth opportunities and make selective acquisitions. Civica’s management team will also reinvest and continue leading the business.

The deal represents Omers Private Equity’s fourth direct investment completed by its European private equity team since it set up its London office in September 2009.

The fund has since built up a London-based team of nine professionals led by senior managing director and former 3i dealmaker Mark Redman.

The team has completed deals including last year's acquisition of Lifeways from August Equity, the 2011 buyout of ship management firm V Group from Exponent Private Equity and a 2009 investment in Haymarket Financial, a provider of credit financing to mid-market businesses.

The Civica deal comes amid an increasing push by Canadian pension funds to invest directly in the UK.

Alberta Investment Management Corporation, the Canadian sovereign wealth fund which made headlines in 2010 with its attempt to buy Candover Investments, is in the process of finalising a move to London within the next six months.

Aimco intends to do all of its private equity investing directly and has previously said it is looking for deals with an enterprise value of between $200m and $500m.

Last year Teachers Private Capital, the private equity arm of Ontario Teachers’ Pension Plan, appointed the former head of venture capital at 3i, Jo Taylor, to head its London office.

The deal also highlights the increasing push by Canada's pension funds away from private equity fund investments and into direct investing. Canadian pension funds completed 27 deals worth $13.1bn globally last year, representing the most acquisitions ever completed, according to data provider Dealogic.
You read articles like this and come away thinking that Canadian pension funds are increasingly going direct, shunning private equity funds, and succeeding on their own without needing to invest in top funds.

Unfortunately, all this hoopla of going direct in private equity is just a lot of hot air. Had a chat with a senior US pension fund manager yesterday who set the record straight. He told me "funds and co-investments still make up the bulk of private equity activity at the largest Canadian pension funds and they increasingly need these fund relationships to deliver their target performance."

The numbers he provided me proved his point. Unfortunately, Canadian public pension funds do not provide a detailed breakdown of their direct investments in private equity so we don't know what percentage is direct and what percentage is fund and co-investments. We also don't know the performance of direct investments, net of all costs, so it's hard to gauge the success of these programs.

What I can tell you is that a senior pension fund officer at CPPIB told me that their private equity investments are done through co-investments with funds. CPPIB provides us with a complete list of their private equity fund partners, many of which are brand name funds well known to pension funds throughout the world.

This senior officer at CPPIB also confirmed that the media exaggerates claims of direct investing in private equity at Canadian pension funds. "At CPPIB, we co-invest with funds because this is how we believe we can add value in private equity. We do direct investments in infrastructure and real estate but not in private equity. We just can't compete with top private equity funds and neither can other Canadian pension funds."

The problem is that even top private equity funds are not delivering in this environment. In my comment on the return of private equity giants, I discussed how KKR is beating its rivals Carlyle and TPG Capital in terms of outperformance in their Asian funds, stating this from a Bloomberg article:
KKR has had a more stable Asia team than its peers since it came to Asia in 2005, with no departures among its partners, and has made fewer mistakes in its investment decisions, according to two investors considering participating in the firm’s second fund who asked not to be identified. KKR is also good at managing client relationships by keeping investors posted on its portfolios, they said.
The senior US pension fund manager told me their group is increasingly looking at the governance of their private equity funds. "If the decision-making is concentrated in a few hands, we won't invest. We want to see stable teams and all the partners taking decisions at the top, not just one or two people. Also, transparency is a must for us."

He also told me that they're increasingly looking at deal terms and negotiating hard on fees no matter which fund they invest with. "We negotiate hard on terms to minimize the J-curve effect. There are some excellent new private equity funds but if the terms aren't right, we won't invest, even if other large pension funds have invested with them."

The point I'm trying to make in this comment is that going direct makes sense in some investments but in private equity, it's a tough slug. Yes, there are very talented individuals at the large Canadian pension funds investing directly in private equity, striking excellent deals. But let's not exaggerate their direct investment capabilities or distort the reality which is that large Canadian public pension funds still rely on top funds to deliver results in private equity.

Finally, had a chance to speak with Bill Hatanaka, president and CEO of the OPSEU Pension Trust (OPTrust). I recently covered their results along with those of CAAT. He told me that OPTrust has a large allocation to alternatives, almost all through external funds. The numbers he provided me are 11% in Infrastructure, 15% in Real Estate and 5% in Private Equity, which they're looking to increase. They also invest in external hedge funds and public market funds.

Mr. Hatanaka is relatively new to this position (6 months) and gave full credit to his internal team for an "outstanding job" at selecting and monitoring external managers. He told me the push into alternatives is a direct consequence of the historic low bond yields which makes it harder to achieve actuarial targets.

You might wonder whether the fees paid to external managers are worth it but if OPTrust is delivering the results their plan requires, remaining fully-funded, then what is wrong with using external managers? Julie Cays, CIO at CAAT told me they invest in external managers  including a few hedge funds because "it diversifies risk, operations, people, processes and philosophies. There are many benefits to investing with some of the sharpest minds in the industry."

The point is that while large Canadian pension funds have the internal resources and governance to go direct, most pension funds prefer investing through external funds and some are are delivering excellent results, net of fees. There is a lot of misinformation on direct investing and while there are risks and costs associated with investing through funds, there are enormous benefits too. Keep this in mind the next time you hear about the benefits of the "Canadian model" of investing directly.

One former senior pension officer in private equity shared this with me:
Institutions certainly have the potential to go direct, the issue is whether they will perform. As you noted, no one can really tell, and the lack of disclosure probably tells you its still work in process. There have been glimpses of large full write-offs in this arena, which while perhaps are a nature of the business also are a reminder that taking higher operational and investment risk does not guarantee a superior return.

Rather than worrying about a bright line in the debate of in-house verses outsourced capabilities, large institutions should simply do both, and just make sure they get what they pay for. No business model is inherently better, it's how it's executed. Some smaller plans clearly demonstrate this.
Those of you who want to understand why direct investing is more complicated than it sounds can go to this Privcap video featuring Drew Guff, Managing Director at Siguler Guff and head of their direct investing business (subscription required).

Also, Bob Rice, author of The Alternative Answer, explains why institutions have an advantage over individuals investing in absolute return, private equity, water rights, farm land and timberland. Keep this in mind the next time someone tells you C/QPP expansion is bad news for Canadians.

Below, there are several bright spots for private equity, including opportunities overseas. Hamilton Lane chief investment officer Erik Hirsch joins the WSJ's MoneyBeat to discuss trends in private equity. Indeed, the landscape for private equity looks good, benefiting PE giants. Hopefully, echoes of a  bond bubble won't rain on their parade.