Tuesday, September 10, 2013

Canadian Pension Plans Flying Solo?

Anne-Sylvaine Chassany of the Financial Times reports, Pension plans: Flying solo:
In October 2010, London-based private equity group BC Partners found itself in a bidding war over Vue, the UK’s second-largest cinema operator. Its rivals included an assortment of buyout firms but one of the bidders stood out: a Canadian pension fund.

In the end, neither BC Partners nor the Ontario Municipal Employees Retirement System (Omers) won the auction. But the bid whetted the Canadians’ appetite.

A year later, Omers joined forces with BC Partners to make an offer for Odeon, the UK’s biggest cinema chain. This failed, too, after Odeon’s private equity owner Terra Firma held out for a higher price.

This year, Omers decided to make a move again. The pension plan, which manages C$60bn ($58bn) of assets for Ontario’s firefighters and other municipal workers, discreetly approached Vue’s private equity owner with a knockout £935m offer and a condition: that no competing bid be considered. Another Canadian pension fund, Alberta Investment Management, backed Omers’ offer and the sale was agreed – without giving BC Partners a chance to compete.

Canada’s pension funds have been moving aggressively into dealmaking and other businesses that they used to outsource to private equity firms and hedge funds. After years of record low interest rates that have dented their returns, the Canadians are seeking to cut back on the fees they pay to these companies. They also want to invest as equal partners with buyout funds, as in this week’s $6bn takeover of US luxury retailer Neiman Marcus by the Canadian Pension Plan Investment Board and private equity group Ares.

Some pension funds are beefing up their internal investment teams to find deals on their own. And when they find a deal, some, such as Omers, are tempted to pursue it without a buyout firm as a partner.

Other pension plans and sovereign wealth funds – including GIC of Singapore and Abu Dhabi’s wealth fund – are beginning to follow the Canadians’ lead, posing a threat to the lucrative model that private equity groups such as New York-based KKR or London-based BC have enjoyed for the past two decades.

“Vue is a prototype of what I expect to see more of,” says Leo De Bever, chief executive of Alberta Investment Management. “We’re at a new stage where pension funds and sovereign wealth funds are saying, wait a second, if we bundle our resources, we can get diversification by sharing the opportunities. Just like any other industry, models have to change. We don’t make cars like we did 20 years ago, or computers like we did 20 years ago, so why should we do finance the way we did it 20 years ago?”

Pension plans and wealth funds have long invested directly in infrastructure projects and property. These were safe, regulated asset-based investments where their liabilities would be limited if they failed. But if these investors, with trillions of dollars of combined assets, begin to move further into acquiring companies outright, it could mark a turning point. Pension funds invest over a longer period than buyout funds – which need to return cash within 10 years – meaning they can afford to use less debt for acquisitions and be more aggressive on price.

Dealmakers at buyout funds dismiss the threat, saying that the volume of deals in question is small. Private equity-backed transactions involving sovereign wealth funds, for example, have reached $11.5bn this year, or 6 per cent of total volume, and the bulk is passive co-investments alongside fund managers. Yet it is 10 times the amount five years ago, according to Thomson Reuters.

The pension plans would be hard pressed to recreate the performance of established private equity groups such as Blackstone or KKR, sceptics say. They are not equipped to find and analyse deals, and are therefore prone to overpaying for assets. And, because they are public entities, it is not in their culture or their mandate to take control of companies and take tough business decisions. Few public pension funds would be willing to face the political repercussions of cutting jobs at a company they have acquired or deal with bankruptcy. “Some will burn their fingers and retreat,” says one private equity executive.

. . .

There have been a few notable disasters. Dubai’s sovereign wealth fund has struggled with its handful of direct “solo” investments in Europe. Some have suffered from losses, such as Omers’ co-investment in Cengage, the US college textbooks business bought by London firm Apax Partners for $7.75bn at the peak of the buyout market in 2007. The company filed for bankruptcy protection in July.

Private equity groups also counter that public pension funds will never be able to match their performance because they cannot afford the best talent. Public pension funds are unlikely to replicate the fat carried interest payments – the standard 20 per cent profit share typically levied on asset gains – paid by buyout funds.

“They are certainly big enough to go direct, but the challenge is to figure out the financial incentives,” says Jon Moulton, head of UK turnround investor Better Capital. “If you’re a pension fund, you have no pressure to sell assets so the prospect of a carry can be very far off.”

Some of those assumptions are increasingly less valid, however. Notably, the belief that pension funds risk being “dumb money” is being shaken by recent academic findings.

After investors asked for data into the largely unresearched matter, three professors at Harvard University and Insead, the business school, examined hundreds of direct investments made over more than two decades by a sample of seven pension funds and sovereign wealth funds. What they found could be bad news for the private equity houses.

First, direct investments by pension investors – comprising co-investments alongside fund managers and “solo” investments – generally outperformed private equity fund investments, even after the extra cost of running a direct operation, Lily Fang of Insead, and Victoria Ivashina and Josh Lerner of Harvard wrote in a working paper.

“A lot of investors believed that this direct investing thing had been a train wreck. Well, first, no, it’s not a disaster,” Mr Lerner says. “But the big surprise was that the success was not in the co-investments but in the solo investments.”

Second, co-investments – in deals initiated and negotiated by buyout fund managers, giving their clients an opportunity to invest alongside them – underperformed fund investments. By contrast, solo deals outperformed strongly, suggesting that investors were better at picking investments than fund managers.

“The problem was, it seems, that the co-investments were doubly cursed,” Mr Lerner says. “They were done at exactly the worst possible time in the cycle and, second, these deals tended to be substantially larger than what the fund managers used to do, in the order three times larger – and those deals seemed to perform poorly.”

Canada’s pension funds, with nearly $900bn in assets under management, are at the forefront of this push partly because many included direct investing in their mandate long before the financial crisis struck in 2008. The credit crash, along with quantitative easing by the US Federal Reserve and other central banks, have accelerated the trend. The Canadians are being emulated by sovereign wealth funds in the Middle East and Asia, which are also shifting more resources into direct investment strategies.

They say they do not have a choice. A combination of ageing populations, wider funding gaps to meet pension obligations and low interest rates is forcing them to cut their costs and move away from safe fixed-income securities into riskier strategies.

A change of just 1 per cent in the interest rate assumption can have an impact of C$25bn to C$30bn on the cost of Ontario teachers’ pensions, estimates Jim Leech, chief executive of Ontario Teachers’ Pension Plan, which manages C$129bn. In this context, paying 1.5 per cent to 2 per cent for managing funds and a 20 per cent carry is a lot of money to give away.

“In a lower rate of environment, cost matters,” says Mr Leech. “It gives us a cost advantage by being a direct investor because we can disintermediate people who charge high fees.”

Ontario pioneered the direct model in 1990. Its first chairman, Gerald Bouey, a former Bank of Canada governor, put in place an independent board and management, ensuring the plan would be run like a business. Its first chief investment officer started direct investments from the beginning because there was no private equity fund in Canada at the time.

Their first deal was a failure. The company, White Rose Crafts and Nursery Sales, defaulted on its debt and Ontario lost its investment. But the plan kept at it. The fund, which has about C$6bn in direct private equity holdings and a similar amount invested via private equity funds, is aiming to increase the share of direct investments to two-thirds, Mr Leech says. It is opening an office in Hong Kong and boosting its London office.

. . .

Other Canadian plans have followed suit, including Omers and Canada Pension Plan Investment Board. In the past four years, Omers has hired a direct private equity team in London and New York to do solo deals. When Mark Redman joined to head Omers Private Equity in London, about 66 per cent of the plan’s private equity holdings were through funds. That has now fallen to one-third, he says. Omers plans to reduce the number of private equity managers it backs from about 30 to just a handful in the next four years.

“It’s cautious but it’s determined,” Mr Redman says. “In a high-return environment, you can be sleepy and allow third-party funds to get on with 2 per cent fees and 20 per cent carry, but in a low-rate environment, it is a lot of value to be haemorrhaging out.”

Others, including some of the largest, such as CPPIB, are adopting a less aggressive approach in part because they rely heavily on third party managers. Toronto-based CPPIB, with C$183bn of assets under management, has built a direct team since 2006 but its private equity portfolio is still two-thirds invested through funds. It committed $4bn to private equity funds over the past year, the largest single amount by an investor in the world, according to data compiled by PEI News. It is seeking to boost direct holdings – to about half of its private equity portfolio – but through what it calls a “symbiotic” relationship with its closest fund managers – meaning through co-investments.

As for the compensation issue, Canadian pensions make the point that while they are paying less, dealmakers do not have to worry about fundraising. “We don’t pay what Blackstone and KKR pay, but it’s fairly close. We do attract extraordinary people,” Mr Wiseman says.

No surprise, then, that unease is spreading among buyout houses.

“They are walking a fine line, trying to put more capital to work directly while not competing too much with us to preserve their relationships as limited partners in our funds,” a UK-based private equity dealmaker says. “They want to have their cake and eat it.”

Investing: New ammunition in the war on fees

Institutional investors have never been overjoyed by the fees they pay to private fund managers, but the sense of discontent has mounted in the aftermath of the financial crisis. Despite some high-profile losses and a much tougher fundraising environment, buyout houses have managed to keep management fees at about 2 per cent, according to Preqin. Nearly 60 per cent of investors say fees should decrease, according to the survey.

New research by three business school professors could bolster their case. The findings by Lily Fang of France-based Insead, and Victoria Ivashina and Josh Lerner of Harvard University, back the idea that pension funds and sovereign wealth funds could get higher returns if they bypassed private equity fund managers.

“If you look at mutual funds or brokerages, a lot of financial services have gone through a substantial change in their economics,” says Prof Lerner. “Private equity has been able to resist those kinds of changes. But I wouldn’t be surprised to see some of the changes we saw in other financial sectors occur in private equity.”

The researchers studied 392 direct private equity transactions made by seven large pension funds and sovereign wealth funds between 1991 and 2011. They found that those direct investments outperformed private equity fund benchmarks. Those deals delivered 76 per cent cumulative gains on a weighted average, when all global private equity funds returned 39 per cent over the same period.

But their strongest finding is that this outperformance was due to the deals those pension plans and sovereign wealth funds initiated and conducted on their own, not with a fund manager. Those “solo” transactions delivered three times the initial investments on average, or a 15.5 per cent return annually, according to a draft of the authors’ working paper, “The Disintermediation of Financial Markets: Direct Investing in Private Equity”, released in June.
This is an excellent article going over why big investors are dodging Wall Street. As Jim Leech states, in a low interest rate environment, fees matter a lot for pensions. A change of just 1 per cent in the interest rate assumption can have an impact of C$25bn to C$30bn on the cost of Ontario teachers’ pensions.

But while the article raises many excellent points, the reality is the Canadian model is full of hot air.  I have to be careful because there are excellent private equity managers at Canada's top ten but this notion that Canadian pension funds are going to bypass top private equity funds is just plain silly and very misleading.

First, while it is true that Canadian pensions have been investing directly for years and are picking up their direct investment activities in private equity, the bulk of the money is still invested through funds and co-investments.

Importantly, large Canadian pension funds simply have no choice but to rely on their relationships with top private equity funds to keep allocating sizable amounts to private equity. If they irritate these funds and jeopardize their relationships, they will be hard pressed to go solo and keep up with their allocations in private equity.

The $6 billion Neiman Marcus deal that CPPIB just announced is a perfect example of this. CPPIB doesn't invest directly in private equity and nor should they. They partnered up with Ares, one the best private equity funds out there, to invest in Neiman Marcus, a luxury retailer.

Why did CPPIB partner up with Ares? Because when you are a $180 billion pension fund growing at the pace CPPIB is growing, you need SCALE to keep up your allocations to private equity. The same can be said of PSP Investments but also of other Canadian pension funds who are not growing as fast. How are they going to manage to keep their allocations to this asset class if they bypass top PE funds?

Second, I'm highly skeptical of this academic paper claiming the performance of direct investments is trumping that of funds and co-investments. If that is true, then why don't Canadian pension funds publish the net IRRs (net of all costs) of their direct investments in their annual reports? Let us see the exact amounts invested directly, in funds and co-investments along with net IRRs of each activity.

One finding of the academic paper I did find interesting is that the performance of co-investments was lower than that of fund investments. Pension funds don't pay fees on co-investments, they are done as part of a fund investment program and they are typically done on big transactions.  I quote professor Lerner:
“The problem was, it seems, that the co-investments were doubly cursed,” Mr Lerner says. “They were done at exactly the worst possible time in the cycle and, second, these deals tended to be substantially larger than what the fund managers used to do, in the order three times larger – and those deals seemed to perform poorly.”
If that is the case, then we should worry about large co-investment transactions like the Neiman Marcus deal. If you read the Reuters article, TPG Capital and Warburg Pincus took the luxury retailer private in 2005 for $5.1 billion. CPPIB and Ares are buying it for $6 billion eight years later. That's a nice premium but not outrageous given the success and growth potential of Neiman Marcus.

CPPIB recently stated it will make fewer deals if rising investor confidence drives prices too high. As I covered  in my recent comment on CPPIB investing Gangnam style, it seems like they and PSP Investments might lose out to an ex-Blackstone top executive on their bid to buy the French assets of TDF, Europe’s largest telecoms tower operator.

This is a highly competitive environment. CPPIB, PSP Investments and all other large pension and sovereign wealth funds looking to invest in private equity are competing to find great deals. The problem is there are not that many great deals in this environment and that is putting the pressure on top private equity funds and their big investors who require increasing scale to keep up with their allocations to this asset class.

The one big advantage Canadian pension funds have over private equity funds is their long-term investment horizon. They don't need to realize on their direct private equity investments every six years or worry about fundraising. And unlike their U.S. counterparts, Canadian pension funds got the governance right, and they properly compensate their investment staff. 

But I caution my readers to be highly skeptical when reading these articles on Canadian funds flying solo. While some are striking excellent deals, most of the big funds still need to invest and co-invest with top private equity funds. Their size and the scale of their activities leaves them no choice. They may be focusing more on fees and alignment of interest, just like most other investors who are lukewarm on private equity, but they are not bypassing top funds. They might do it on a few deals but they still need their fund and co-investment program to maintain their allocation to private equity.

Finally, one private equity expert shared these great insights with me after reading comments above:

Interesting note. A few follow on thoughts. The pension plans may well take on industry leading firms, and have the resources to do so quite credibly if they choose. They are largely tax free pools, and can on the margin outbid taxable industrial buyers barring major synergies. And they have very large balance sheets which means one or two deals going bad doesn't impair fund raising or ambitions to sustain the business, at least not as rapidly as can be the case in the private equity funds model.

The bigger issue is whether even industry leading franchises are actually delivering acceptable returns, and this is far less clear than generally believed. The move to do it yourself approaches is usually a result of poorly performing alternatives, and that may well be a more important motive in the current trend. Leo de Bever may be right in that a new approach is warranted, and the incentives and such at a pension plan despite limitations may prove more amenable to success than the present industry model. Private equity thrived on relatively short term investment thesis, and a transactional approach. That era is fading, and longer holds really don't fit conventional private equity funds as well.

This private equity industry simply is mature, and the balance of power has shifted to the institutional buy side for the foreseeable future. Mature industries usually provide low returns. How low a pension plan can justify for the risk, and perhaps underestimated and not fully tested responsibility of ownership, will be the question. You will hear "risk adjusted" returns in the language more than one has in the past.

The irony is most institutions co-investing which is a prelude to doing solo directs have done less well than those who just did the funds, and the funds themselves have struggled to meet return expectations. Arguably, the institutional focus might better be on reaffirming old fashioned public markets capabilities, long only or hedge fund style but emphasizing the traditional stock picking types of approaches which were the engine room activities of most institutions not that long ago. These capabilities have atrophied, and could well present the real latent opportunity for institutions.
Below, Fred Katayama of Reuters reports on a deal to buy luxury retailer Neiman Marcus. The news comes just two months after Hudson's Bay bought Saks in a deal that Ontario Teachers' has a stake in.