PSP Ramping Up Direct Private Equity?

Kirk Falconer of PE Hub Network reports, PSP Investments ramps up direct deals to half of PE portfolio assets:
Public Sector Pension Investment Board, one of Canada’s largest and fastest growing pension systems, is doing more direct deals as part of a strategy intended to transform its approach to private equity and infrastructure investing.

Over two-plus years, PSP Investments has deployed billions of dollars to a series of global transactions, shining a light on the characteristically low-profile institution.

One result has been growth in PE co-sponsorships and co-investments to “slightly above” half of portfolio assets today from 40 percent in 2015, Guthrie Stewart, PSP senior vice president and global head of private investments, told PE Hub Canada.

PE investing set a new record in PSP’s fiscal 2017, when outlays totalled $4.8 billion, more than half of them earmarked for direct deals. Stewart says activity in fiscal 2018, about which PSP will report in June, will show the “momentum has continued.”

PSP has been just as aggressive on the infrastructure side, investing $2.6 billion in fiscal 2017, nearly 70 percent of it on a direct basis.

Combined deployments in this period lifted PE and infrastructure assets to more than $27 billion, up 57 percent from two years earlier.

Stewart says these statistics mark a “dramatic shift” since 2015, when he came onboard to overhaul the private-markets operation.

At the time, both asset classes were underallocated. PSP’s goal was to turn things around by “broadening the strategy, taking a more disciplined approach, and achieving more diversification,” Stewart said.

Initiatives included scaling the talent and capabilities of internal personnel, split between PSP’s Montréal headquarters and London office opened last year. Focus was also given to building more external relationships that could add value and “drive direct investments,” Stewart said.

External partners are mostly select PE firms. PSP commits capital to more than 30 general partner teams, a “foundational number” that will likely continue to expand, Stewart said. About a dozen infrastructure firms also secure commitments.

Examples include American Securities, which in March supported PSP’s investment in early childhood educator Learning Care, and Ardian, which in December sold stakes to PSP and Caisse de dépôt et placement du Québec in industrial engineering group Fives, reportedly for US$1.8 billion.

Two others are BC Partners, which in October teamed up with PSP and Ontario Teachers’ Pension Plan in the US$3.1 billion buy of ceramic products supplier CeramTec, and Blackstone, which early last year partnered with PSP and CDPQ in the US$6.1 billion buy of hospital staffing provider Team Health.

Other disclosed examples are Apax Partners, Apollo, Lightyear Capital, MBK, New Mountain Capital, Partners Group and TPG.

Stewart says a linchpin of the new strategy is the ability of PSP’s in-house investment pros — led by Simon Marc, head of private equity, and Patrick Samson, head of infrastructure — to “exercise strong judgement and execute rapidly” when picking partners and opportunities.

“We strive to be as non-institutional as possible, to move at the same speed as our GPs,” he said.

Getting bigger

Doing more direct deals is essential to returns and “rounding out diversification,” as well as being “more deliberate about the assets we add to the portfolio,” Stewart said.

It is also key to generating investment volumes that facilitate PSP’s rapid growth.

PSP is the youngest of Canada’s four largest pension systems, overseeing $139 billion in retirement savings on behalf of federal public employees, including defence and police forces. Its capital pool, fueled both by contribution flows and investment returns, is projected to exceed $200 billion by 2026 and $250 billion by 2029.

Stewart, 61, was recruited to PSP by André Bourbonnais, who was appointed president and CEO in 2015 after running private investments at Canada Pension Plan Investment Board.

Earlier this year, Bourbonnais departed PSP for BlackRock. He was replaced by Neil Cunningham, previously global head of real estate and natural resources.

Stewart’s prior career included serving as a partner at EdgeStone Capital Partners. He also spent 15 years in executive roles in the telecom industry, including as president and CEO of Teleglobe Canada.
Guthrie Stewart was also André Bourbonnais's boss at Teleglobe Canada and that's how he landed this job at PSP Investments.

Anyway, the article focuses on how PSP is ramping up its co-investments in private equity, a group led by Simon Marc.

Nothing new to me. Last February, I attended a CFA lunch with André Bourbonnais where he explicitly stated the organization was ramping up private equity co-investments:
[...] in private equity, PSP invests with top funds and pays hefty fees ("2 and 20 is very costly so you need to choose your partners well"), however, they also do a lot of co-investments (where they pay no fees or marginal fees), lowering the overall fees they pay. André said "private equity is very labor intensive" which is why he's not comfortable with purely direct investments, owning 100% of a company (said "it's too many headaches") and prefers investing in top funds where they also co-invest alongside them on larger transactions to lower overall fees (I totally agree with this approach in private equity for all of Canada's mighty PE investors). But he said to do a lot of co-investments to lower overall fees, you need to hire the right people who monitor external PE funds and can analyze co-investment deals quickly to see if they are worth investing in (sometimes they're not). He gave the example of a $300 million investment with BC Partners which led to $700 million in co-investments, lowering the overall fees (that is fantastic and exactly the right approach).
I remember André also saying PSP was playing catch up to CPPIB in private debt and other areas and I'm pretty sure he meant co-investments.

The key thing to note is in order for PSP or any large institution to get invited to co-invest alongside a general partner (GP) on a much bigger transaction, it first needs to develop a strong relationship with that GP or fund. And that means first investing in their private equity funds where they pay big fees.

What are the advantages of co-investments? Scale and fees. The transactions are typically larger and there are no fees paid to the GP for co-investing alongside them (which is why it's called direct investing). Larger transactions allow PSP or another large pension to allocate more to private equity quickly and efficiently.

But as the article above states, you need to hire smart and capable people internally to evaluate large co-investments quickly and thoroughly because when the GPs come to you with large deals, you'd better be ready or else they'll move on to the next investor.

Now, PSP isn't the only large pension ramping up co-investments to lower private equity fees. The Caisse's private equity group led by Stephane Etroy is also going direct in PE.

Last week, I discussed how CalPERS is bringing private equity in-house to do more co-investments but unlike PSP and the Caisse, CalPERS isn't paying its private equity team properly to evaluate these deals so it needs to outsource these activities to BlackRock where Mark Wiseman and André Bourbonnais now work, helping Larry Fink beef up his private market operations.

Again, it's confusing but let me explain three forms of direct investing in private equity:
  1. Purely direct: This is where the pension sources its own deal and invests 100% in a private company, taking it over to improve its operations over time and selling it for multiples of what it bought it for. These purely direct deals are extremely rare because most pensions don't want the headaches that come with owning 100% of a company. Also, pensions can’t compete with private equity giants on the very best deals all over the world.
  2. Co-investments: This is a form of direct investing because pensions pay no fees to co-invest alongside GPs on larger transactions but in order to gain access to these co-investments, the pension needs to pay fees to the GP's traditional private equity funds (typically 2% management fee on committed capital which declines as the fund's life progresses and 20% carry or performance fee). The GPs are happy because they still get their juicy fees and the LPs (limited partners or investors) are happy because they get to co-invest with their GPs on large transactions to lower overall fees and scale up their private equity portfolio.
  3. Bids on companies when fund's life ends: Yet another form of direct investing is an auction that can take place when a PE fund's life nears its end and the GP wants to auction off some portfolio companies. If the LP is interested in carrying this company longer in its books (remember, pensions have a longer investment horizon than PE funds), then it is invited to bid on a portfolio company.
Either way, the bulk of direct private equity deals at Canada's large pensions and elsewhere comes through co-investments and in order to gain access to these large direct transactions where they pay no fees they first need to pay fees to traditional funds and hire capable people to quickly evaluate these large deals.

Basically, it's all about building solid long-term relationships with partners all over the world and having the right staff to quickly evaluate and execute on these large co-investments.

Below, a discussion on the challenges of co-investing, special accounts & the divergence in the returns that LPs will earn from private equity featuring Guthrie Stewart, Global Head of Private Investments, PSP Investments (clip is from last year but still worth watching).