Understanding Private Equity at OPTrust
Wouter Klijn of i3 Insights reports on how Sandra Bosela and her team run private equity at OPTrust:
COVID-19 has had a different impact on the various segments in the private equity sector. We speak with OPTrust’s Sandra Bosela about the fund’s experience pre and during the pandemic.
Private equity investors seek to generate above market returns by taking an active role in the management of a company: cutting costs, expanding into new markets and attracting new talent.
But in the context of a broader multi-asset portfolio, private equity also functions to smooth out returns. Since they are unlisted, these assets are not subject to the whims of the news cycle or the sometimes erratic behaviour of the retail market.
In this context, investors often look for businesses that are not beholden to the economic cycle, but produce stable profits in any environment.
Dental businesses are a good example of this. Recession or not, most people still value clean teeth, devoid of any holes. But the coronavirus pandemic challenged even these otherwise robust businesses.
“We have invested in a couple dental businesses; we really like that industry. Dental has been very stable over many recessions, partly because a lot of people are not paying for dental services themselves, they have healthcare plans and they just want to practice good hygiene,” Sandra Bosela, Managing Director and Global Head of Private Equity at Canadian pension fund OPTrust, says in an interview with [i3] Insights.
“But in the early days of the COVID pandemic dental was probably near the top of the list of perceived high risk businesses given the aerosols that come out of someone’s mouth during dental and hygiene services. This resulted in most dental services, other than emergency services, being prohibited during initial lockdowns in the spring which had an impact on businesses across the industry.
OPTrust’s dental businesses have since reopened and recovered as initial lockdowns were eased in many parts of the world and people have once again returned to the dentist, with additional precautions being taken and even more PPE used to protect dentists and hygienists. But it proved to be a reminder that risk can hide in unexpected places.
“We do a lot of scenario analysis prior to making investments to truly understand downside risk. Recession cases are certainly part of that analysis. Now I think pandemic scenario analysis will be something that investment teams will look at as they go forward. We certainly will,” Bosela says.
“We are always trying to analyse what could go wrong with a business, what could disrupt its performance and will any negative impact be short term, or long term? In a pandemic scenario there could be things that happen that are just very different than what you would see in an economic recession,” Bosela says. “So, it is important to understand these risks”.
Planning for a Recession
Bosela and her team have an impressive track record, clocking up returns in the 20 per cent range over the last number of years, including last year when the private equity portfolio produced a return of 24.7 per cent.
“The outsized performance in 2019 came from multiple deals, across different geographies and sectors,” Bosela says. “It wasn’t just one deal that made that return; it was also a combination of actual realisations, as well as increases in our mark-to-market valuations as a result of organic growth and strategic growth initiatives.”
And although this year certainly proved to be a challenge, OPTrust managed to avoid some of the hardest hit sectors during the pandemic.
“We don’t have a lot of exposure to retail or restaurants, travel or tourism, large scale event businesses, commodities or other industries that were hardest hit,” Bosela says.
“We’ve tended to focus our investments in the portfolio over the last number of years more on essential service type businesses and industries. We didn’t do that with a pandemic in mind, but because we were thinking that we were late in the cycle and if a recession was imminent then we wanted to invest in recession resilient businesses that would have stable demand characteristics that could help to minimize volatility in our portfolio. These types of businesses often have more limited downside risk but offer strong upside potential. We like investments where we see that asymmetric return profile.”
With the potential of a recession in the back of mind, the team has taken a very disciplined approach to valuations for new investments, especially as valuations have continued to rise across the board.
“When I think back to when I first started in this industry, we were buying businesses at four to six times EBITDA and today you are often paying 10 to 15 plus times EBITDA, so we are really in a different environment,” Bosela says.
“When you pay those types of valuations for businesses, you can’t assume multiple expansion on exit; in fact, we are often factoring multiple contraction into our investment cases given where we think we could be in the cycle and what more long term sustainable valuation levels could be. The ability to successfully execute on value creation opportunities becomes critically important and plays a much larger role today in generating returns.”
But even with the portfolio positioned defensively, 2020 has been a more challenging year for OPTrust’s private equity portfolio. It might have avoided the hardest hit sectors, but the pension fund still saw the performance of many of its portfolio companies impacted by the lockdowns globally in the Canadian spring.
“A number of our investments were certainly impacted; some businesses were virtually completely shut down for a few months earlier this year and other businesses had negligible to no impact, and then a range were in between where there was some level of demand softness for a period of time.
“Growth was temporarily put on hold for many of our businesses through the second quarter as we worked with our companies to preserve liquidity until their business operations returned to more normalised levels. We were very fortunate in our direct portfolio that we didn’t have any rescue capital calls to support operations through those challenging months and we are quite proud of that,” Bosela says.
“We think that was really driven by the flexible and conservative capital structures that we put in place in our companies, as well as the ability for our management teams to conserve cash through the cost-saving programs that were implemented across the portfolio.
“Throughout the summer and into the fall most of our businesses have seen a gradual recovery to near pre-pandemic levels and in some cases we are actually seeing growth above pre-pandemic levels.
“Despite the challenges of 2020, we feel very good about the resilience of our private equity portfolio and the ability for it to continue to deliver attractive risk-adjusted returns in line with our expectations over the longer term.”
The transport sector has been one of the hardest hit sectors during the pandemic. As lockdowns became commonplace, airports saw traffic volumes collapse by up to 90 per cent. Toll roads were less impacted as many people avoided public transport and opted for their private vehicle, but even here the greater use of cars hasn’t made up for the overall drop in traffic.
OPTrust owns investments in this sector, including Kinetic Group, which started out with a single bus route from Melbourne Airport to the city’s CBD under the SkyBus brand.
“When we acquired our bus business, it operated a single bus route from the Melbourne airport into the downtown. That would feel like a high-risk business in today’s environment, but if you fast forward from our initial investment to today that business is now Australia and New Zealand’s largest diversified bus, mass transit operator,” Bosela says. “Today, that aviation segment represents only 10 per cent of the business.”
Not only is Kinetic a well-diversified business today, its revenues are also largely tied to government contracts, which has made it more resilient during the lockdown.
“The vast majority of the business comes from government contracted bus services, so it is not linked to passenger or fare risk. Even if people in Australia, New Zealand weren’t riding the bus we would still have a stable demand, because it is contracted.”
Allocation to Private Equity
As with many pension funds that have adopted the Canadian Model, private equity is an important part of OPTrust’s portfolio. The internal team of 19, which manages both the private equity and infrastructure programs for OPTrust, runs about 50 per cent of the assets directly or via co-investments, which helps reduce costs, influence the composition of the portfolio by overweighting certain sectors and allows the team to have a more active management style.
“Active management and governance provide a lot of benefits including access to real-time information, something that was especially valuable during the early months of the pandemic this year. Having more control over our investments and a voice at the table in shaping strategic plans and other value creation initiatives allow us to better influence the outcomes of our investments, which is important to us”, Bosela says.
“We are targeting a long term allocation to private equity of approximately 15 per cent of OPTrust’s total Plan assets; we are slightly below that at about 13 per cent right now. We hope to get to 15 per cent over the next year or so, but as with any private equity portfolio you have a natural level of churn, where every five to seven years you are selling investments, so our actual allocation ebbs and flows.
“In 2016, we added a long-term equities strategy to our portfolio. The assets under this strategy are lower risk private equity assets, with more stable growth and cash flow profiles that have the potential to be longer term holds, up to 10 years or longer. We like having a component of the portfolio in these longer-term investments, to complement our traditional buyout strategy from a risk perspective and average hold period”.
When asked what industries OPTrust favours for its private equity portfolio Bosela says, “We like healthcare and healthcare services businesses because they are generally needs-based services and have resilient business models with stable demand characteristics.
As an example, we own a veterinary services business. It doesn’t matter what economic environment you are in, if your pet gets sick, you are still going to the vet.
“We focus on sectors where there is a large market opportunity with a stable reimbursement environment or revenue model, in sectors with room to execute consolidation strategies and by providing clinical services that can address growing consumer demand with better quality solutions.
“There are also businesses we like that combine healthcare and information technology, doing thing such as improving the quality, integrity, security, compliance and timing of information and data flow, providing secure payment solutions, creating end-to-end solutions or taking cost out of the healthcare system. We believe businesses that offer better solutions through the use of technology offer great opportunities to earn very attractive risk adjusted returns.
“We like a lot of other essential services businesses and industries outside of healthcare, such as transportation, education, telecom and power sector service providers, insurance, banking and other financial solutions, among others.
“Businesses in all of these industries tend to be relatively stable and perform well throughout cycles, without a whole lot of volatility. They also have the ability to generate very attractive risk-adjusted returns through various growth and other value creation initiatives. Again, we like that asymmetric payoff curve.
“And then we try to complement the portfolio with some higher risk, higher growth opportunities that we believe have real outsized potential, such as in the software, financial and information technology sectors, among others”.
Private for Longer
Since the global financial crisis there has been a clear trend that companies stay private for longer, before listing on the stock exchange. As a result, much of their growth takes place before their IPO.
Asked whether this has helped private equity companies in achieving their performance, Bosela answers that this dynamic has been somewhat of a double-edged sword for the industry.
“I think one of the main reasons why companies stay private for longer is that they are actually able to raise the capital outside the public markets from private market investors,” she says.
“It is obviously attractive to them for a number of reasons: they avoid the volatility of public stock markets, they don’t have the distraction of quarterly reporting cycles, they maintain more control and it is less expensive for the business.
“While it definitely creates more opportunities for private equity investors, there is a lot of capital trying to gain access to these opportunities and it is a very competitive landscape.
According to a Bain & Co. report, there was US$ 2.5 trillion in dry powder at the end of 2019 and US$830 billion of that was committed to buyout funds.
“With companies staying private longer, private equity investors have the opportunity to either invest in a business at an earlier stage and generate an attractive return by professionalizing the business and identifying profitable growth initiatives or invest at a later stage, buying a business from another private equity investor that has de-risked the business.
“By coming in later, they might be paying a higher valuation for the benefit of scale and lower business risk, but private equity investors are still able to generate an acceptable return through ongoing growth and other value creation initiatives.
As companies are staying private longer and often not choosing to go public at all, there are many more sponsor-to-sponsor transactions happening than there were 10-15 years ago,” she says.
This was a fantastic interview with Sandra Bosela, the Co-Group Head, Managing Director and Global Head of Private Equity at OPTrust Private Markets Group where she is responsible for jointly managing the Private Markets Group and oversees OPTrust's global private equity program.
Her partners at OPTrust Private Markets are Gavin Ingram, Co-Head Private Markets Group, Managing Director and Global Head of Infrastructure who is responsible for overseeing OPTrust's global infrastructure strategy and investments in North America, Stan Kolenc, Managing Director (Sydney) who is responsible for Sydney office and infrastructure and private equity investments in developed Asia and Morgan McCormick, Managing Director (London) who is responsible for London office and infrastructure and private equity investments in Europe.
Interestingly, OPTrust's Private Markets does not include real estate. That portfolio which represents roughly 15% of total assets is run my Rob Douglas, Managing Director of Real Estate.
Mr. Douglas was featured in an article in Real Estate News Exchange last year and earlier this year, before the onset of the pandemic, a group of co-investors, including OPTrust, announced a major, long-term, downtown Toronto office leasing transaction at 65 King East, which was suppose to see Google occupy 400,000 square feet of office space across 18 floors in Toronto’s newest, next-generation office development.
IMCO was also part of that deal and I wrote about it here. I have no idea whether this deal is still happening or if Google walked away from the lease, but it's been a tough year for some segments of Real Estate and I'm sure Mr. Douglas and his team have been very busy.
Anyway, back to Sandra Bosela and Private Equity at OPTrust.
If she comes across super smart in this article, it's because she is and really knows her stuff.
Ms. Bosela holds an Honors Business Administration degree from Ivey Business School at the University of Western Ontario, and completed the General Management Program at the Harvard Business School.
She is a board member of the Business Development Bank of Canada, an organization I know all too well as I worked there as a senior economist for two years (2008-2010) replacing someone who left on maternity leave (it's one of the better Crown corps in Canada, along with the EDC, and we worked hard back then because of the Great Financial Crisis).
Even though I never met her, my industry contacts tell me she's super smart, very nice and likes to work alongside partners in private equity.
Her team invests in private equity funds and also co-invests alongside them on bigger deals to reduce fee drag.
Because of its size, OPTrust's Private Equity group can focus on mid-market space, which isn't where its larger Canadian peers focus as they typically invest with larger PE funds.
OPTrust manages roughly $22 billion and and roughly $2.9 billion (13%) is invested in Private Equity and the allocation will go up to 15% over the long run, so it's an important asset class in terms of providing stable and attractive yields.
Below, I provide you with a summary of long-term strategic allocation ranges which you can find in the Statement of Investment Policies here:
What is interesting to note is that 23% is the target weight for Public and Private Equities and 13% of that is in Private Equity, so with a 10% weighting in Public Equities, OPTrust didn't get hit as hard as others when stocks got clobbered earlier this year but also didn't reap the gains when they bounced back and recouped their losses.
Keep in mind, however, OPTrust is a defined-benefit plan which has a member-driven investment (MDI) strategy, so their focus is solely on matching assets with liabilities, aiming at delivering the highest risk-adjusted returns across public and private markets.
Also, OPTrust is now the only large public Canadian DB plan which still offers guaranteed inflation protection, not conditional inflation protection (like CAAT, HOOPP, OTPP and now OMERS).
What else? Like other large Canadian pensions, OPTrust uses leverage to take advantage of opportunities across public and private markets as they arise and to make efficient use of their capital.
But the focus is on risk-adjusted returns and making sure they deliver on their promise to members.
In her comments above, I highlighted passages where Sandra Bosela explains in detail where they focus, why they focus on certain sectors which are more defensive in nature, and why they're always analyzing their portfolio to try to figure out what can go wrong.
She raises a good point, with interest rates at record lows, valuations are at record highs, and you're paying much higher multiples for deals but can't assume multiple expansion on exit.
All the Private Equity teams at Canada's large shops and all private market teams have a value creation plan on all their investments. They work with their partners and guys like Tim Prince at KPMG (might as well plug him as I worked there briefly and spoke to him a couple of times) who help them execute on their value creation plan.
What does that mean in practice? Sandra goes over it in detail above, it's not just cost cutting, it's adopting new technologies to make businesses more efficient and more profitable, and a lot of other things.
What did you think, Private Equity is not simple, the easy part is writing a big check, the hard part is sitting on boards, getting to know the business and management team intimately, implementing and realizing on your value creation plan (same for infrastructure and real estate).
As Sandra states above: “Active management and governance provide a lot of benefits including access to real-time information, something that was especially valuable during the early months of the pandemic this year. Having more control over our investments and a voice at the table in shaping strategic plans and other value creation initiatives allow us to better influence the outcomes of our investments, which is important to us.”
Having more control over their investments (than say public markets which are volatile) allows them to execute better on their strategic plan and that also includes an ESG plan which was not discussed in the article above.
Next Wednesday at noon, the Canadian Club of Toronto is hosting a free virtual event on ESG and sustainable investing moderated by Mark Wiseman (AIMCo Chair) and featuring Gerald Butts (Eurasia Group)and Veronica Chau (BCG) and Alison Loat who is the Managing Director of Sustainable Investing and Innovation at OPTrust.
Join me for the @CdnClubTO's free virtual event on December 9 as I moderate a discussion with Gerald Butts (@gmbutts), Veronica Chau and Alison Loat (@AlisonLoat) on #ESG and #sustainableinvesting.— Mark Wiseman (@MarkDWiseman) November 23, 2020
Register for the free virtual event here: https://t.co/MDSaw1Czmb
Alison and I chatted earlier this year and I'm looking forward to catching up with her after this panel discussion to get her views on responsible investing at OPTrust across public and private markets.
What else? Also on December 9th at 3 p.m., Mantle314 along with Ortec Finance, a leading provider of technology and solutions for risk/return management (helped OPTrust on its climate-savvy project), are holding a webinar on scenario analysis and climate disclosures on the The Task Force on Climate-related Financial Disclosures (TCFD). You can register for that here and it should be really interesting.
Alright, will wrap it up here, hope you enjoyed reading this comment and I enjoyed covering Sandra Bosela and Private Equity at OPTrust.
While I enjoy talking to CEOs and CIOs, I also like covering thoughts from managing directors and senior managing directors at all of Canada's large pensions because they're working directly on deals.