Canadian LPs Selling PE Stakes in Higher-For-Longer Environment
Canadian pension funds bulked up on private equity investments for their attractive returns over the past couple of decades, but changing dynamics in the PE sector and volatility in public markets are now leading some to reverse course and put holdings on the block.
The Canada Pension Plan Investment Board, for example, which invests on behalf of the Canada Pension Plan, sold a diversified portfolio of limited partnership fund interests in mostly North American and European buyout funds to French private investment house Ardian for around $2 billion on Nov. 7. The portfolio represented various commitments made by CPP Investments over the past 20 years.The next day, Bloomberg News reported that the Caisse de Depot et Placement du Quebec is shopping private equity assets, also valued at as much as $2 billion.
There are several factors that could be contributing to the selling spree, according to people who track such fund investments.
The first is what’s known as the “denominator effect.” This occurs when the value of bonds and shares of publicly listed firms decline, as they did recently, bringing down the total assets of a pension fund. When this happens, reported values for private assets tend to lag their public counterparts, which results in these private assets becoming a larger proportion of a fund’s total assets.
“Selling part of the private equity portfolio is a way to bring the total portfolio back to balance,” said Sebastien Betermier, an associate professor of finance whose area of focus at McGill University includes pensions and other funds.
Betermier said recent “benchmarking” research he and colleagues have done shows a smoothing and lagging effect for private asset valuations when compared to publicly traded assets. The data show that private real estate markets values, for example, lag public market values by about a year, while the private equity lag is between three and five months, he said.
“The lag effect means that any significant decrease in the value of publicly listed equities isn’t reflected in the value of privately listed equities for several months,” he said.
Public markets have shown recent signs of life, a shift that could bolster private assets as well, but trends in the bond market suggests private equity sales are likely to remain desireable for pension funds at this point in the cycle, said Jim Keohane, a director at Alberta Investment Management Corp. (AIMCo).“Improving equity markets do help somewhat but the decline in the bond market has more than offset that so most funds are still overweight private equity,” said Keohane, who was also CEO of the Healthcare of Ontario Pension Plan (HOOPP) until his retirement in March 2020.
Canadian pension funds are among the largest private equity investors in the world. Global private equity is one of the largest single components of the $576-billion CPP fund, for example, with net investments at $146.5 billion as of the end of September 2023. The Caisse had $80.7 billion in net private equity assets at the end of December 2022 across a variety of sectors in North America, Europe, Asia and Latin America, representing 20.1 per cent of the fund. The holdings put both Canadian funds among the world’s 10 largest private equity investors, with CPP Investments in the top spot, according to 2023 rankings by Private Equity International (PEI).
‘Virtually no inflows’
Another trend behind the recent private equity sales by large funds, Keohane said, is that private equity is experiencing outflows and “virtually no inflows” for the first time. This is thwarting an established practice of general partners selling a private equity fund’s underlying companies to new funds when existing limited partners reach a pre-established wind-up date.
“Now what is happening is that they are unable to do that so most funds are extending (the) term,” Keohane said, noting that this prolonged investment horizon means pension funds have to adjust to the fact that they aren’t getting the return of capital they were expecting at this time.
Higher interest ratesInterest rates, too, are a factor in the current developments — and likely future trends — in private equity.
At the moment, valuations “are probably also unrealistically high given the run up in interest rates we have experienced,” Keohane said, adding that the rising rate environment has muted the outlook for private equity compared to the lustre of the past 20 years or so when rates were historically low.
That is because private companies are generally highly levered, which plays in their favour in a time of declining interest rates but becomes a negative factor when the debt is rolled over at much higher rates.
“All of these factors contribute to pension fund decisions to try to reduce their exposure,” he said.
From these three factors, I'd say the most important one right now is valuations are rich and with a looming global recession, LPs like CPP Investments, CDPQ and other large Canadian pension funds are selling using the secondary market.
They typically sell at a discount -- anywhere from 10 to 20% of NAV -- to shore up liquidity and diversify vintage year risk, pouncing when opportunities arise later on.
Go back to read a comment I wrote this summer where BCI's Head of Private Equity Jim Pittman discussed how they stay liquid in an illiquid market:
BCI has offloaded C$4 billion to C$5 billion of private equity stakes via the secondaries market since Pittman’s appointment. The most recent of these transactions took place in June, with another expected to close by year-end, Pittman says, noting that the pair will generate “up to a billion-and-a-half” of liquidity. He declined to share the specifics of the two transactions. “One of the things that… myself and the executive team often say is: ‘In an illiquid market, we don’t want to be illiquid ourselves’,” Pittman adds. “So we always want our own dry powder of a few billion dollars to sort of take advantage, and you never want to be forced to sell.”
BCI isn’t alone in utilising secondaries to generate liquidity. LP-leds accounted for about 61 percent of the $44 billion of secondaries transactions completed in H1 2023, per data from Greenhill. According to affiliate title Secondaries Investor, notable sales included Kaiser Permanente’s $6 billion portfolio sale, New York State Teachers’ Retirement System’s sale of a portfolio valued at around $6 billion, and Norinchukin Bank’s process to sell a portfolio that is around $1.5 billion or more in size.
LP portfolio pricing across asset classes rebounded to 84 percent of net asset value – down 2 percentage points on H1 2022 figures – and up considerably from the 78 percent of NAV seen in the second half of last year, according to Jefferies.
“It not an ideal market to sell,” Pittman says. “But you’ve got to take a view as to, is the NAV inflated? Is that the true value of the portfolio? In our view, we’ve been taking somewhere in the order of magnitude 15 percent discounts, but we believe our portfolio is 10 percent overvalued in general.
“We don’t think we’re taking a very large discount, we just think we’re reflecting what’s going on in the market. And liquidity is an important factor just to be able to have C$2 billion available to continue to do deals.”
Now, what are the prospects for private equity?
With a looming global recession and a long bear market ahead, I'd say not good.
In fact, I agree with those who warn of a shakeout in the industry:
The private equity industry is facing a “shakeout” that could result in painful losses for investors who piled into the sector without properly understanding the risks of holding illiquid assets, according to the chief investment officer of one of the world’s largest charitable foundations.
Years of low interest rates have attracted a wave of “tourist capital” into private equity, Nick Moakes, chief investment officer of the £38bn Wellcome Trust, told the Financial Times Future of Asset Management Europe conference in London on Wednesday.
“It’s people who are investing in assets that have inappropriate risk profiles for them, which is many types of money, but it’s all been prompted by the fact that capital was free, and it will wash out.”
Partners Group just put out a comment, Navigating the "higher-for-longer" environment, which you can download here.
The report is short and well written and discusses all private assets but I note the executive summary and their thoughts on private equity:
They discuss liquidity stating:
Limited partners' (LPs) liquidity needs will be another driver of this next wave of investment activity. We anticipate the secondaries market to play an increasingly important role, with LPs more proactively managing their portfolios while managers explore ways to extend their hold on prized assets.There is no doubt about it, secondaries will play a critical part in shoring up liquidity as will leverage which Canadian pension funds can tap when needed.
The most important points in this comment are (1) the environment for private equity has changed considerably and (2) LPs are tapping into the secondaries market to shore up liquidity.
The other story for PE is maybe the better deals lie outside the US and Europe right now.