Canadian Pension Funds Cutting Back on Pioneering PE Investments
Top pension funds are stepping back from competing head-on with private equity groups to buy up companies, instead opting to invest alongside them to secure access to the best deals.
Caisse de dépôt et placement du Québec (CDPQ) and the Ontario Municipal Employees Retirement System (Omers) are scaling back the proportion of their funds exposed to directly owned private companies, while Ontario Teachers’ Pension Plan has said it is eyeing more strategic partnerships.
A tough period for exiting investments over the past two years has encouraged the Canadian pension groups to back more companies alongside huge private equity managers as direct ownership has become increasingly challenging, requiring big in-house teams and a higher risk appetite.
“The private equity downturn is making the direct investing model harder as we are facing a shortage of viable projects and difficulty in exiting from our existing investments,” said an executive at one of the funds.
There are three main ways pension funds allocate to private equity: direct investing, where they buy a stake in a company on their own; through a private equity fund; or through co-investments, where they invest in companies alongside a private equity fund but without having to pay the fund fees.
Canada’s $3.2tn pension system is a major private equity investor with 22 per cent of its public sector funds’ assets allocated to the asset class, according to think-tank New Financial.
At present, the nine biggest Canadian pension funds have about half of their private equity exposure in buyout funds and half through direct holdings and co-investments, according to analysis from CEM Benchmarking.
But that balance has shifted as pension funds have come under pressure to invest in buyout funds to secure access to the best co-invest deals, where they get to invest alongside the firms but without having to pay fund fees.
CDPQ is in the second year of a five-year plan to lower the proportion of direct private equity investments from 75 per cent to 65 per cent, while Omers pivoted from allocating very little to private equity funds to announcing last September it would no longer invest directly in European opportunities.
Ontario Teachers’ has said it is “tactically looking to invest more with other partners in areas where it makes sense as the portfolio and market evolves”, though direct investments are still a core part of its strategy.
The shift comes as the private equity industry has ballooned in size, resulting in fierce competition for both assets and talent — and as some Canadian pension funds are also rethinking their US exposure.
Marlene Puffer, former chief investment officer at Alberta Investment Management Corporation, said Canadian pension funds were “in the boat of having to add more value into every holding because exits are more challenging now — they have to do more hands on management and it becomes increasingly complex”.
She added that pension plans allocated money to private equity funds on the understanding that they would be invited to invest in many of the co-investment opportunities that arise with them.
It was “difficult for Canadian pension funds to compete for talent with Apollo that pays much better”, another fund executive said.
Martin Longchamps, CDPQ’s head of private equity and credit, said the rationale behind its shift towards more partnerships was to “drive access to deal flow through those relationships”. Omers’ chief investment officer, Ralph Berg, said the pension fund had “evolved our investment strategy over the last couple of years to explore different models and use funds where it is complementary”.
Canada Pension Plan Investment Board, the country’s largest pension fund with C$699bn (US$504bn) in assets, said it had “always pursued a partnership strategy and continue to be committed to that approach”.
I read this article yesterday and it brought me back to a meeting I had with Mark Wiseman when he was CEO of CPP Investments years ago.
We were in a small conference room at their offices in Toronto and he explained to me while they mostly do direct investing in infrastructure and real estate, in private equity all they were doing back then was investing in top funds and co-investing alongside them on larger transactions.
"If I could afford to hire David Bonderman, I would but I can't so we invest in his fund and co-invest alongside them on larger transactions."
Wiseman’s successor, Mark Machin, told me the same thing when I met him n Montreal:"In private equity all we do is invest in top funds and co-invest with them on larger transactions to reduce fee drag."
John Graham also expressed the same views when I met up with him here in Montreal.
That's three CEOs of the largest and most important pension fund in Canada with the biggest private equity portfolio in the world among institutional investors expressing the same thing.
Basically, if you can't beat them, join them and negotiate hard on co-investments to lower fee drag.
There is nobody working at a pension fund in Canada who can compete with the world's top private equity funds.
Sure OMERS and OTPP did some purely direct deals and some were incredibly profitable over the long run but it's almost impossible nowadays to compete with the top private equity funds and things are also changing in infrastructure and real estate.
Just like top hedge funds that pay big commissions to investment banks gain access to the best trades first, top private equity funds that pay huge advisory fees to big banks get the first phone calls when a major deal is in the works.
It doesn't mean that there aren't good private equity managers at Canada's large pension funds, it just means they cannot compete head on with top PE firms.
And to be clear, the majority of direct private equity investing at Canada's Maple Eight is co-investing alongside top funds (a form of direct investing) not purely direct investing where they source deals themselves.
What about Erol Uzumeri, one of the founders of Searchlight Capital Partners? He came from OTPP Private Capital.
Yes he did and he was lucky that Derek Murphy, former Head of PE at PSP, seeded him because without that anchor investor, Searchlight would have never gotten off the ground.
Same goes for Steve Faraone and Mike Murray of Peloton Capital Management. They too came from OTPP Private Capital and were lucky billionaire Steven Smith seeded them and IMCO made an allocation to them because phone calls were made at the highest level.
Don't get me wrong, Erol, Mike and Steve are all excellent private equity investors but no way in hell would they be where they are without seed capital from major anchor investors.
The bottom line is this, if you're as good as KKR, EQT, TPG, Blackstone, Apollo, etc. then why would you work at a Canadian pension fund?
The same goes when traders who use pension fund's balance sheet tell me "You know, I can easily work at a big hedge fund."
I laugh and tell them straight in their face: "No you can't buddy because if you can work at Citadel, Millennium, Bridgewater or Rokos Capital Management, you would be there making millions in bonuses every year."
Again, it doesn't mean they are bad traders but the world of elite hedge funds is on another level, just like the world of elite private equity funds.
What else do I want to get off my chest?
OTPP once did a performance attribution on their private equity holdings and it turned out co-investments and direct investments were the best performers over the long run and the worst performance came from fund investments and syndicated investments where they got a small slice and didn't do their own due diligence on a deal.
Again, they had done some great purely direct deals years ago but times have changed drastically which is why OTPP is reassessing its private equity approach.
Same goes for OMERS and others, there's simply no choice, times have changed, adding value is harder, exits are extremely challenging, competing in this arena with top funds is not in the best interest of your pension fund.
And times are also changing for real estate and infrastructure so large pension funds better adapt fast or risk underperforming there too.
And by adapt, I mean invest in top funds and co-invest alongside them.
The world of pension fund investing in private markets is all becoming investing in strategic partners that can add value over the long run.
Always remember what Mark Wiseman told me: "If I could hire David Bonderman, I would but I can't afford him."
It's that simple folks, let's not make it out to be more complicated than what it truly is.
Private equity will always remain an important asset class but if you don't have the right approach investing in top funds and co-investing alongside them on larger transactions to reduce fee drag, you're going to significantly underperform over the long run.
Below, Joseph Bae, Co-CEO, KKR discusses what's driving private equity returns and where its finding value across the market with Bloomberg's Sonali Basak at Bloomberg Invest.
And Bruce Flatt, CEO, Brookfield discusses tariffs against Canada, structural trends in asset management and investing in digital infrastructure with Bloomberg's Erik Schatzker at Bloomberg Invest.
Both interviews are from a month ago and well worth watching.
Lastly, David Bonderman was a private equity legend who built TPG Inc. into a firm with $239 billion in assets under management. He was known for his kind and respectful treatment of people, as well as his wise counsel and extraordinary business judgment. His business partner Jim Coulter spoke to Bloomberg's Jason Kelly about Bonderman's life and legacy.
Read more on David Bonderman on TPG's website here.
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