Pension funds take more control with private investments

It used to be pri­vate equi­ty firms that owned every­thing, to quote the title of Jason Kelly’s 2012 book on the tril­lion-dol­lar indus­try. Today there’s a high chance a pen­sion fund also owns the com­pa­nies that pop­u­late our lives from child­care and mobile phone providers to cin­e­mas and funer­al par­lours.

Dif­fi­cult returns in pub­lic mar­kets have encour­aged pen­sion funds to invest in pri­vate assets such as infra­struc­ture and prop­er­ty, and pri­vate com­pa­nies pro­vide some of the best returns out there.

Yet invest­ing in funds man­aged by the likes of pri­vate equi­ty titans Black­stone, Apol­lo or Car­lyle can cost a for­tune in man­age­ment and per­for­mance fees, known in the busi­ness as car­ry. In 2015 America’s biggest pen­sion fund the Cal­i­for­nia Pub­lic Employ­ees’ Retire­ment Sys­tem (CalPERS) revealed it had paid $3.4 bil­lion in per­for­mance fees to man­agers since 1990. Fund invest­ment also restricts investors, or so-called lim­it­ed part­ners (LPs), in their abil­i­ty to con­trol their cap­i­tal and doesn’t put them on an equal foot­ing with their man­agers, the gen­er­al part­ners (GPs).

Pen­sion funds have respond­ed in two ways. Most have begun invest­ing in com­pa­nies along­side the main GP fund in co-invest­ment deals that gives them the free­dom to make their own deci­sions on risk, cuts fees and improves returns. Accord­ing to a recent sur­vey by data provider Pre­qin, 68 per cent of investors gen­er­ate high­er returns in co-invest­ments than invest­ing in funds.

“We aim for five to ten co-invest­ments year­ly,” says Mau­rice Wilbrink of PGGM, a Dutch fund which man­ages mon­ey on behalf of a pen­sion fund for nurs­es and social work­ers.

But oth­er investors have gone one step fur­ther, buy­ing chunky direct stakes in pri­vate com­pa­nies and bypass­ing GPs alto­geth­er. Sov­er­eign wealth funds like Singapore’s GIC and Abu Dhabi’s ADIA have got in on the act.

Among pen­sion funds, it’s the Cana­di­ans who have blazed a trail in strate­gies learnt from the best pri­vate equi­ty man­agers in the world. Like the cal­cu­lat­ed call by Cana­da Pen­sion Plan Invest­ment Board (CPPIB), which man­ages the assets of Canada’s biggest pen­sion fund, to up its invest­ment in China’s e‑commerce giant Aliba­ba. CPPIB invest­ed in the tech com­pa­ny direct­ly and via a com­mit­ment to a pri­vate equi­ty fund; it then increased its stake again in Alibaba’s block­buster IPO in 2014.

In co-invest­ments, GPs rather than pen­sion funds still call the shots when it comes to man­ag­ing investee com­pa­nies. But when a busi­ness is direct­ly owned by a pen­sion fund, it can be a dif­fer­ent ball game. GPs have a typ­i­cal three to four-year invest­ment hori­zon before they have to realise investors’ returns, but LPs can own a busi­ness for years.

“Pen­sion funds don’t have a tick­ing clock,” says Gra­ham Elton, who leads Bain & Company’s Europe, Mid­dle East and Africa pri­vate equi­ty prac­tice. It could mean a gen­tler jour­ney to improv­ing the busi­ness before sale and more deals from busi­ness founders that don’t like the more aggres­sive GP mod­el.

Ontario Teach­ers’ Pen­sion Plan, which owns stakes in UK com­pa­nies such as child­care provider Busy Bees and lot­tery group Camelot, plays the long game with a dis­tinct edge. It posi­tions itself to scoop up exit­ing GPs assets, like the major­i­ty stake it bought in Ket­tle crisp mak­er Shearer’s Snacks when the pri­vate equi­ty firm sold out in 2015.

Large inter­nal teams with indus­try-spe­cif­ic exper­tise work on val­ue cre­ation to ensure the busi­ness grows

It’s an abil­i­ty to be patient that man­i­fests in oth­er ways too. If invest­ment oppor­tu­ni­ties are thin on the ground, pen­sion funds can bide their time or invest else­where. In con­trast, un-deployed cap­i­tal or “dry pow­der”, which Pre­qin cur­rent­ly esti­mates at $1.3 tril­lion, burns a hole in GPs’ pock­ets.

But com­pa­nies would be wrong to assume that being owned by a Cana­di­an pen­sion fund is an easy ride. Large inter­nal teams with indus­try-spe­cif­ic exper­tise work on val­ue cre­ation to ensure the busi­ness grows, while pro­por­tion­ate gov­er­nance rights often include a voice on the board. “It is hard to see the dif­fer­ence between these funds and a GP,” says Ludovic Phalip­pou, asso­ciate pro­fes­sor of finance at Oxford University’s Saïd Busi­ness School.

Oth­ers are not so hands-on. Singapore’s wealth fund Temasek doesn’t demand cor­po­rate restruc­tur­ing or man­age­ment changes in its “bot­tom-up” strat­e­gy. Dif­fer­ent val­ues from some sov­er­eign funds could man­i­fest in less than respon­si­ble invest­ment. “GPs have a rep­u­ta­tion and have to be care­ful of the press. A sov­er­eign wealth fund from the Mid­dle East or Chi­na would be less con­cerned,” says Pro­fes­sor Phalip­pou.

Com­pe­ti­tion is increas­ing as more investors enter the fray. None more so than for the long-term, income-gen­er­at­ing asset such as motor­way ser­vice sta­tions, logis­tics facil­i­ties or elder­ly hous­ing that pen­sion funds like and are straight­for­ward enough for them to fly solo. It is here in “cen­tre of the fair­way deals” that Mr Elton believes tra­di­tion­al pri­vate equi­ty funds will soon feel the pinch.

And com­pe­ti­tion will also dri­ve up asset prices, ulti­mate­ly lim­it­ing the cap­i­tal gain oppor­tu­ni­ties avail­able to investors. Com­pe­ti­tion will also bring down fees, although this hasn’t hap­pened yet since funds are still over­sub­scribed. Investor demand won’t ease off until the fundrais­ing cycle goes the oth­er way, pre­dicts Mr Elton. “Pri­vate equi­ty com­mit­ments are dri­ven by exits. GPs will start to feel a slow­down once the mon­ey com­ing out from exits reduces.”

But pri­vate equity’s glo­ry days aren’t over yet. Com­pe­ti­tion promis­es a shake-up, but even the biggest LPs will always spread risk between funds, co-invest­ment and direct, and small pen­sion funds will stick with their GPs. Besides, where Cana­di­ans and sov­er­eign investors have led, many can’t fol­low. Co-invest­ment isn’t a step­ping stone to going direct, says PGGM’s Mr Wilbrink. “The team is not equipped nor has a clear man­date to invest direct.”

The Canadian’s have nur­tured world-class deal teams that comb the globe for oppor­tu­ni­ties. But US and Euro­pean pen­sion funds have dif­fer­ent gov­er­nance struc­tures with trustees who wouldn’t sanc­tion the cost of retain­ing top tal­ent with mil­lion-dol­lar salaries.

“It would be very, very dif­fi­cult to accom­plish,” says John Cole, invest­ment direc­tor at CalPERS. Inter­nal teams also require scale and many pen­sion funds don’t have large enough pri­vate equi­ty allo­ca­tions to make it worth­while.

It’s all about ways of invest­ing with­out the same man­age­ment and per­for­mance fees

They may not be able to do it like the Cana­di­ans, but pen­sion funds have oth­er options as well as co-invest­ment, part­ly as GPs adapt their offer­ing. Man­agers like Black­stone have cre­at­ed sep­a­rate accounts for their biggest investors. Held apart from the main fund, these offer many of the ben­e­fits of going direct. GPs are also set­ting up funds which hold on to com­pa­nies for longer, but offer low­er returns.

And in the lat­est twist, CalPERS is con­sid­er­ing buy­ing direct stakes in pri­vate equi­ty firms them­selves to get a slice of the pie. “It’s all about ways of invest­ing with­out the same man­age­ment fee and car­ry. It’s led to strat­i­fi­ca­tion in the pri­vate equi­ty mar­ket,” Mr Elton con­cludes.