Pension plan investment professionals frequently cite the search for incremental returns in a low-growth economic environment and a growing weariness with market volatility as reasons behind their interest in investing in private equity.
A number of studies demonstrate that global pension plans have steadily increased allocations to private market investments in the past few years. According to Towers Watson’s 2013 Global Pension Assets Study, assets under management dedicated to alternative investments reached record levels (19%) at the end of 2011, up from 5% in 1995, outpacing net new allocations to traditional asset classes for institutional investors around the globe. This growth is expected to continue in 2013 and beyond.
Same goes for Canada. RBC Investor Services’ September 2012 Pension Quick Poll: Navigating Low Growth indicated that 48% of Canadian pension plans planned to boost their alternative asset holdings; of those plans, 14% were planning private equity investments.
Then there’s the recent press coverage. Two transactions—the 2013 buyouts of Heinz by Warren Buffett’s Berkshire Hathaway and 3G Capital (a Brazil-based private equity manager) and Dell by Silver Lake Partners (a U.S.-based private equity manager), Microsoft and Michael Dell—highlight the benefits of private ownership that these investors are betting on, including the longer-term investment horizon that enables and informs the actions necessary to drive improved operational performance and create shareholder value.
This renewed recognition of the promise of private equity is understandable. When compared with the S&P 500, the asset class has generated returns that are more than 450 basis points ahead of global public equities over the past 15 years. And BNY Mellon’s 2013 10-year Capital Market Return Assumptions report predicts that private equity is the only asset class that will achieve double-digit annual returns over the next 10 years.
On Companies and Managers
Globally, the private equity asset class comprises thousands of individual funds. (According to industry estimates, there are 16,000 private equity funds around the world, with the majority in North America.) The managers of these funds build a portfolio by seeking out and acquiring private firms, then they work with management at these acquired companies to improve business performance with a view to selling or taking the company public at a profit.
The strong investment returns generated by the best private equity fund managers are driven primarily by an unwavering focus on operational value creation in each portfolio company that they acquire. Top managers take an active hands-on approach and create a close alignment of interests between management and shareholders. Private equity-owned companies benefit from effective involved boards and senior management teams that are incented through direct equity participation. As a result, private equity managers are able to implement dynamic organizational changes across their portfolio companies; provide secure financing for capital investment, organic growth or industry consolidation; and focus the energy and attention of the entire organization on business building and shareholder value creation. These structural advantages of the private equity model have produced consistently superior returns relative to investments in publicly listed companies—and access to the value creation potential of the large number of companies that cannot be accessed through the public markets. (More than 80% of companies in the United States with revenues over $10 million are privately owned.)
Numerous studies have lamented the frequent inability of public company boards and shareholders to achieve a comparable degree of positive focus and engagement. For example, a 2009 U.K. survey of top board priorities found that 90% of private equity-owned firms ranked value creation in their top three priorities, as compared with only 25% of public boards, which were more focused on succession planning, compliance and risk issues. Private ownership also provides important advantages that stem from a longer-term investment horizon, insulated from the quarterly earnings pressure that absorbs and often frustrates many listed company management teams. With committed sources of funding and fully engaged shareholders, private equity-backed companies are better able to batten down the hatches and weather the storms of unfavourable markets—and are also well positioned to quickly take advantage of episodic market opportunities. For investors, this provides comfort that managers will focus on long-term business building rather than merely react to the constant pressure to make short-term decisions.
Up for Challenges
Unfortunately, most institutional investors face significant barriers to private equity investing. While some large Canadian pension plans employ extensive, experienced in-house private equity investment teams, according to the RBC Investor Services pension poll, smaller plans report that they simply don’t have the scale, expertise, time and resources to identify, invest in, manage and monitor a diversified portfolio of private equity investments on their own.
First, identifying and selecting top quartile private equity managers is critical. There is a wide dispersion in the returns generated by top quartile managers versus bottom quartile managers. In fact, many investors surveyed in RBC Investors’ pension poll report that they don’t have the requisite resources, information or expertise to source and critically evaluate the options available.
Moreover, accessing top quartile managers can be difficult. Current investors will continue to invest with top fund managers as they raise successor funds and often seek to increase the size of their investment. As a result, the best funds in the world typically do not need to find new investors and are often oversubscribed by their existing investor base, leaving no room for new investors.
And, as with other asset classes, one of the most effective ways to mitigate the risks inherent in private equity investing is through diversification. For example, a portfolio approach to private equity fund investing can provide investors with exposure to different strategies, sectors, geographies, investment types (including primary fund investments, secondary investments and co-investments) and vintage years (the year in which a fund is raised). Yet, for many small and mid-size pension funds, diversification is difficult to achieve without increasing costs and sacrificing returns. Many will find it impracticable to create a portfolio of direct private equity fund investments given the capital and resources required. In addition, determining the appropriate level of diversification can be difficult—too much diversification can lead to index-like returns and erode the return premium that a private equity allocation is designed to produce.
Appropriately timing and sequencing an allocation across private equity investments is also a challenge. Investors need to create and maintain a pacing model that will allow them to determine when they need to commit additional capital to the asset class to maintain their overall allocation. They also need to address the J-curve (a period of negative interim early returns) and how it can be mitigated by successful investments in secondary and co-investment transactions.
Lastly, private equity investors must deal with multi-faceted, complicated administrative requirements—something that, for many resource-constrained institutional investors, is a barrier to investing in the asset class in the first place. Tax and legal issues alone, for example, can themselves be challenging, especially for investors that want access to global private equity.
Partnering for Returns
Help is available for small and mid-size pension plans that do not have the scale and resources to address these challenges internally. Selecting an experienced fund manager or proven investment advisor with an established track record to assist in developing and implementing a private equity investment program is the most effective way to sustainably participate in this asset class.
Large Canadian pension plans such as the Canada Pension Plan (CPP) and the Ontario Teachers’ Pension Plan have addressed the implementation challenges of private equity investing by building large internal investment teams with sector expertise and experience in sourcing, selecting and accessing top-tier fund managers and acquiring and directly managing large cap private companies. These large pension funds benefit from having the scale and the resources to hire world-class in-house teams across multiple offices to execute their global private equity strategy. The CPP Investment Board currently has well over 100 professionals on its private markets team; Teachers’ has 50. While some smaller plans have tried to emulate their larger brethren by adopting a do-it-yourself approach to private equity investing, many have found sub-scale internal programs difficult to successfully implement and have been disappointed with their net returns.
By selecting an implementation partner with an established track record, domain expertise and the ability to identify and access top-performing private equity funds, secondaries and co-investments, small and mid-size pension funds can collaboratively leverage a proven team of private equity specialists. While there are costs involved in doing so, these will be more than offset by the net risk-adjusted returns that a well-established and experienced partner can deliver.
Moreover, small and mid-size investors should not underestimate the direct salary, travel, legal, audit and compliance costs involved in attempting to build out a credible internal program, or the opportunity costs that come with creating and owning a substandard private equity program that will underperform for many years. One investor recently acknowledged that the capital loss it incurred on a single underperforming direct fund investment would have more than covered a decade’s worth of the costs of hiring an implementation partner to build and manage its entire private equity program.
As small and mid-size pension plans continue to strive to meet their return targets in the current market environment, private equity is in the spotlight. The key to success in private equity, however, lies in addressing the practical implementation challenges of the asset class. For investors that do not have the scale to develop and maintain a large internal team and program, an implementation partnering option is the most effective way to participate in private equity’s promise of enhanced returns in a low-growth and volatile market environment.
Phillippa Perkins is vice-president of Northleaf Capital Partners. phillippa.perkins@northleafcapital.com