By Scott Blythe
The New York Times recently printed a scathing article on the performance of the alternative investments sought by some public-sector pension plans to diversify away from bonds paying nest to nothing and stocks that have become increasingly volatile.
It looks like the pension funds are worse off than if they had stuck to vanilla bonds and stocks, not least because of the management fees they pay to alternative investment managers.
Yet, there may be a way to reap the alternative investment premium — which for most large pension plans is not a skill premium but instead an illiquidity premium. Perhaps there are lessons to be learned from large Canadian public-sector pensions plans.
They are relatively new to the alternative scene, having been formed only in the 1990s. But many have embraced alternatives wholeheartedly, while acknowledging a margin of error,
“We’ll never get the price point right,” says Jim Fasano, vice-president head of the Canada Pension Plan Investment Board’s principal investment group. CPPIB controls $152 billion in assets, making it one of the larger investment pools in the world. Unlike U.S. Social Security, its assets are not held in non-marketable bonds; instead, in its short history (the CPPIB approved its first, mostly passive investments in 1998) it has not only made a mark in private equity, but also profited. It has roughly a 37% exposure to private equity, which provided returns of 16.6% in 2011. Of course, there was a loss of 7.9% in 2010.
Still, with a 15 to 25-year horizon, it doesn’t matter. CPPIB wants to own quality businesses, preferably those down on their credit luck, rather than looking for a quick flip whose returns are dependent on how much leverage is applied to the buyout.
But there are long-term opportunities, and there are opportunities. Fasano admits that the scale of CPPIB’s private investment group – with $35 billion divided among private equity funds, principal investing, infrastructure buys and private debt – precludes investing in otherwise tempting deals because they won’t push the needle: they’re just too small.
At the same time, with cash inflows of $5 billion a year, CPPIB can afford to wait out illiquidity, and sometimes deals turn around in a surprisingly short time.
“We like private equity where we believe we get paid for the illiquidity,” Fasano says. “On the flip side of that, however, there’s a challenge that comes with our scale and our rate of growth and quite simply there are a number of smaller opportunities and a probably a lot of really attractive smaller opportunities that we just frankly can’t pursue. Our main strength is our resources and the size of the assets we have, so obviously if we have a choice between a very attractive small investment or an attractive larger investment, in order to most move the needle .. that is naturally going to focus us on high end as a consequence.”
But CPPIB only came to this after years in the trenches, which mark its private market efforts still. As with many pension plans, it got into private equity through funds of funds. The funds segment is still the biggest portion of the portfolio, and lately it has expanded to include purchases of secondary interests – from other institutional investors facing liquidity constraints, which now account for $2 billion.
But it is developing a direct investing platform – and opening offices outside Canada. But these are not so much to compete with its former funds of funds partners. Instead it’s to be able to co-invest. Fasano sees that as advantageous for CPPIB – which needs the partners to get access to the deal flow – and also to the partners, who can raise cash from a trusted counterparty.
“We’ve always had a very strict program policy that, outside of Canada, we are only going to invest alongside GPs with whom our fund group has an established relationship,” Fasano explains. He cites a number of reasons. First, he didn’t want to create a brand new competitor to the funds CPPIB had already invested in. Avoiding “channel conflict:” was a second reason: “we believe that gives us the opportunity to access more attractive deal flow and thirdly, and quite importantly, it makes our direct investing program much more efficient in particular in being able to leverage our partners’ global networks in order to be able to source attractive opportunities around the world which just quite frankly we would not be able to do.”
Yet, CPPIB has had to build up the teams to be able to do this.
All that has made for a set of concentrated investments. On the one hand, there was CPPIB’s participation that saw Skype being vended by E-Bay. Skype had growth potential but a niggling problem: it’s founders were suing over the technology. To make that transaction work, CPPIB had to adopt a two-track process that essentially involved timing whether the development of an alternative technology for Skype could happen before the patent case was settled. In the end, CPPIB gained 3.2 times its original investment, in just over two years.
With other investments, always with partners, there have been even shorter time lines for profit. But that’s frequently from partnering up. “One of the hypotheses we had when we started this program was that our model of operating with a small group of sponsors would be more appealing to them when it was their more attractive proprietary deals that they needed a partner for, whereas they would be much more hesitant to phone one of their competitors and quite frankly this has played out a lot more strongly than we expected. Given how few deals these days tend to be truly proprietary., we’ve gotten a massively disproportionate amount of opportunities on a propriety basis through these partners.”
There’s another feature that’s interesting about CPPIB’s approach. When it comes to sectoral diversification – even though the private sector portfolio is quite concentrated – the diversification is achieved by selling an equivalent amount of a sector in the publicly traded portfolio.
Thus, when CPPIB teamed up with Apax Parnters and PSP Investments to take medical device maker KCI private last October, in a $6.3 billion deal, CPPIB sold off an equivalent amount of U.S. publicly traded health stocks.
Are there takeaways for alpha watchers? More than a few, one would think. There are deep pools of capital out there, but accessing them means reciprocity and trust. The biggest pools of capital could compete with private equity managers, but they’d rather not. They’d rather co-invest. In fact, with co-syndication with other pension plans, they could have even deeper pockets. That is, if GPs reach out to the LPs.