By Scot Blythe
They’ve got the money, but they want to share brains
When there’s almost $400 billion in institutional money in the room at a private equity conference, general partners are bound to pay attention. But they’re also going to have to take careful notes, because these are sophisticated investors who know the market – and have their own direct investing programs.
Which is what happened in Toronto last month, when the Canadian Venture Capital Association and the Canadian chapter of Financial Executives International held their biannual pulse-taking of the private equity industry. In the room were allocators from the Canada Pension Plan Investment Board ($157 billion) Ontario Teachers’ Pension Plan ($117 billion), Alberta Investment Management Corporation ($70 billion) and Ontario Municipal Employees Retirement System ($50 billion).
Increasingly, big Canadian public plans are shifting from funds to co-investment and even direct investment, with their own merchant banks. What’s also interesting is that the share of investments devoted to private markets is growing. OTPP, perhaps the Canadian pioneer in the space, has $12.5 billion. CPPIB, which manages the equivalent of Canada’s social security system, has $25 billion with another $11 billion in commitments. OMERS has $5 billion and has also set up its own venture capital fund. AIMCo, traditionally a fund of funds investor, has $2 billion, with some direct investments.
That doesn’t mean fund investing is dead. All four institutions got into the private equity space through funds. Now that they’ve been seasoned by experience, they’re taking advantage of their relatively long investment horizons, and are more discerning in what they want from GPs.
“We’re unique in that we don’t have a specific [allocation] target,” says Henry Zhang, an associate at CPPIB Private Investments. “The role of private equity is really to outperform or to generate alpha over the public [market] program.” And that means business for CPPIB. If they make a private equity allocation, they sell off an equivalent amount of public holdings in the same sector.
The financial crisis – and the freeze in private equity activity – of course is on plan sponsors’ minds. But they haven’t given up on the asset class.
“I think we have the benefit of seeing what happened in the financial crisis and how some managers or sectors or geographies might have some better things going forward,” says Tanya Carmichael, portfolio manager OTPP Private Capital. “We are very selective in how we choose to go in and get the investment right in terms of top teams and returns, but we also want to leverage that to see what relationships may form in terms of co-investing “
While CPPIB, for one, may be buying fund interests on the secondary market, others are selling into it.“We were shifting from a funds-based program to more of a balanced funds and co-investment program,” says Edward Rieckelman, AIMCo’s vice-president of private equity. “We also took the opportunity in this market to sell into the secondary market some of the funds that were underperforming so we sort of shrunk down our fund portfolio by about a third.”
Housekeeping, one might argue, rather than a retreat from the asset class. Certainly that’s the argument argument from OMERS.
“Largely speaking, private equity is a long-term asset class,” says Jim Orlando, managing director at OMERS Private Equity.”That means, largely speaking, you can’t really afford to press the gas or take the foot off the gas in terms of investments we make. We can’t time markets.”
Nevertheless, the way the private equity bubble worked out has given long-term partners cause for concern. They, can, in some sense, second-guess their GPs–because they have the in-house teams and analytics to do so, even if they don’t have the Rolodex. So they’re particular about the GPs with whom they partner.
“From the starting point, you need to have a strong and consistent track record,” says CPPIB’s Zhang. “We’re looking for outperformance compared to the public benchmark and then we have a fairly rigorous analysis where we benchmark all the funds we deal with by geography and by sector. Given what happened during the financial bubble, we want to see from GPs a sense of discipline in terms of the investment activities and in terms of the value added and valuation..”
Sophisticated LPs can actually be quite demanding in a particular way: prudence in raising money and putting it to work wisely. “It’s a discipline question, certainly in terms of not rushing out to raise money just because it’s there,” notes OTPP’s Carmichael. But, she adds, it’s about having relationship between true partners.
“I really dislike this idea of the pendulum shifting where the GPs have the upper hand, the LPs have the upper hand. I think that’s not that constructive.”
In the end, though, it does come down to the GP team. Institutional investors who are in it for the long haul want no surprises. “With funds what really attracts us is the stability of the strategies, the stability in people,” says AIMCo’s Rieckelman. But no surprises goes further: is there a competitive advantage, he explains. “It could mean a unique knowledge of a particular sector. It could be a network. It’s hard to gauge competitive advantage all the time, especially when you’re running a generalist fund, but many of these groups have specializations and I think the negatives would definitely be change, if there’s … a shift in strategy, a shift in people, it’s too much of a gamble. It’s very unpredictable. Why would we want to be on the cutting edge of that investment?”
Exactly. Years ago, institutional investors did seek a cutting edge in turning to alternative investments. Now they’re more sophisticated. They know what works, and who can do it best on a risk-adjusted basis.