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ANALYSIS
Extracting value from managers
- March 30, 2012
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Three funds find effective ways to get better value from staff, co-investment and private markets.
The Danish ATP, Australian Sunsuper and the Teachers Retirement System of Texas are among the funds looking at innovative ways to extract value and interact with the managers of their private equity allocations.
Institutional investors are increasingly seeking new ways to extract value from their private equity holdings, including forays into emerging markets, direct investing and innovative investment vehicles.
One fund that has taken an innovative approach to accessing the asset class is Denmark’s ATP, which utilises an innovative incentive structure that attempts to deal with some of the pitfalls of fund-of-funds models.
The problem of fees-on-top-of-fees, where investors are paying fees to both underlying managers and the fund-of-funds manager, has been a common criticism of these types of vehicles.
In 2000 the fund took the view that it should expand its private market program and decided to launch ATP Private Equity Partners (PEP).
“If ATP had invested their entire private equity program with external fund-of-funds managers, you could say that their returns would have been impacted by another layer of fees. As we are managing our business in a very cost-effective way, this is not the case,” ATP PEP managing partner, Torben Vangstrup says.
“If they had committed to a fund-of-fund manager, they would have had to pay annual management fees in the range of 0.25 to 0.8 per cent and that will have an impact if they do so for 10 or 15 years.”
Staff incentive schemes
ATP PEP manages four funds for ATP, and has €7 billion under management. Funds are typically €1 billion to €1.5 billion in size. ATP has targeted a 7-per-cent allocation to private equity and currently has 5.5 per cent of its overall portfolio allocated to the asset class.
The key difference between ATP PEP and typical in-house private-equity team or a fund-of-funds manager can be found in the incentive scheme offered to staff, according to managing partner Torben Vangstrup.
“We wanted a program in place so we could incentivise people for doing a great job, but also to give us an opportunity to attract and retain the right people,” Vangstrup says.
“The incentive structure we have put in place is very much like what you see in those funds where we invest. In general, many pension funds do not want or have the capability for this type of incentive system.”
A key problem for funds looking to build out internal-asset teams is the retention of talented staff. Pension funds, which must strictly control costs, often cannot compete with the generous bonuses paid by private-equity firms in the private sector.
ATP requires all partners at ATP PEP to invest their own funds in any investment the pension fund makes.
Under the carry program, when all the capital drawn down has been returned to ATP, including an 8-to-10-per-cent-hurdle rate, further distributions are shared between ATP PEP, other general partners and ATP.
“But this split is not even close to the typical 80/20 carry split in the private-equity industry,” Vangstrup says.
While it is voluntary for non-partner staff to invest in the scheme, the entire team currently participates. Its first fund has achieved an internal rate of return net of fees of 15.8 per cent since inception.
“The beauty of the system is that you will only be rewarded if and when you have been able to create excess returns for investors,” he says.
One key difference to other private equity managers is that you will not see ATP PEP partners walking away with headline-grabbing bonuses. Total remuneration from the carry program is capped.
“If you look at a traditional buyout fund there is no limit in terms of how much they can get, when they have a homerun they can get extremely rich from such a carry system,’ he says.
“We can’t, because we are part of a pension fund, we can get rich but we can’t get very rich because the carry program is capped.”
Co-investment can count
Since inception the fund has also looked to invest up to 10 per cent of any of its four funds in co-investment opportunities.
In a study released this month, research firm Preqin finds the appetite for co-investment opportunities was strongest among investors with sizeable allocations to private equity, with 66 per cent of LPs with allocations of more than $250 million looking to pursue such opportunities.
“Co-investments are where we invest directly into companies, typically with one of our existing buyout-fund managers, and that has been something we have been doing very successfully since our first fund,” Vangstrup says.
Preqin’s study reveals that 61 per cent of LPs it interviewed would use allocations to co-invest from their existing private-equity-fund allocation, with about the same proportion doing so on an opportunistic basis.
More than half of investors listed better returns and lower fees as the reason for seeking out co-investment opportunities.
Co-investments form part of the $19.8-billion Australian superannuation fund SunSuper’s private equity strategy, which includes using the secondary market and going directly into funds.
SunSuper chief investment officer, David Hartley, says the lower fees are an attractive aspect of this form of investment.
“The J curve, which is often put forward as a feature of this type of asset class, you actually find it’s a lot less significant when you buy secondaries or go into co-investments. In a lot of cases you can do co-investments at zero fee,” he says.
The fund invests 7 per cent of its balanced fund into what it describes as private capital, which includes equity as well as debt opportunities.
Large managers such as Apollo Global Management have looked at various private-equity strategies being more attractive during different market cycles.
In a recent presentation to the Teachers Retirement System of Texas (TRS), Apollo co-founder Leon Black told trustees that distressed debt, rather than buyout opportunities, represented a compelling opportunity in this current market environment.
It is a view shared by Hartley, who has upped its allocation to private debt recently.
“We are heading to 15 to 30 per cent of the portfolio in debt and the rest is in equity-type investments. But if the situation continues where we think we can get better returns versus risk for debt, that will increase over time, but we don’t necessarily expect that this will always be the case,” Hartley says.
SunSuper has achieved a net internal rate of return of 10 per cent above the listed market alternative since the inception of its private equity program in 1995. It aims for 5 per cent above the MSCI World index.
Both SunSuper and ATP have diversified their private-equity holdings beyond their domestic markets.
Emerging markets now make up 10 per cent of ATP PEP’s fourth fund, while SunSuper has a 7 per cent allocation to Asia.
Private markets pay, too
Cambridge Associates Australian managing director Eugene Snyman says that private markets are an increasingly popular way for investors to play the growth story in emerging markets.
While public markets in emerging markets can be dominated by large companies in the finance, mining and energy sectors, private investment gives exposure to fast growing consumer-based and technology sectors, Snyman says.
“The return enhancement is what draws investments to private equity but it is that additional diversification that also draws them to the asset class,” he says.
“That is true for the Indian and Chinese market where a lot of our clients have been wanting to gain exposure to the growing middle class. But if you are just playing the public-market exposure to those markets, the cap-weight exposure you are going to get puts you into the largest companies that are ultimately selling to the US and European consumers.”
Ralph Jaeger, managing director at Siguler Guff’s Boston office, says that as investors have looked at their private-equity holdings since the global financial crisis, they have found that emerging markets have been one of the strongest portfolio performers.
“When it comes to the risk profile in emerging markets, there is a misconception. There is less – significantly less – volatility in emerging-market private equity than in emerging-market public markets,’ he says.
“Emerging-market private equity has also significantly outperformed emerging-market public markets since around 2003. What we also see is that it has been very resilient from a performance point of view in the global financial crisis [when] compared to emerging-market public equities.”
Cambridge Associates research shows that since 2006, emerging-market private equity and venture capital has an annual compounded premium of 1000 basis points.
Emerging-market private equity and venture capital is also consistently approximately half that of the MSCI EM index volatility, Cambridge finds.
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