Who should co-invest in private equity?

Some pension funds have hit on a lucrative strategy to extract more value from their private equity portfolios. The £34-billion ($51.6-billion) University Superannuation Scheme, the United Kingdom’s second biggest pension fund for university and higher education staff, is expanding a private equity co-investment strategy begun in 2008. It’s a model whereby schemes portion some investment to private equity funds run by managers, but the rest goes directly into the same projects in which the funds are investing. The strategy incurs a fraction of the fees and enables schemes to better tailor their exposure. It’s a strategy increasingly available as private equity funds struggle to close in today’s climate, offering co-investment rights to secure commitments and access larger deals.

Private equity plus

“Our aim is to make co-investment account for one third of our $6-billion private equity program up from current levels of around 13 per cent. We now have a strong origination network of private equity managers that we regularly co-invest alongside,” enthuses Mike Powell, head of alternative assets at USS Investment Management Limited, inhouse fund managers for the scheme. “Co-investment reduces the fee drag for the overall program and allows us to better tailor our risk exposure within the portfolio. We don’t necessarily believe we are better at selecting transactions than our managers, but we do have superior information around our own portfolio exposures and risk tolerances.”

The USS says it now commits to private equity funds on the basis of strict co-investment deal flows and although returns from co-investment don’t exceed broader private equity returns, co-investment allows a lower level of risk within transactions. “We’ve found that with co-investment, we can reduce the risk but maintain the return because we are not paying normal private equity fees,” says Powell. USS benchmarks its private equity portfolio against public equity plus an illiquidity risk premium, which it has historically “materially outperformed.”

The scheme’s push into private equity co-investment comes at a time Canada’s biggest pension schemes, Ontario Teachers’ Pension Plan and Canada Pension Plan Investment Board are abandoning such handholding in the asset class altogether. They are taking the principle of co-investment one step further by cutting out the middleman, both reportedly considering direct bids for Ista, a German meter operating company being sold by its private equity owner. “Our co-investment strategy will always need managers to generate the deal flow,” says Powell. “There is no reason you can’t go direct but it will involve recruiting talent and appropriate compensation levels – you are creating an internal GP.”

As it is, USS has a 26-strong alternatives team with seven years’ experience. Within private equity it uses 34 managers and invests in 63 funds with commitments ranging from $100 million to $500 million.

The cost of diversification

But not all schemes have had such a profitable relationship with the asset class. The $6.8-billion London Pension Fund Authority, LPFA, began its foray into private equity a decade ago in response to the Myners Report, a review urging pension funds to diversify. “We decided to take our private equity strategy seriously and by 2004 we had $530 million invested with three fund of funds managers,” says Mike Taylor, chief investment officer of the LPFA, talking recently at the NAPF investment conference in Edinburgh. Taylor recalls that his only prior experience of private equity back then was a stake the pension fund he ran before LPFA had in Sanctuary Records, the management company for heavy rock group Iron Maiden. He enjoyed trawling their back catalogue, but it was no preparation for the bumps the LPFA has endured with its 14-per-cent allocation to the asset class, he notes with a rueful smile.

“It’s too early to tell how it’s performed. We’ve got several years to go until we get our money back,” Taylor says. “The entire program is running two to three years behind schedule.” The portfolio won’t be cash-flow positive until 2014 after losing ground for being too diverse, changes in European government regulation on feed-in tariffs that hit investments in green tech and the biggest bugbear, high fees. The fund of funds approach, invested with HarbourVest, Pantheon and LGT, meant the scheme paid nearly double the fees, he says. “We were never happy with the fee levels and should have negotiated harder. We didn’t stress-test the cash flows and had administration overheads too,” he says. “The correlation with global equities also returned in times of stress.”

Fees, liquidity and style drift

Trustees raise other worries with the asset class too. The downturn has led to managers selling fewer portfolio companies because of a lack in investor appetite for private equity-backed IPOs. It’s left less money available for some investors, although the USS has received $2.28 billion in distributions back from managers over the course of its program. Timing of cash back is also unpredictable, with some trustees saying they are forced to pull money out of other assets to cover liabilities. And despite declining distributions, fund managers have stuck to the 2-per-cent annual management fee and the 20-per-cent performance fee structure. High fees are particularly contentious given unknowns around fund drawdown. Management fees are payable on commitments, not investment but sometimes private equity managers, waiting for the right opportunity, have money languishing uninvested. “This is an issue although we had no problems getting our money away,” says Taylor.

Liquidity is another concern. Investors got their fingers burnt during the financial crisis when calls on their capital resulted in them having to sell private equity assets at distressed prices. US endowments Harvard and Yale University were hit this way. “The liquidity risk associated with private equity is arguably exaggerated, particularly since the secondary market has become much more liquid,” reassures Powell. “Investors who historically were locked in for 12 years or more now have the ability to sell. It’s just an issue of price and valuation. A private equity program can also be highly cash-generative once it’s through its investment phase”.

Schemes also bemoan a “style drift” in private equity whereby managers tout the asset class for investments that don’t necessarily qualify as private equity. “We’re seeing private equity being launched for anything,” said Steven Daniels, chief investment officer of Tesco Pension Fund, the $10.6-billion UK defined benefit scheme, also speaking in Edinburgh. Some managers are creating investment models that allow them to take private equity-style fees when in fact the underlying investment is not truly a private equity investment, he explains.

Many schemes want to raise their exposure to alternative investments, and greater private equity allocations are one option. But it’s a complex, expensive business and only the biggest schemes may have the resources to make it pay.