The Canada Pension Plan Investment Board is a true long-term investor. It considers investments in quarter-centuries not the next quarter, amortises returns over 75 years, and can put capital to work in long-term projects, such as infrastructure.
But CPPIB still has about 10 per cent of its assets handled by external managers in public market exposures. This style of investment management is not typically associated with the long term, so how the board works with those managers is important to maintaining a consistent long-horizon framework.
The C$337 billion CPPIB has more than 150 private equity and public market fund manager relationships around the world.
Poul Winslow, managing director and head of thematic investing and external portfolio management, says CPPIB has a clear focus on how to align managers’ behaviour with its own long-term thinking.
This centres on the “economics of engagement”, or an alignment of fees, and maximised transparency.
Why transparency works
“The more we know about a manager, the better we understand what they do and the better we can ride volatility in tough times,” Winslow says. “We spend a lot of time on due diligence, more than a lot of managers are used to, but this gives us comfort in why they’re doing what they’re doing and then we can live with things like short-term underperformance.”
While he recognises that due diligence is not unique, the amount of time and resources CPPIB spends on it contributes to a true partnership with the manager, which he does think is special. The fund also has the advantage of internal specialisation in many areas, so its portfolio managers have an in-depth understanding of the strategy and can ask detailed questions of external providers.
The benefits of working in this way are many, but Winslow says the biggest one is less manager turnover. A relationship with a manager typically ranges about five to 10 years for CPPIB, with some lasting even longer than that.
“Looking at investment with a long-term perspective benefits the manager, they can exercise their strategy to the fullest – and that benefits us,” Winslow says.
It’s not just in the hiring of managers that CPPIB exercises understanding and patience. It’s also in the firing.
“You need to understand a manager’s performance and shouldn’t redeem just because of bad performance,” Winslow says. “If you’ve underwritten the process and the team and the execution is still intact, you should be able to understand why the performance is as it is at a certain point in time.
“Underperformance shouldn’t be the driver of sacking a manager. It’s more important to understand what’s happening. For many asset owners, the biggest risk they face is style drift from their managers. Style drift, or the strategy changing, happens when short-term pressures hit the manager.
“You should expect to see performance when the market is honouring that type of strategy.”
Designer fee structures
Winslow says asset owners need a deep understanding of the strategies and actions of managers because it underpins alignment on fees.
As a general principle, CPPIB subscribes to performance fees, with the belief that when they are well constructed they’re the best way of incentivising good performance. The board also believes it is essential to measure and evaluate fee structures over long periods of time.
Ten years ago, CPPIB developed its own fee structure for paying managers, which aims to reward long-term skill.
In a paper titled Paying-Only-for-Skill_A-Practical-Approach, Don Raymond, who was senior vice-president at CPPIB at the time, outlined the fund’s design objectives in creating the structure.
The first objective was to align the manager’s interests with the client’s. The board also wanted to pay only for skill and it wanted to avoid any moral hazard; for example, active managers who have no downside in their performance fee.
When developing the fee structure, the board was not attempting to reduce the fees paid, but to align the managers’ interests with the clients’.
The first task in designing a structure to pay only for skill, was to define skill. CPPIB does this with a seemingly complicated, but relatively simple, formula that can be seen in Raymond’s paper.
The major component is a performance fee that is scaled to how successful the manager is over multiple years, and deferred in earlier years. The intention is that, over time, a manager will be paid a fixed proportion of the value added.
The base fee is the negotiated base rate multiplied by the active risk target, and that kicks in if the manager has not met requirements for its performance fee. Implicit in this fee structure, Raymond outlines, is the idea that the base fee is an advance on future performance fees.
To date, many managers have responded well to the fee structure because they get rewarded for their skill and long-term performance.
For Winslow, it’s all part of building a relationship with managers and the mission of securing the ones that can think long term.
“Fee alignment and monitoring of managers are the most important things in this,” he says. “When our managers are partners, we have built close ties with them. They see the benefit of the long term. It’s paid off for them and for us.”
CPPIB’s annualised rate of return for the 10 years to March 31, 2017 was 6.7 per cent. In 2017, it paid $987 million in management fees and $477 million in performance fees to external managers.
Institutional investment mandates: Anchors for long term performance
Focusing Capital on the Long Term, an organisation CPPIB co-founded with McKinsey & Co, recently released a paper, Institutional Investment Mandates: Anchors for Long Term Performance, which includes 10 recommendations for long-term mandates that cover fees, benchmarks, the term of a contract, and performance reporting.
The paper gives investors ideas for changing behaviours to better inform long-term thinking; for example, changing the frame of reference of performance reporting, and flipping the standard practice of listing short-term results ahead of longer-term outcomes.
For more on these recommendations, see our earlier article, A guide to long-term mandates.