In a harsh capital-raising climate, ATP Private Equity Partners and TRS have different startegies on how to drive hard bargains on private equity fees.

Institutional investors are gaining concessions on private equity management fees, with a near-record number of funds on the road seeking funds resulting in a shift in bargaining power to limited partners.

The head of Danish fund ATP’s private equity arm ATP Private Equity Partners (ATP PEP), Torben Vangstrup, says that it has seen management fees drop to as low as 1.5 per cent for bigger players and remain as high as 2.5 per cent for smaller venture capital managers.

“We are in a situation today where the private equity market is not as hot as it was a few years ago,” he says.

“So we do have more opportunities to impact the terms and conditions under which we are going into these partnerships. Having said that, it is about finding a fair balance between the general partners (GPs) and limited partners (LPs). In my mind what is important is that GPs are not going to get rich from management fees, but only from outperformance.”

ATP allocated 5.5 per cent of its overall portfolio to private equity, with ATP PEP managing €7.5 billion in four funds, which range from €1 billion to €1.5 billion in size.

Vangstrup says that ATP PEP aims for an optimal uniform allocation of $65 million to each of the underlying managers, with 10 per cent of the fund kept for co-investment opportunities.

 

Better access at lower cost in Texas

Along with driving a hard bargain, large institutional investors are concentrating their allocations to managers to achieve cost benefits and better access to quality managers.

The $107-billion Teacher Retirement System of Texas (TRS) has been a high-profile case of where providing steady capital to a manager has given them both better access at lower cost than the general market.

There allocation of $6 billion to two managers, Kohlberg, Kravis Roberts (KKR) and Apollo Global Management, was on terms considerably better than the market, according to TRS chief investment officer Britt Harris.

The announcement of these ‘strategic partnerships’ were followed closely by the New jersey Division of Investment, which manages New Jersey’s $66-billion-public-pension fund, saying in December it would provide $1.8 billion to Blackstone to invest in private equity and other investments.

While big investors such as TRS have been able to gain better terms and conditions by using top-performing managers, smaller players have also seen the benefits of consolidating managers.

One fund that has looked to increase the concentration of its managers is Australian fund, SunSuper.

The $19.8-billion-superannuation fund allocates around 7 per cent of its balanced fund to private equity, and currently has committed capital to 20 private-equity managers.

“Over time we have been getting more consolidation of managers, we have identified the managers we think are worthwhile continuing with and some we are not quite as enamoured by,” Hartley says.

“We think we get a better deal on fees, terms and access when we compensate managers.”

 

Fundraiser jam

The better terms and conditions come amid a backdrop of record numbers of funds on the road trying to raise capital in many markets.

Alternative asset-research firm Preqin says that in February this year there was a ‘log jam’ of funds seeking capital, with more than 1800 private equity fundraising vehicles in the market.

This amounts to effectively three years of stock in the market, seeking an aggregate of $777.5 billion in investor capital.

The tough fundraising market has seen investors bear down on the traditional 2-per-cent management fee and the structure of the ‘carry’ part of the fee structure, which sees the general partner take 20 per cent of returns generated.

Steven Kaplan, professor of entrepreneurship and finance at the University of Chicago’s Booth School of Business, says the bargaining power has shifted to investors, with the management-fee component of private equity arrangements coming under particular scrutiny.

“There is definitely pressure from limited partners on management fees but less pressure on the carried interest where there is alignment, but there is definitely pressure on management fees,” Kaplan says.

“That is likely to continue for the next couple of years because of the huge amount of fundraising in 2006 and 2007. Those funds are coming back to market and there is less money now than there was then. While there is excess demand from the GPs for private equity, the LPs have some bargaining power.”

In addition to a focusing on fees, most managers are now required to make a hurdle rate, typically set at 8 to 10 per cent, Vangstrup says.

However, according to Preqin, management fees still remain a bone of contention for investors, with a survey of last year showing half of investors saying it was an area where alignment of interests could be improved.

In a study of fees that analysed 2400 funds over the past 20 years, Preqin showed that the mean-management fee for larger funds had only fallen marginally to 1.71 per cent, despite the recent fundraising conditions.

Cambridge Associates’ chairman and chief executive officer Sandy Urie says that managers with strong track records are still in high demand and don’t need to discount.

She notes that Cambridge predicted fees would come down after the 2008 financial crisis, but was surprised at how resilient management fees have been overall.

“For the good providers, there is a long line of capital [to which they] would love to have access,” Urie says.

It is a view shared by Cambridge managing director for Australia, Eugene Snyman, who warned that investors must think carefully about managers who are discounting to raise capital.

“Where we have seen some changes on the edges are that managers that have really struggled in a tough fundraising environment and have had to present themselves in a different way,’ Snyman says.

“But this asset class is all about manager selection and you don’t want the median of the asset class. So for managers who are struggling to raise capital and are looking to get more attractive from the fee point of view, due diligence has to be very solid to buy at the end of the day.”

A study comparing the performance of equal-, value-, and price-weighted portfolios of stocks in the major US equity indices over the last four decades has won a prestigious award.

Raman Uppal, Member of EDHEC-Risk Institute and Professor of Finance at EDHEC Business School, along with co-authors Grigory Vilkov and Yuliya Plyakha, both of Goethe University in Frankfurt, has been awarded first prize at the SPIVA Awards for the paper “Why Does an Equal-Weighted Portfolio Outperform Value- and Price-Weighted Portfolios?”

The paper finds that the equal-weighted portfolio with monthly rebalancing outperforms the value- and price-weighted portfolios in terms of total mean return, four factor alpha, Sharpe ratio, and certainty-equivalent return, even though the equal-weighted portfolio has greater portfolio risk.

To read the paper click here

 

Public pension funds make up almost a quarter of the world’s 100 largest institutional investors in infrastructure and, while still favouring unlisted funds, they are increasingly investing directly and pushing back on management fees, research reveals.

The research by global alternatives research firm, Preqin, shows a record number of funds on the road seeking a record amount of capital, giving large institutional investors bargaining power to negotiate on fees and conditions.

Pension funds and other large investors are pushing hard on the typical 2 per cent management fee, according to Preqin researcher and author of the report Iain Jones.

In March 2012 there were 150 funds on the road raising money, seeking more than more than $95 billion in capital.

 

Partners push for low fees

However, last year the total number of funds that raised capital and the aggregate capital raised are still short of the peaks of 2007 and 2008.

“Terms and fees is certainly an area that both general partners (GPs) and limited partners (LPs) are looking at, with particular push back over the 2 per cent management fees that became industry standard under the fund model, 2/20, inherited from private equity,” Jones says.

“Essentially this 2/20 fee structure could be justified by private equity fund managers due to the returns that they could expect to make. This however is not the case with infrastructure, where the underlying assets tend to be further down the risk/return spectrum.”

Jones says that investors are looking for GPs to structure funds that take advantage of the traditional characteristics of the asset class, such as inflation hedging and steady cash flows, rather than employ financial engineering, such as leverage, to obtain higher internal rates of return.

Previous information on management fees for 2010/2011-vintage funds and those funds currently fund raising shows that LPs are enjoying some success at negotiating favourable terms.

Half of these funds now charge less than a 2 per cent management fee and just 3 per cent are charging more than that.

The reduction in fees is most marked in so-called big-ticket fund commitments.

Citing the recent CalSTRS and Industry Funds Management mandate as an example, Jones says CalSTRS received concessions and in return invested $500 million with the manager.

According to Jones, GPs are also evolving the way they construct management fees, and are competing for mandates by offering staggered fees for large investors.

Changing the fund structure to better match liabilities for key parts of the investor base is another way that funds can gain an advantage over their competitors, Jones says.

The most recent Preqin study, The Top 100 Infrastructure Investors, shows these large investors are also preferring to invest in infrastructure assets in developed market economies, with energy, transportation and utilities, and waste management the most popular industries.

 

Direct investment on the rise

Pension funds made up 23 of the biggest 100 investors measured by their committed capital. This group of 100 investors have an aggregate of $204 billion committed to the asset class to date through a combination of unlisted and listed funds, and direct investments.

Despite slow growth, Europe and US markets are the most popular destination for infrastructure investment, with Asia proving the most attractive emerging market.

While Jones notes that many larger investors are increasingly looking to invest directly in infrastructure and thereby avoiding the higher fees of funds, the survey showed that unlisted funds still remain the primary route to market.

“As the asset class matures it is likely that a growing number of larger institutions will have the in-house capability to handle direct investments and bypass fund managers, meaning GPs must evolve and adapt in order to secure commitments from the largest investors in infrastructure,” Jones writes.

“However, for the vast majority of smaller LPs, third-party fund managers will remain the only feasible route to the infrastructure market.”

Of these 100 investors, 89 said they gained exposure to infrastructure through unlisted funds. This compared to 64 per cent who say they access the asset class through direct investment.

Jones also broke up the group into three categories, determined by how much they invested in infrastructure.

The top third had the strongest preference for direct investment, with 94 per cent saying they used direct investment compared with 71 per cent and 27 per cent for other investors.

In previous reports Preqin has put the total number of infrastructure investors at 1352 globally and says the mean current allocation to the asset class is 4 per cent.

In its 2011 Infrastructure Fundraising and Deals report released in January, Preqin found that funds are typically looking to increase their allocations, with a mean target allocation of 5.3 per cent.

When it looked at the 100 largest infrastructure investors it found that investors had mean capital commitment of $92.4 billion.

Infrastructure used to be typically categorised in the alternatives or real estate bucket, but Preqin found that almost three-quarters of these large investors now operate a separate infrastructure allocation.

One investor who has looked to build a specific infrastructure allocation in recent years is large US public pension fund CalSTRS. In 2008 the fund decided to target an allocation to infrastructure of 2.5 per cent of the total portfolio.

It has since set up a small internal team that has invested with managers in order to leverage off their specialist knowledge to build the fund’s internal capacity, with a view to eventually investing directly.

Its biggest allocation is to Industry Funds Management’s open-ended fund, which manages $10 billion in infrastructure investments.

 

As debate rages in the US about the generous retirement benefits and high cost of state and local defined benefit (DB) schemes, new research sheds light on the role these funds play in stimulating the economy and creating jobs.

Pensionomics 2012: Measuring the Economic Impact of DB Pension Expenditures looks at the effect of DB schemes and in particular retiree spending of benefits in each state of America.

The report reveals that payments made out of DB schemes collectively supported 6.5 million jobs and produced $1 trillion in total economic output nationally.

Commissioned by the US not-for-profit National Institute on Retirement Security (NIRS), the study aims to measure what it describes as ‘the ripple effect’ in the economy of pensioners spending their benefits in local communities.

For the first time, the study includes information from private sector and federal DB plans.

In separate research utilising the same US census statistics, it is also shown that the proportion of government spending on public pensions has fallen in the last 30 years.

Defined benefit funds are particularly sensitive to accusations that they pay generous retirement benefits to public servants and are a drain on public resources.

Author of the NIRS report, economist Ilana Boivie, shows that for a period from 1993 to 2009 the majority of contributions to DB pension schemes came from investment earning.

Despite two major market downturns, investment earnings contributed 58.85 per cent of aggregate state and local pension contributions, with employers contributing a further 27.15 per cent and employees the remaining 14 per cent.

“Conversations are always focused around state budgets and funding priorities, and it is important to remember that it is not the only story,” Boivie says.

“Every dollar going into pensions is certainly a dollar that could go elsewhere and needs to get looked at, but it is important to note that retirees are contributing back to the economy. Every dollar that goes into these plans is going to multiply over time and investments will finance much of the benefit. But once the benefits are paid out to retirees, it is going to come back to the economy both in terms of the economic effect of the spending and the tax impacts.”

In separate research the National Association of State Retirement Administrators, a non-profit association whose members are the directors of the nation’s state, territorial and public retirement systems, has found that state and local governments spend on average 3 per cent of their annual budgets funding their employees’ retirement schemes.

This funding has fallen from a high of more than 4 per cent in the early 1980s, according to the State and Local Governments Spending on Public Employess Retirement Systems report.

The states with the biggest proportion of their budgets going towards public employee retirement benefits were Alaska (6.35 per cent), California (5.98 per cent) and Nevada (5.39 per cent).

The report notes that in these states more than half of public employee payrolls are estimated to be outside social security.

Investment returns have been a particularly thorny issue for DB pension funds, with even minor adjustments to expected-return objectives used to calculate future liabilities that potentially cost state budgets hundreds of millions of dollars.

 

State-by-state breakdown of the proportion of state budgets allocated to public pension schemes.

[Click to enlarge.]

SOURCE: Table 1 from NASRA ISSUE BRIEF, February 2012. Accessed March 2012.

 

Keep the home funds burning

 

CalPERS is one of several pension funds to recently announce that they would cut their return objective from 7.75 per cent to 7.5 per cent.

These changes are predicted to cost the Californian budget – already $9.2 billion in deficit – $165 million per year.

The CalPERS board have also resisted calls from state politicians for the country’s biggest pension fund to invest more in its home state, arguing that it concentrates risk for the $237-billion fund.

The fund seized on the report’s findings, which also analysed the economic effect of DB schemes in all US states.

According to the NIRS study, DB pensions supported more than 300,000 jobs and $52.5 billion in total economic output in California.

California Governor Jerry Brown has proposed sweeping changes to the state’s public pension system, including introducing a hybrid defined benefit/defined contribution scheme for all new hires.

CalPERS chief executive Anne Stausboll says that secure retirement payments were a vital part of the state’s economy. “According to the report, the positive impacts are ‘quantifiable’ not only in real dollar purchases and jobs that benefit the service, retail and health industries, but they also benefit the quality of life that our seniors experience after retirement,” Stausboll says.

Boivie’s research shows that state and local employees in 2009 received benefits of $23,407 a year compared to private sector employees on DB schemes at $20,298.

A recent retiree on a corporate defined contribution plan typically has an average balance of between $50,000 and $60,000, Boivie says.

It is the certainty of these payments that leads to the most sustained economic benefit, resulting in stable consumer spending in local economies, which flows through to a wide range of industries, Boivie argues.

 

A State by State breakdown of the economic stimulus DB schemes provide to their local economies

[Click to enlarge.]

SOURCE: Figure 4 from Pensionomics 2012. National Institute on Retirement Security. Accessed March 2012.

 

The analysis finds that in 2009 (the most recently available statistics) $426.2 billion in gross public and private pension benefits were paid out.

Of this amount, public pension funds contributed $187 billion. Using US census data and input-output modelling software IMPLAN, Boivie estimates that every dollar paid to retirees with DB pension schemes generates $2.37 in total output nationally.

The research also reveals that in 2009 $50.8 billion of these payments were funded from taxpayer dollars.

Using the same modelling techniques, Boivie estimates that of every dollar of taxpayer money invested in public pensions over the last 30 years, $8.72 of total output was created.

Governments have also gained a tax benefit from DB schemes, researchers find. State and local DB schemes, either directly through beneficiaries paying taxes on benefits or through tax revenue resulting from retiree expenditure, contributed $26.2 billion to state and local tax revenue in 2009.

These same schemes also contributed $32.6 billion to federal tax revenue.

The report’s methodology has been refined in recent years, as the IMPLAN software has become more sophisticated.

One such change to the input-output model has allowed researchers to better estimate where spending goes by matching it to the different spending patterns that occur as household incomes rise. The NIRS will also look to break down the benefits at a state level on a per capita basis.

However, Boivie acknowledges that the economic impact of DB schemes goes beyond just the benefits paid to retirees: there is currently insufficient data and overwhelming complexity in trying to measure what the overall effect of DB investments are on the US economy, she says.

Up to 8.9 basis points will be slashed from the total cost of managing the CalPERS’ investment portfolio in the next three years, under a new investment resource strategy which could also see internal administration costs increase by $6.5 million next year, and internal staff accountable for internal versus external management allocations.

The internal investment team is targeting a total cost range of between 50 to 54 basis points, down from the total of 58.9 basis points recorded in 2010.

It has asked for an increase of investment administration costs of $6.5 million in the next financial year to help achieve this.

The argument is that it is important to focus on total cost, and that internal management results in lower total costs, even if the internal costs are higher due to more staff.

It argues that if a total basis point cost target is set, and the investment management team is accountable for that target, they should be able to trade-off across external and internal expenses, making decisions about the use of internal versus external resources based on economics instead of budget process.

The $225 billion CalPERS manages 93 per cent of total public assets and 64 per cent of total assets in house.

While the cost reduction is significant, the total target is still a lot more than the 30.9 basis point total cost the fund recorded in 2006. This is due primarily to the amount of private assets in the portfolio, which has increased from 16 to 26 per cent from 2006 to 2010.

Of the total cost of 58.9 basis points in 2010, 47.7 basis points were attributable to private assets including hedge funds. Reducing complexity is also being targeted as a way to reduce costs and, where possible, it is focused on eliminating small non-value-add programs and reducing the number of managers.

According to papers presented to the board, the reduction in total fees will primarily come from a reduction of external management and consulting expenses, with a reduction between $100 million and $200 million over the next three years.

The vast majority of the total costs, $1.15 billion of $1.26 billion, is from external asset management fees. About 87 per cent of the total external assets management fees come from private assets and hedge funds.

The internal team plans to develop a long-term “resource strategy” for the investment office and reinvest some of the external savings in internal capabilities.

The papers say the target operating-model implementation is to move down the complexity spectrum, but selectively adding complexity where significant value can be added, such as co-investment in the alternative investment management program.

The CalPERS investment office believes there is an opportunity to further reduce external management and consulting costs and reinvest some of those savings in missed internal capabilities.

It outlines three cost drivers of investment management organisations: private versus public assets, external versus internal management, and the breadth and nature of the investment strategies and activities.

Only 26 of 4300 companies surveyed by Governance Metrics International (GMI) have a specific clause that measures executive compensation against a sustainability metric, and institutional investors play a pivotal role in transforming this behaviour.

Kimberly Gladman, director of research and risk analytics at the governance research company GMI, says investors should set the expectations that sustainability metrics are included in executive compensation packages.

“They should ask companies how they integrate those metrics, in a really concrete way, and make it part of the routine of dealing with companies,” she says. “It is a failure of imagination that more companies have not integrated environmental, social and corporate governance (ESG) metrics into executive remuneration.”

She says that companies should be required disclose sustainability measures.

“It would be ideal that every company has a mandate to disclose the top three social or environmental issues material to its business risks or opportunities, why they exist and what the company is doing about them, then they should be built into the executive compensation.”

Similarly Nicolas M0ttis, professor of accounting and business control of ESSEC Business School, says institutional investors can keep pressure on companies at the chief executive officer-level to improve ESG performance.

“They can also do more to publicise the good examples and support good practice,” he says

Linking executive remuneration and sustainability has not been a priority for companies, Gladman says, because they don’t prioritise it as important enough to core business.

“With sustainability in general, you can’t make a consistent case that it will lead to profitability – you can say its neutral or won’t hurt you. But outside of measuring profits, there is an argument it is necessary for company’s survival, its licence to operate, and its reason to exist at all.”

 

Linking ESG to strategy and compensation

The United Nations Principles of Responsible Investment (UNPRI) is facilitating a project between companies and a group of 11 institutional investors with the aim of creating overarching principles of how ESG metrics are linked to executive remuneration.

As part of the project it is looking for a group of 10 global companies whose boards have experience, or have recently embarked, on integrating sustainability into reward schemes for executives, and want to learn more about peer practices and investors’ expectations.

The investors include PGGM, APG, AustralianSuper and Colonial First State.

Manager of ESG research and engagement at Colonial First State, Nick Edgerton, who is involved in the project, says while it is very early days, the research reveals most companies are “unsophisticated in the main”.

“What we want to do is link ESG to strategy and compensation,” he says. “There are ESG risks to the business and this creates targets around that, for example in the property sector occupational health and safety is an issue, so a good safety performance will be an edge, and so good safety metrics linked with remuneration make sense.”

This would play out in key performance indicators looking at business requirements such as return on equity and sales targets but there would also be a metric on safety record such as the lost time frequency rate, he says.

 

Data and collaboration get results

The link between executive compensation and sustainability metrics is a topic of much discussion amongst academics. However, as in other areas of sustainability academic study, a lack of data is hampering research.

“Academics can’t do the research because the data is not available,” Gladman, who joined Mottis on a recent UNPRI Academic Network webinar on the topic, says.

Both M0ttis and Gladman believe, instead, that academics should be looking at more in-the-field study.

“There is a research gap,” Mottis says. “I feel there are many papers based on statistical analysis but the marginal output is limited because data is not there yet. Academics need to go into the field to look at detailed examples and the practical challenges. In three to five years there will be a long list of companies looking at how to improve ESG performance.”

Similarly Gladman says there is potential for interviews with corporate committees, designers of compensation packages, and executives inside companies to get their opinions of what would work and what the company has tried.

Conducting his own fieldwork has revealed some interesting examples to Mottis.

He gives the example of a steel industry company that wanted to reduce its water consumption. It examined its existing practices, designs and processes, and decreased water consumption by 40 per cent.

“That is a very impressive figure and they achieved it by working together,” he says. “At first they didn’t change incentives, but it became more institutionalised. Every manager has a clear objective related to a general target of water consumption, and part of the bonus, something like 10–20 per cent is connected to this collective action. The main driver at first was not cash but the belief it was possible to improve things and make changes.”

Mottis believes collective action, and team collaboration, is a sensible way to connect sustainability metrics and executive remuneration.

 

Greening the long term

The GMI company research looked mainly at large cap-listed firms in developed markets but also those in MSCI emerging markets with more than $1-billion market capitalisation.

While only 26 companies were found to be using a specific sustainability metric in executive compensation, a larger number also “say something vague”, Gladman says.

A paper by the governance analysis and proxy voting firm, Glass Lewis, Greening the Green: linking executive compensation and sustainability 2011, tells a slightly different story.

Of the companies it surveyed, it found that 40 per cent provided a link between executive compensation and sustainability, up from 29 per cent in 2010.

The report shows that “social” links were the most prevalent type of link cited by companies when constructing compensation packages. This is not surprising, the paper says because employee health and safety represents the most visible link to shareholder value.

It measured the link between sustainability and compensation in companies in the US, Canada, Australia, the UK, Norway, the Netherlands, France, Switzerland and Germany, and found that Australia has the largest proportion of companies that link sustainability metrics to compensation.

However, CFS’ Edgerton says for the most part ESG metrics reside in short-term bonuses such as a one-year time frame.

“We haven’t seen them flow through to long-term incentives, even though they are long term issues. It would be good to see the alignment of those time frames,” he says. “It is the responsibility of fiduciaries to understand remuneration, to understand best practice, and the sustainability strategy.”

Gladman agrees that even the companies that are looking at the link between sustainability metrics and remuneration are looking at it as short-term bonus, not a long-term bonus strategy

Another limitation, observed by both Edgerton and Gladman, is that even those companies that do report a sustainability metric, the percentage it makes up of executive remuneration is so small, “it’s almost an afterthought”.