A large photograph stands apart on the corridor wall of the private capital division on the 8th floor of Ontario Teachers’ Pension Plan’s (OTPP) Toronto offices. It shows a crowd of 70-odd employees gathered in front of a sign celebrating the pension fund’s quarter century of investing in private equity and the 20 per cent returns, net of all costs, the asset class has brought in. Taken in February 2016, it captures what Jane Rowe, senior vice-president of private capital at OTPP calls an “awesome, awesome” achievement.
Since its inception in 1990, the C$175.6 billion ($138 billion) fund for more than 300,000 of Ontario’s teachers has achieved an average, annualised return of 10.1 per cent; fully funded four years on the trot, it now boasts an $9 billion surplus. It’s a track record achieved by a revolutionary investment approach that prioritises active, internal management and buying chunky direct stakes in companies, infrastructure and property, and has made OTPP the benchmark for endowments and pension funds the world over.
Much of that investment alchemy takes place on the 8th floor where Rowe nurtures a culture balanced between honouring all her department has achieved in the past, with encouraging innovation.
A 75-strong team oversees a $20 billion global portfolio that spans funeral parlours, crisp manufacturers and childcare providers, and complex relationships with some 40 core private equity funds.
Rowe joined OTPP in 2010 from a distinguished career at Scotiabank Group. Back then Ontario Teachers’ had $9.5 billion in private equity representing 11 per cent of the assets under management. Today this has grown to around 15 per cent — although it shifts in line with realisations of which 2016 saw a lot — and will grow, she says, to at least 19 per cent of assets under management in the future.
OTPP invests in private equity funds where managers serve as general partners, but it also invests directly into portfolio companies. Here OTPP co-underwrites deals with GP fund partners in a relationship Rowe likens to having “a smart friend at the table”; it also allows more control over issues like capital deployment and risk, and cuts costs.
In 2010 about 60 per cent of the private equity portfolio was in funds versus 40 per cent directly into portfolio companies. Now this has shifted in favour of direct investing with around 30 per cent of the allocation in funds and the remainder directly into portfolio companies, the vast majority in developed markets. Until now.
Looking for opportunities
Last April OTPP co-sponsored its first deal with India’s Kedaara Capital, co-founded in 2011 by Manish Kejriwal, the former India head of Singapore’s state investment fund Temasek, to back micro-finance provider Spandana. The small deal has given OTPP a taste of the opportunity to be found in India; it also provides a window into how Rowe moulds new fund relationships as it pushes into emerging Asian markets, adding to its relationships with names like South Korea’s MKB Partners and Hong Kong-based Boyu Capital.
“Whenever you work with a fund partner in a first co-investment opportunity, you are both learning how the other thinks,” Rowe say. “You have to make sure you are thinking about the risks in a similar way; how you want to incentivise the managers that work in that business and the key metrics to measure that. These are the growing pains of an evolving partnership. It is about ensuring how everyone gets everything they need and strengthening the relationship with our GPs so that when the next opportunity comes along in that market, it is even smoother.”
Fast forward a couple of years and OTPP is in a position to swoop on the highest quality deals. None more so than when managers, with their typical three to four year investment horizon, need to realise their investor’s returns.
In 2012 OTPP was a minority investor alongside Wind Point Partners in snack industry group Shearer’s Snacks, best known for manufacturing Kettle potato chips, a brand she admits, with the humour that peppers her speech, is a summer weekend favourite. A couple of years later, when Wind Point sought to share its realisations with investors, OTPP bought out Wind Point.
“We already knew the company, we knew the management team, the sector and key customers,” she says. “We like this company and like where it’s going.”
She used a similar strategy to snap up a stake in OGF, France’s funeral services group, buying out some of private equity group Pamplona’s position. Proven market share and the demographics of the business, she says in another flash of humour, made it stable and lower risk.
“We are not an investor in their fund but we were intrigued by the ownership they had in OGF. We went in there as a minority shareholder under their stewardship and have since bought out a lot of their ownership position and become the controlling owner in OGF in France.”
It’s this ability to invest longer-term that distinguishes OTPP from conventional private equity, and is something Rowe is making much more of in another innovation.
A relatively new allocation to long-term equities now sits within private capital and accounts for at least 25 per cent of the direct portfolio. It is distinct because here OTPP typically invests alone.
“It’s one of the things we’ve done since I joined; I would love to say that I was the mastermind but I wasn’t,” she says with disarming self-deprecation.
It’s a strategy other pension funds are desperately trying to copy. The $323 billion California Public Employees’ Retirement System, CalPERS, is the latest to shift its strategy and consider direct investments in private companies.
“We identify companies where the management teams, and maybe the founder, don’t want to be in a typical private equity structure where someone will be looking to sell them after three or four years,” she says. “We go in with the desire to hold onto the company for a long time and this differentiates us from private equity. It is an ability for us to work on some unique opportunities outside the typical private equity structure. OGF is an example.”
Her team targets lower risk companies able to generate cash dividends that sit between the two spots on the risk spectrum of infrastructure and the typical private equity LBO-like exposure. Seniors housing, storage, and the lottery space are typical examples.
Long-term investment and expert advice may sound like corporate nirvana, but Rowe is quick to clarify it isn’t.
“When we do all our due diligence and figure out the price we need to pay, often as not, people walk away from that discussion disappointed. We have to be very careful, particularly that our risk colleagues are aligned with us. They have to agree that it is a lower risk and potentially higher cash yielding type of business.”
Selection is the beginning of a rigorous corporate journey. All direct and long-term equity investments come with hands-on management in the investee company and proportionate governance rights including a voice on the board.
“As good fiduciaries for the teachers of Ontario we have to make sure they are growing their business well, and not just taking our capital for granted. The easy part in our business is buying a company. The really hard work is growing a company and we make it clear that the hard work begins after we become the owner.”
In recognition of this she has beefed up her portfolio management team, the in-house experts behind the value creation that in turn becomes the blueprint when OTPP becomes an owner in the business. Called “engaged ownership” it lays out how the business will grow over the next five to 10 years and includes key performance indicators “to make sure that folks have scorecards”, she says, to track progress.
She says that jointly owning businesses with “the best private equity funds around the world” has allowed OTPP to learn to craft these blueprints in an ongoing learning process. It does little to deflect from the fact that OTPP’s own expertise and reach must now be equal to all of them.
All direct deals are reviewed by an internal committee twice a year in check-ins with deal teams. And all investments are viewed through an ESG lens. She makes sure funds are aligned on ESG; with co- and direct investment, she says “creating change and raising consciousness” depends on how much of the company OTPP owns. But the questions she asks are penetrating.
“Are our companies honouring diversity in management teams? How is a company sourcing from Asia honouring strong labour practices in its suppliers? We own a wine company in Canada; how is it honouring responsible drinking and anti-drink drive campaigns.”
Pushing fee barriers
At OTPP private equity is one the asset classes most likely to use external managers and the direct and co-investment program has helped reduce fees. In 2016 management fees for all asset classes were $358 million, down from $421 million in 2015 due to a reduction in external assets under management and related management and performance fees.
Investing in funds, where a 2 per cent management fee is the norm, Rowe takes advantage of opportunities for lower fees where possible. She likes the benefits of being an early investor “as long as we’ve had the opportunity to do all of the work.” She also welcomes the benefits from committing more than the next LP.
“We know what those discounts are and we’re able to decide if we want to take advantage of them or not,” she says. And she likes the fee advantage that comes with backing newer funds.
“We take comfort from the fact that other pension funds have endorsed young GPs and my guess is that the industry takes comfort if we’ve endorsed a young team too.”
She insists on hurdle rates before GPs can take carry, which is usually charged at 20 per cent.
“We like to see a typical 8 per cent hurdle rate and see recovery of this before the really big profit share takes place through the carry,” she says. She doesn’t see any need to grind down on the carry. “Twenty per cent is fine as long as the hurdle rate has been reached. Let’s just make sure we’ve had some good returns before they earn their 20 per cent carry on the profit.”
Her unwavering commitment to this comes as a handful of high-performing GPs have taken advantage of stellar market conditions to raise large funds without hurdle rates. But rather than target the GPs which have seen more than $500 billion pour into their private equity funds every year since 2013, her criticism is aimed at the LPs who sign up without hurdles rates in place.
“I think anybody who is a fiduciary for a pension plan ought to be putting a discipline in place that says mega profits to you shouldn’t happen until after we’ve had at least modest returns for our illiquid capital that we’re putting at risk to back you.”
CVC Capital Partners reportedly plans a hurdle rate of 6 per cent for its Fund VII, compared with the industry standard of 8 per cent. Advent International removed the hurdle rate outright from its latest fund, which closed at $13 billion.
Greater fee transparency, backed by industry body the Institutional Limited Partners Association, ILPA, would help.
“We don’t think you should have to have people in a back office spending days trying to figure out how much is going into the pockets of GPs versus recovery by the LP.”
Private equity engrained at OTPP
Private equity at OTPP had an inauspicious start all those years ago when its first ever investment turned sour. Yet despite losing money, the board and chief investment officer at the time, Robert Bertram, remained steadfast, setting a precedent that Rowe believes is fundamental to today’s success.
“Private equity was seen as an asset class that would be important for the pension plan,” she says. “This was honoured from the very beginning.”
Success, she believes, is also rooted in the engrained belief in delegated authority, passed from the board to the CIO, and then down to the people running the asset classes. It is something she practices today, spending little time working on the nitty gritty of the deals she loves.
“I typically have to restrict myself to enjoying it to our weekly underwriting and portfolio meetings. With a focus on our broader strategy, I rarely get involved in negotiating the specific details of a transaction. If something comes up that is an outlier from the norm, the team judges when they have to get me involved.”
And perhaps the most important pillar of success is found in the expert team she leads, divided between a funds team, portfolio management and value creation, and direct investment teams, organised by the sector where the great majority now work.
Most of the team have been encouraged and nurtured to rise up through the ranks so that her department fills most positions from within. The fact that Jim Leech, OTPP president and chief executive who retired in 2013, was head of private capital before he became chief executive isn’t lost on Rowe’s many admirers.