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Finding the Key: Canadian Institutional Investors and Private Equity
1. Executive Summary
For industrialized countries like Canada and the U.S., fostering the growth of new and developing businesses is essential to a successful economy in the 21st century. Key to this result is access to risk investment that facilitates high growth in innovative firms and competitive transitions for traditional firms. This implies the need for a dynamic and well-established national market for venture capital and other types of private equity.
Finding the Key: Canadian Institutional Investors and Private Equity explores the role of institutional investors (i.e., corporate and public sector pensions, insurance companies, endowments and foundations, and so forth.) in Canada and the U.S. in this realm. While American institutions have found superior, risk-adjusted returns in close to two decades of participation in domestic and global private equity markets, many members of Canada's institutional community remain reluctant to embrace the asset class.
Based on the American experience, and on the leadership shown by large Canadian institutions that have been active in venture capital and other types of private equity since the 1990s, it is evident that an institutional program that is returns-oriented and diversified by market focus and geography can produce benefits to both institutions and the economy as a whole. This is because a diversified approach to private equity will ultimately include viable opportunities in all regions of Canada.
These are just some of the conclusions of Finding the Key, which was commissioned by the federal government and six provincial governments, and which was based on surveys of almost 100 institutional managers in Canada and the U.S., conducted by Macdonald & Associates Limited.
Research Methodology
In the summer of 2003, Macdonald & Associates conducted detailed interviews with key informants representing 74 institutional funds, with headquarters in all regions of Canada, on issues relevant to their interest or activity in private equity at home or abroad. At the same time, senior managers of 20 of the largest pensions, endowments and funds-of-funds in the U.S. were interviewed concerning their market experience and interest in Canadian private equity opportunities.
It should be noted that Canadian and U.S. survey samples were generally skewed towards large institutions and those with some interest in private equity. Such respondents tended to be more willing or able to participate.
Institutional Investors and Private Equity: Canada-U.S. Comparisons
Finding the Key discovered that American institutions have a very strong appetite for private equity right across the market spectrum (i.e., buyout, mezzanine and venture capital). This appetite is expressed in the substantial volume of assets currently committed by American institutions, and by the assets they intend to commit in the years ahead. Furthermore, all types and sizes of American institutions participate in the market. By contrast, only Canadian public sector pension funds, and $5-billion-plus Canadian institutions, are similarly active.
| UNITED STATES | % Of Total Assets |
|---|---|
|
Source: Greenwich Associates, 2003 |
|
| Endowments and Foundations | 8.0% |
| Pension Funds (Corporate) | 3.3% |
| Pension Funds (Public Sector) | 3.1% |
| CANADA | % Of Total Assets |
|---|---|
|
Source: Greenwich Associates, 2003 |
|
| Endowments and Foundations | 1.0% |
| Pension Funds (Corporate) | 1.3% |
| Pension Funds (Public Sector) | 2.8% |
| Fund Size | |||||
|---|---|---|---|---|---|
| +$5 Billion | $1-5 Billion | $501 Million – $1 Billion | -$500 Million | ||
|
* Includes available data for endowments/foundations and corporate and public sector pension funds Source: Greenwich Associates, 2003 |
|||||
| % Total Assets | UNITED STATES (US$) | 3.4% | 2.6% | 1.5% | 1.5% |
| CANADA (CDN$) | 3.2% | 0.5% | 0.1% | 0.1% | |
Themes from the U.S. Survey
Survey responses that contributed to Finding the Key helped to explain this Canada–U.S. gap. Respondents in the U.S. reflected a "who's who" of institutions active in global private equity, with most getting started in the mid-1980s. Since then, American institutional managers have successfully "learned by doing" in a challenging market — an experience that has confirmed their belief in the high return and diversification benefits of the asset class.
American institutional managers proved successful by observing patience and overcoming challenges through the acquisition of market expertise, resources and relationships. For instance, key to their sustained activity was the development of supporting infrastructure, such as specialty advisors and agents (e.g., gatekeepers). In particular, funds-of-funds have been a vital resource, especially to smaller institutions, given their ability to pool assets, house expertise and select funds with strong track records.
American institutions expressed a keen interest in top-tier investment opportunities wherever these exist. However, they also see Canadian opportunities in the context of an increasingly integrated North American market, suggesting that private equity funds in Canada must demonstrate a clear competitive advantage if they are to attract institutional resources from south-of-the-border. American institutional activity in Canada may also be impeded by the costs of addressing, or avoiding, certain tax regulations.
Themes from the Canadian Survey
Survey responses in Canada painted a much different picture. On the one hand, Canadian institutional managers were found to have some new awareness of private equity, apparent in the 14 institutions that have launched programs since 2000 and another four that plan a program launch in the near future.
On the other hand, most current or prospective market participation in Canada's institutional community is represented by public sector pensions, while over half of corporate pension funds were found to be without programs. Doubtless, the number of reluctant institutions would be greater in a larger universe than was reflected in the sample.
In many Canadian institutions, the survey found no significant pressure being applied to managers by trustees, directors or advisors to investigate the potential benefits of private equity. In these cases, knowledge of the asset class was quite limited, with institutional managers viewing such activity in a strictly "Canadian" context and, in so doing, neglecting the advantages of broader diversification, including American exposure.
Many Canadian institutional managers emphasized challenges to entry or sustained activity in the private equity market. For instance, survey respondents gave voice to difficulties accessing expert advice, as some externally based investment consultants do not possess the knowledge or resources to advise them effectively on this topic. These respondents also had difficulty finding reliable, market-specific data.
Structural barriers to private equity activity also appear to be compounded for small and medium-sized institutions in Canada that lack "relative capacity" (i.e., numbers of internal staff, skill sets or other resources).
This issue may be of particular concern to certain types of Canadian institutional investors, including corporate pensions and endowments, as well as those based in regions. "Relative capacity" is even a concern of some larger entities. As in the U.S., such institutions are in particular need of new forms of external support if they are to gain market exposure.
Finding the Key discovered several potential means for overcoming such barriers, including made-in-Canada funds-of-funds, gatekeepers and other types of emerging infrastructure that offer a key source of market leverage for institutions, regardless of size, type or location across the country. In addition, Canadian institutions can already avail themselves of the highly advanced infrastructure based in the U.S.
More Canadian institutional exposure to the market may also result when private equity industry players observe best practices in limited partnership agreements and observe more transparent valuation policies. Finally, tax policies and other regulations should be addressed to remove unintended impediments.
Finding the Key: Conclusions and Recommendations
Finding the Key concludes that Canada faces several fundamental challenges with respect to the participation of our institutional community in domestic and global private equity. For example, many of the attitudes of Canadian institutional managers captured by the 2003 survey are identical to those noted in prior reports. This suggests that, for many institutions, the obstacles associated with undertaking private equity have remained unchanged with the passage of time or events.
One explanation for this situation is the long shadow cast by a negative market experience in the 1980s, when many corporate and public sector pension funds, among others, first made capital commitments to private equity funds. Poor returns and conflicts with investment professionals at that time helped to shape perceptions that persist today, despite many years of subsequent growth and development in the industry.
A second explanation probably exists in the sheer volume of issues that confront a given Canadian institution when it elects to participate in private equity activity. High levels of American institutional participation did not, of course, take place overnight or as a result of a single initiative. Rather, in "learning by doing," American — and some Canadian — institutions found a home in private equity through a variety of strategic solutions.
In the coming years, the national ecosystem for private equity activity — based on a sizeable pool of seasoned investment professionals on the one side and a solid base of entrepreneurial and business management talent that inspires deal flow on the other — must continue to evolve to give Canadian institutions sufficient confidence about the long-term returns they can ultimately obtain.
To change the status quo, Canadian and U.S. survey responses indicated that an important first step was increased communication and education, not just among managers, but also among trustees, directors and advisors. Ideally, this should include more interaction between Canada's institutional and private equity communities, to correct misinformed impressions and to collaborate to meet shared objectives.
For this reason, Finding the Key proposes that a new process of multi-stakeholder discussion should begin in Canada. This process should include senior representatives of the institutional community, the private equity industry, government and other interested parties. It should focus on expanding on report findings, on deepening awareness about related issues and on considering alternative strategies for action.
An essential aspect of a national process of discussion would be cross-country seminars organized by federal and provincial governments and by industry associations, including the CVCA-Canada's Venture Capital and Private Equity Association, Réseau de capital de risque du Québec and the Pension Investment Association of Canada.
These same organizations should also be involved in new strategies for increasing awareness and understanding in the American institutional community about distinctive private equity investment opportunities in Canada.
Finally, industry associations should continue their work with the federal Department of Finance and other government bodies concerning tax and regulatory changes on behalf of institutions, private equity professionals and entrepreneurs.
By engaging in an open and thoughtful national dialogue, it is believed that means can be found to increase Canadian institutional activity in private equity in a way that secures the mutual benefits of superior portfolio returns, a stronger domestic industry and a more competitive and productive economy.
