Finding the Key: Canadian Institutional Investors and Private Equity

2. Introduction

The objective of this report, Finding the Key: Canadian Institutional Investors and Private Equity, is to stimulate a process of broad-based discussion in Canada about the role of institutional investors — pensions, insurance companies, endowments, foundations and other investment funds — in venture capital and other types of private equity.

To a significant extent, the impetus behind Finding the Key came from federal and provincial government interest in the contribution of venture financing to new generations of high growth businesses in all regions of the country. To obtain these and other "collateral" benefits to economic growth, productivity and jobs, Canada must have a private equity industry that is competitive and increasingly well grounded in stable and diverse sources of capital supply.

It is recognized that multiple elements, and multiple stakeholders, make up a national ecosystem that fosters venture and other private equity investments made in new and developing Canadian businesses. In other words, no one strategic solution will lend additional momentum to private equity activity in this country. This being said, an especially important factor is the market role assumed by pension funds and other institutions in Canada that today manage close to $1.5 trillion in assets.

An international example of this role has been set in the U.S., where the world's largest and most sophisticated private equity market has emerged, chiefly as a result of long-term capital commitments from American pension funds and other institutions seeking superior, risk-adjusted returns.

Canada's venture and private equity professionals are also keenly interested in this topic. Representatives of Canada's Venture Capital and Private Equity Association (CVCA) and Réseau de capital de risque du Québec gave valuable input to Finding the Key. Of equal value was the contribution of senior managers of institutions, many of whom are members of the Pension Investment Association of Canada (PIAC) and other national industry associations.

Private equity professionals and institutional managers participating in the market believe that exposure to this asset class is in the financial interest of Canadian institutional investors.

Those that have neglected the asset class may well be missing out on a vital source of returns and portfolio diversification over the long term.

All stakeholders in Finding the Key — whether government, industry or institutional — believe that Canadian institutions should consider private equity in this financial context, with due regard to their policies for prudent management and risk tolerance.

If experience is the guide, a private equity program that is soundly conceived, returns-oriented and widely diversified by market focus and geography (i.e., North American or global in focus), will produce broader collateral economic benefits to the country as a whole, as well as superior returns to the investor. This is because a diversified approach to private equity will ultimately include viable investment opportunities in all regions of Canada.

To prompt a national discussion about the role of institutional investors in private equity, Finding the Key explored a number of issues of consequence. Conducted by Macdonald & Associates Limited over the summer and fall of 2003, this research attempted to build on the findings of several preceding studies of importance (see examples in Appendix III) in Canada and around the world.

Research undertaken for this report consisted of the following.

• Background data and analysis related to this topic, including that which clarifies the scope and dimensions of Canadian institutional exposure to private equity vis-à-vis that of American institutions.
• A survey targeted to leading pension, endowment and fund-of-funds managers in the U.S., to draw lessons from American market experience and gauge awareness of Canadian private equity investment prospects.
• A survey targeted to senior managers of corporate and public sector pensions, life insurance companies, endowments and other institutions in Canada, to gauge perspectives on private equity.
• Other background materials that amplify on data or themes discussed over the course of the report.

The findings of each of these items are found, respectively, in Section 3, Section 4, Section 5 and Appendices II–V.

Based on this research, Finding the Key advances recommendations intended to encourage interaction and discussion among Canadian stakeholder groups. These recommendations are found in Section 6.

An advisory committee to this project, which supervised the survey and report-writing process, also provided advice on the recommendations. Committee members consisted of a mix of government representatives and leaders in the institutional community and private equity industry, as well as participating research consultants.

This report was commissioned by the Alberta Ministry of Economic Development; Industry Canada; the Manitoba Ministry of Industry, Trade and Mines; the Nova Scotia Ministry of Economic Development; the Ontario Ministry of Economic Development and Trade; Prince Edward Island Business Development; and the Quebec Ministry of Economic and Regional Development.

2.1 Research Methodology

As the economic presence of institutional investors has grown in Canada and globally, particularly in the 1990s, a body of research literature has developed concerning their influence in capital markets (see Appendix III for selected examples). Some of this research has addressed their role in private equity.

Existing Research Literature in This Area

In 1998, the Organization of Economic Co-operation and Development (OECD) published one of the most important of these studies: Institutional Investors in the New Financial Landscape.

This OECD report confirmed the global relevance of research previously conducted in the U.S. by Peter Drucker and the Harvard Business School, among others. In general, such research concluded that a trend towards the "institutionalization" of savings had led to the creation of numerous, massive investors — the largest of which have tended to be pension funds — that were, and remain, fairly new to the financial world.

In all industrialized countries, said the OECD, a key by- product of this phenomenon was "an increased supply of long-term funds" that should result in "an increase in the supply of risk capital."

Recently, the link between institutions and risk capital has been further probed. For example, in 2001, the high-profile "Myners report" (Institutional Investment in the United Kingdom) was issued, containing a detailed examination of the perceived low rate of British institutional activity in private equity.

Myners found identifiable barriers to this market participation. Most of these derived from the nature of institution-based investment processes and its failure to secure the necessary resources and expertise for decision-making. To a much lesser extent, government regulation was also held responsible.

Similar ground has been tread in Canada. A 1999 report, Prudence, Patience and Jobs: Pension Investment in a Changing Canadian Economy (Falconer, Canadian Labour Market and Productivity Centre), attested to Myners-like barriers when it came to institutional exposure to venture capital and other types of private investment in this country.

Based on a survey of PIAC members, this report found that Canadian pension managers felt impeded by such challenges as market entry costs, limited access to data, concerns about the ability of private equity professionals to deliver returns, oversight difficulties, and the attitudes of trustees and external advisors.

A common feature of many of these reports has been the research methodology utilized. Instead of relying on quantitative models, research has frequently been driven by qualitative approaches. Qualitative research goes to the heart of structural issues relevant to both institutional management and private equity activity by providing a better understanding of the attitudes and perceptions that underlie decision-making processes.

For instance, considerable economic and business research (e.g., Berger and Udell, 1998, MacIntosh, 1994; see Appendix III) has shown all private capital markets to have inherent inefficiencies, particularly as transactional information is not readily available, in contrast with public markets. For this reason, private equity activity is complex and management-intensive for investors.

In addition, as Myners and Falconer revealed, institutional management cultures are also complex, and internal processes for arriving at well-informed investment decisions are not always optimal. The more challenging the asset class, the more apparent this potential deficiency becomes.

Hence, researchers have often used opinion surveys (or equivalent research tools) of key informants, such as institutional managers, trustees (or directors) and advisors, to consider attitudes toward private equity. Other qualitative research may explore the inputs and outputs of investment processes (to test effectiveness) and other structural issues, such as the influence of regulatory systems.

Research Underlying This Report

In keeping with the methodological approach described above, Finding the Key relied on key informant surveys, conducted in an interview format and designed primarily to obtain feedback from institutional managers and their advisors concerning their awareness, attitudes, policies and decision-making procedures with regard to venture capital and other types of private equity.

Questions addressed to key informants were intended to elicit detailed responses concerning structural issues pertaining to private equity, both institution-based and market-based. In addition, researchers probed managers for potential strategies whereby impediments could be overcome.

Before interviews, respondents were assured that their comments would not be disclosed. In Canada's small institutional community, this also precluded non-attributed quotes. Instead, responses have been paraphrased in this report and organized according to primary themes.

The Canadian Survey

Appendix II provides a very brief summary of questions addressed in Canadian interviews. Questions varied according to whether the survey respondent represented an institution with an active private equity program.

The Canadian survey was targeted to a cross-section of institutions, by type (i.e., corporate and public sector pensions, insurance companies, endowments, foundations and other investment funds) and by region.

Where possible, researchers also attempted to diversify the survey sample by size of institution. They tried to ensure the sample had a broad regional composition, based on a minimum of 20 interviews in both Ontario and Quebec and 3, 4 or 5 in each of British Columbia, Alberta, Manitoba and the Atlantic provinces. Their results are found in Figure I and Figure II.

In all, the survey was directed to 94 Canadian institutional investors, 74 of which (79%) agreed to an interview. Respondents tended to be senior managers of individual funds or, in some cases, multi-fund operations (e.g., Alberta Revenue, British Columbia Investment Management Corporation, CDP Capital, New Brunswick Investment Management Corporation and University of Toronto Asset Management).

In addition, interviews were obtained with top consulting firms that advise fiduciary clients, as well as fund-of-funds managers and leading private equity fund managers.

The final Canadian sample, while relatively large for a survey of this kind, reflects several key limitations, which should be recognized.

Surveyed institutions were predominantly large.

Institutions with substantial assets under management were more likely to have the time and ability to participate in an interview, so the there was a sample bias towards larger institutions. Of all institutions that agreed to an interview, 62% had assets of over $2 billion (see Figure I). For the majority of respondents that were corporate or public sector pension funds, this statistic points to the large size bias, as there are more than 3,000 trusteed funds in Canada (Statistics Canada, 2002) and the 100 largest (as defined by Benefits Canada) have assets of approximately $1 billion or greater.

FIGURE I
Canadian Survey Respondents and Non-Respondents, Profile Data

Type of Canadian Institutions	Assets by Size					TOTAL
	>$10B	$5B-$10B	$2B–$5B	$1B–$2B	< $1B
Agreed to Interview
Public Sector Pension Funds	6	11	12	10	7	46
Corporate Pension Funds	2	2	9	3	2	18
Foundations/Endowments				2	2	4
Life Companies	3	1		2		6
Declined to Interview
Public Sector Pension Funds	2		1	1		4
Corporate Pension Funds		1	7	3	1	12
Foundations/Endowments
Life Companies	2		2			4

In other words, the survey reached the upper echelon of a broad Canadian institutional universe (i.e., trusteed and other pension funds, insurance firms, endowments, foundations and so on) comprised of literally thousands of individual funds of diverse types and sizes, headquartered in all regions of the country (see Figure II) in a pool of roughly $1.5 trillion. As there is no comprehensive directory of institutions in Canada, it is impossible to calculate precisely the actual percentage of the aggregate number represented by the survey sample.

Greenwich Associates, a U.S.-based financial research firm, conducts an annual institutional survey in North America (quoted in this report). It encounters a comparable large- size bias in its work. Greenwich data from 2003, quoted in Finding the Key, shows that 67% of the 402 Canadian institutions contacted also responded. Greenwich confirms that non-responding institutions tended to be smaller than responding institutions.

The same holds true for the biennial international survey of Goldman, Sachs & Company and Frank Russell Company (also quoted here), in which the respondent cut-off is $US3 billion.

FIGURE II
Canadian Survey Respondents and Non-Respondents, by Regional Location of Principal Headquarters

Most respondents had some interest in private equity.

In an effort to fully understand the variables that determine whether an institution allocates assets to private equity, the Canadian survey targeted both institutions active in the market and those that are not. However, those institutional managers that agreed to an interview tended to represent those with private equity programs, currently or formerly, or those that were at least curious about the topic. While some institutional managers declined interviews because of lack of time, most cited lack of interest in the market.

For this reason, it is believed that the survey results reflect a greater interest in private equity than would be found in the Canadian institutional community at large. Lack of interest in the market appears to have been most prevalent among corporate pension funds. Of 30 corporate funds contacted for an interview, 40% declined. By contrast, only 14% of the 29 public sector pension funds approached declined an interview.

Greenwich and Goldman, Sachs-Russell acknowledged a similar characteristic in responses to their surveys.

Insurance companies are under-represented in the sample.

With respect to private equity, insurance companies tend to be those based in the life and health industry. Representatives of 6 of the 10 insurers contacted agreed to an interview, a low response rate that suggests limited interest in the asset class.

The American Survey

The American survey was also targeted to a cross-section of institutions, concentrating on those that have been especially active in private equity over a long period of time (i.e., corporate and public sector pensions, and endowment funds). Interviews were also conducted with top fund-of-funds managers. There were 20 American survey respondents.

Many of the questions posed of Canadians institutions were also put to Americans, so as to draw lessons from more than two decades of American institutional history in the market. In addition, researchers probed American institutional managers concerning their awareness about, and interest in, private equity opportunities in Canada.

Data on Trends in Institutional Activity in Private Equity

To add insight to the input received from key informant interviews, Finding the Key also relied on comparative, quantitative market data assembled from assorted research sources. These data highlight recent trends in institutional exposure to private equity, with a strong emphasis on comparisons between Canada and the U.S.

Comparative market data proved useful in establishing the broad parameters of current and anticipated private equity activity in Canada and the U.S. based on specific categories of institutional investor. Greenwich Associates also assembled data for this report that highlight current market participation by different institutional fund sizes. These data were used, in part, to demonstrate the recent impact of different levels of institutional activity in Canada and the U.S. on their respective national private equity industries.

These data also helped to establish an informed context for understanding attitudes and perceptions underlying the private equity decisions of institutions, as revealed in Canadian and American survey responses.

2.2 Key Terms and Acronyms Used in this Report

Alternative assets: Investments that fall outside of the realm of public stocks and bonds, including real estate and private equity.

CVCA: Canada's Venture Capital and Private Equity Association.

Capital commitments: Resources flowing from institutions (and other sources) to private equity funds.

Fiduciaries: Managers or trustees of pensions and some other fund types.

Fund-of-funds: A pool of institutional assets managed by professionals that performs due diligence and selects private equity funds on behalf of clients. According to Private Equity Analyst, there are two essential types: the commingled fund-of-funds (a pool based on the assets of multiple investors) and the captive (a pool based on the assets of a single investor).

Gatekeepers: Expert professionals that advise institutional clients on private equity decisions and/or act on their behalf in the market, sometimes through funds-of-funds.

GPs and LPs: General partners (or private equity fund managers) and limited partners (or capital suppliers to private equity funds).

Institutional allocations (actual): The current amount of capital allocated by institutions to an asset class (e.g., private equity), as a percentage of total assets. Over time, the current allocation rises to meet the targeted allocation (see below).

Institutional allocations (targeted): The authorized allocation of institutions to an asset class (e.g., private equity) as a percentage of total assets. Private equity targets typically reflect a relatively small fraction of total assets.

Institutional investors: Trusteed corporate and public sector pensions, other pension funds, insurance companies, university endowments, charitable foundations and other fund types with similar investor characteristics (based on the 1998 OECD definition).

Limited partnerships: Funds managed by GPs on behalf of LPs that supply capital.

PIAC: Pension Investment Association of Canada.

Private equity market: The non-public market for all forms of equity and quasi-equity activity. In a mature market, there are usually three distinct sectors:

Buyout: Risk investment in established mid-market companies, typically in traditional sectors.

Mezzanine: Same market focus as buyout, but using subordinated debt.

Venture Capital: Risk investment in new or young companies, typically in innovative sectors.

Private equity programs: Defined here as the formal activity of institutional investors, whereby criteria and targets are established and allocations (or commitments) are made regularly.

Réseau Capital: Réseau de capital de risque du Québec.

For additional definitions, readers are invited to visit the glossary on the Macdonald & Associates Web site: www.canadavc.com.