Finding the Key: Canadian Institutional Investors and Private Equity

3. Institutional Investors and Private Equity: Canada–U.S. Comparisons

Private equity has grown steadily in popularity in the global institutional investor community. Particularly in the 1990s, private equity emerged as a distinct and substantial asset class in many of the world's largest institutional portfolios.

This trend had its genesis in the U.S., where institutions of all kinds and sizes have supplied most of the fuel to a burgeoning market over the past decade. According to the biennial international survey conducted by Goldman, Sachs & Company and Frank Russell Company, called Alternative Investing by Tax-Exempt Organizations, institutional funds in other countries are starting to follow this American lead.

Goldman, Sachs-Russell also found that, despite their global focus, American institutions commit most of their considerable private equity assets to funds at home. Not surprisingly then, they have been integral to the growth of the world's largest and most sophisticated market. For this reason, private equity in the U.S. has become a model for other countries.

There are various ways of measuring institutional activity in private equity and comparing measures between two or more countries. Among the most common is to compare private equity allocations (actual or targeted, as a percentage of total assets) among different types of institutions, in different nations. Another is to compare, country by country, the annual rate of new capital commitments that institutions make to private equity funds.

Because of major national differences in retirement income systems, types of institutions and the structure and orientation of private equity industries — as well as different methodologies for describing these components — making direct comparisons is a daunting task and can be misleading. For this reason, the data and analysis that follow are grounded in a North American context (with other international data presented in Appendix IV).

Using both of these measures of institutional activity, data assembled from multiple sources show that there has been, and continues to be, much greater breadth and depth in American institutional exposure to private equity (i.e., by type of institution, by size of institution and so on) as compared to Canadian exposure.

American Institutions Commit More Assets to Private Equity

Figure III highlights actual (as opposed to targeted) allocations to private equity by major institutional types in Canada and the U.S. In its annual survey, Greenwich Associates found that current allocations in the U.S. were typically highest among endowments and foundations (8% of assets), followed by corporate pension funds (3.3%).

Despite allocating a lower share of their total assets, public sector pension funds are now the biggest contributors to American private equity in absolute terms, due to their sheer size.

FIGURE III
Institutional Allocations (Actual) to Private Equity United States, 2002

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%

FIGURE III
Institutional Allocations (Actual) to Private Equity Canada, 2002

CANADA	% Of Total Assets
Source: Greenwich Associates, 2003
Endowments and Foundations	1.0%
Pension Funds (Corporate)	1.3%
Pension Funds (Public Sector)	2.8%

In Canada, the standings are reversed. Public sector pension funds lead with 2.8% of assets allocated to private equity.

Canadian corporate pension funds are under-represented in private equity, as compared to their American counterparts. It is probable that Greenwich data also include legacy assets, as most Canadian corporate funds are not currently active (suggesting that the Canada–U.S. gap in this area is perhaps even wider).

The data also show that endowments and foundations in this country are only just beginning to form a tangible market presence.

FIGURE IV
Institutional Fund Allocations (Targeted) to Private Equity
North America, 1995 and 2003

Source: Goldman, Sachs-Russell, 2003

There is evidence of a similar pattern in private equity asset allocation targets. For instance, the Goldman, Sachs-Russell survey for 2003 (see Figure IV) shows recent trends in private equity targets, based on a North American sample of comparable institutional categories (consisting predominantly of American respondents). While targets have risen or fallen in individual cases, the long-term, aggregate trend has been steadily upward.

According to survey data collected for Finding the Key, Canadian public sector pensions and some other institutions active in the market have generally been part of this trend. However, as compared to the entire Goldman, Sachs-Russell sample for North America, overall Canadian target levels tend to be lower.

Finding the Key discovered that among active Canadian institutions, the average allocation target was 6.0% of total assets in 2003. This compares with the blended North American average of 7.5% of Goldman, Sachs-Russell.

Neither the Greenwich nor Goldman, Sachs-Russell survey samples included Canadian or American insurance companies.

American Private Equity Activity Involves Institutions of All Sizes

The data in Figures III and IV indicate that private equity activity spans at least three major American institutional categories, while only Canadian public sector pension funds are similarly engaged. In addition, the market stakes of American institutions are deeper than those of Canadian institutions.

Further data drawn from the latest Greenwich survey demonstrate that American institutional funds of all sizes also tend to participate in the private equity market.

As Figure V highlights, actual private equity allocations increase with the size of American institutions, with the largest ($5 billion or more) allocating 3.4% of total assets on average, as compared to the smallest ($1 billion or less) with 1.5%.

Canadian allocations in similar categories (even adjusted for currency differentials) typically fall far short of the American standard. The exception is Canada's largest institutions ($5 billion or more), which approximate their American peers in private equity exposure. Asset allocations fall off dramatically for Canadian institutions with less than $5 billon.

FIGURE V
Institutional Allocations (Actual) to Private Equity* Canada and the United States, 2002

		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%

Data in both countries indicate the importance of “relative capacity” (i.e., numbers of internal staff, skill sets and complementary resources) necessary for undertaking a private equity program. In other words, there is an institutional size threshold whereat launching a program becomes feasible. Furthermore, the dimensions of a program increase with increasing size.

The issue of size and “relative capacity” may have a direct bearing on the Canadian situation, especially with regard to specific institutional categories. For instance, most university endowment funds contacted for Finding the Key had assets of around $1 billion or less. In addition, of the 30 corporate pension funds that were contacted (18 of which formed part of the Canadian survey sample), only five had assets greater than $5 billion.

These points notwithstanding, the data also reveal that even small institutions in the U.S. have found the means to create some exposure to the asset class. For the most part, institutions of comparable size in Canada have not.

Greenwich data align with a study by the Centre for Economic Policy Research, University of British Columbia (Chemla, 2003), which was rooted in a survey of Canadian and American pension funds. This study concluded that when size differentials were taken into account, American pensions were still found to commit a significantly greater proportion of their assets to private equity.

Rates of Institutional Participation Key to Private Equity Growth

In both Canada and the U.S., an active private equity program will tend to be diversified by market segment (i.e., buyout, mezzanine and venture capital), with commitment preferences varying from one institution to another. Institutional managers responding to the surveys that contributed to Finding the Key (Sections 4 and 5) confirmed this truism.

For instance, American survey respondents said that the biggest share of their total private equity allocations typically go to buyout funds (60%), followed by venture funds (35%) and mezzanine funds (5%). From the much smaller universe of Canadian institutional participants in the market, buyout funds will typically attract 45% of committed assets, followed by venture funds with 40% and mezzanine funds with 15%.

It should be recognized that these data provide only a thumbnail sketch of Canadian and American program criteria, based on limited samples of differently mixed institutional categories in the two countries. A more complete sample of institutions active in private equity would doubtless show somewhat different proportions. It should be further recognized that many programs are also diversified by geography, meaning that the market preferences of institutions will benefit funds in more than one country.

FIGURE VI
New Institutional Commitments to Venture Capital* Canada and the United States, 1996–2002

* Includes available data for corporate and public sector pension funds, endowments/foundations, insurance companies and funds-of-funds.

** Excludes a significant new internal allocation by CDP Capital – Technologies.

Source: Macdonald & Associates, Ltd. Thomson Venture Economics, 2003

This being said, differences between Canadian and American institutional allocations to private equity have had a clear impact on the resources available for investment in their respective national private equity industries. Figure VI compares institutional participation in industries in Canada and the U.S., based on new commitments from 1996 to 2002, using venture capital as a proxy for all private equity activity.

These data show the extraordinary contribution of American pension funds, endowments, insurance companies and other groups to the rapid expansion of American industry resources. In the peak year of venture fund-raising (2000), these investors accounted for 56% of the $US107.2 billion in new supply. Even in the very difficult fund-raising climate of 2002, institutional investors held the course, with their share of new commitments rising to 75% as a result.

These levels reflect a consistent pattern in broad private equity exposure in the U.S. over the past ten or more years. Indeed, institutional assets underlie the bulk of the

$US698 billion under management in American buyout, mezzanine and venture sectors at the present time (Thomson Venture Economics, 2003).

In most corresponding years, the share of annual new venture commitments attributable to institutions in Canada was well short of that south of the border.

In 2000 (also a vital year for venture fund-raising in Canada), pension funds, insurance companies and other institutions accounted for 31% of $3.8 billion raised, while in the down-cycle of 2002, they accounted for 16% of $3.2 billion raised. The latter share is more typical of Canadian institutional participation before 2000, when new commitments from this source typically accounted for between 5% and 15% of the new capital coming into the industry each year.

It is also important to clarify that some of the institutional resources entering the Canadian venture industry during this period went into the internal programs of institutions for the purpose of making direct investments.

Comparatively limited institutional activity has had crucial implications for the Canadian private equity industry. While buyout, mezzanine and venture sectors have experienced impressive growth in recent years — with resources under management hitting almost $50 billion in 2003 — a major fraction of overall supply has come from non-institutional sources (e.g., retail investors in the case of labour-sponsored venture capital corporations).

In addition, the more modest size of the private equity industry in this country, relative to the U.S., has led some analysts to argue that the market here may be under-capitalized, precisely because so many Canadian institutions have stayed on the sidelines (Private Equity Canada 2002, Goodman & Carr LLP, McKinsey and Company, 2003).

Consideration of the very different industry structures between Canada and the U.S. lends support to this perspective.

While over 80% of American private equity funds are based on institutionally supplied limited partnerships (Thomson Venture Economics), such funds account for 25% of the Canadian industry (Macdonald & Associates). As noted earlier, the smaller Canadian share is partly due to the preference of some Canadian institutions active in the market to invest directly, rather than to focus exclusively on committing capital to external pools.

What Do Canada–U.S. Comparisons Tell Us?

The facts suggest that American institutional investors have embraced private equity to a far greater degree than have their Canadian counterparts. Comparative data substantiate this conclusion in the following ways.

• Current actual and targeted allocations of American institutions to the asset class are generally higher than those of Canadian institutions.
• Private equity activity spans at least three of the major institutional categories in the U.S., while only public sector pensions funds in Canada are similarly engaged.
• American corporate pension funds are leading market players, in contrast with their Canadian counterparts.
• Canadian endowments and foundations are not yet a tangible market force — probably due to size — while their American counterparts are among the most aggressive of participants.
• American institutional funds invest in private equity irrespective of their size (although the extent of activity is size-sensitive), while only the largest Canadian institutions lean towards participating in the market.
• The American institutional appetite for private equity has, in turn, contributed significantly to an American industry of size and scope.
• Canada's private equity industry has not similarly benefited from an infusion of institutional capital.

Why Is There a Canada–U.S. Gap?

In part, the gap can probably be explained by the fact that the U.S. private equity industry has existed in its current form for several decades, with the attendant infrastructure (i.e., advisors, agents, pooling vehicles and other resources) that enables widespread institutional participation to evolve in the process.

By contrast, in Canada, the industry only really just started to gain momentum in the past ten years or so. However, to fully understand why the gap exists, it is important to understand the attitudes and perceptions underlying the decisions of institutional investors. This helps to explain the rationale for conducting interviews with key informants in both countries, the results of which are summarized in Sections 4 and 5.