Finding the Key: Canadian Institutional Investors and Private Equity

4. American Institutional Investors and Private Equity

Section 3 provided evidence of the active participation by American institutional investors in the private equity market. But how did this occur and what lessons can be gleaned from American experience that are relevant to Canada? This question is the focus of Section 4.

There was no single event that introduced the full range of American institutions to the market. However, it is clear that fundamental changes in regulatory systems in recent decades laid much of the groundwork for that introduction.

For instance, a milestone of the 1970s was reform of the Employee Retirement Income Security Act enshrining the "prudent person" rule. This rule, which gradually became an essential principle of pension supervision in the U.S., Canada, the United Kingdom and other countries, gave fiduciaries more investment freedoms, in the context of more explicit obligations under the law.

Concurrent with federal and state regulatory changes was the development of the private equity limited partnership vehicle. Industry GPs could commingle capital from different types of investors and return it to them on a tax-exempt basis, thereby protecting the income tax status of pension funds. As institutions entered the market, the modus operandi of the American industry itself evolved, to the point where this vehicle became the primary means for raising capital.

Over the 1980s, some of the biggest names in the American institutional community initiated private equity programs. In these pioneering years, institutional managers had to "learn by doing" in an inefficient market. In practice, this meant refining internal procedures and external strategies for sustaining participation over highs and lows in market cycles.

As the following summary of survey responses reveals, American institutions were ultimately successful in this regard. In time, a growing number sought exposure to top-performing funds at home, as well as in Europe, Asia and other regions around the globe. Pension funds have become especially active abroad, becoming key sources of capital in some foreign private equity markets. While hard data are not available, such activity does not appear to be extensive in Canada, however.

To probe the American experience, Finding the Key targeted senior managers in some of the top institutional funds in the U.S., 20 of which agreed to an interview. The final sample is a selection of corporate and public sector pensions, endowments and fund-of-fund managers, and "gatekeepers" or advisors based in that country. Taken together, total managed assets of this group approach $US700 billion. In addition, respondents reflect a "who's who" of institutions active in American and international private equity.

American institutional managers were asked questions about their perceptions and experience of private equity at home and in Canada (see 2.1 Research Methodology). In reply, they sent important messages to Canadian institutional managers, private equity professionals, government officials and other interested parties. The following is an overview of what these survey respondents said. Where appropriate, Macdonald & Associates has added background information and analytical points.

4.1 Themes Emerging from the American Survey

Private Equity Exposure Can Contribute Substantially to Overall Returns

The survey found senior managers representing all 20 American pension funds, endowments and fund-of-funds expressing considerable enthusiasm for private equity.

Enthusiasm is grounded in nearly two decades of sustained market participation. The average inception date of the private equity programs of surveyed institutions was 1985. All American managers reported achieving superior, risk-adjusted returns, with several disclosing a net return of 20% overall. For this reason, they are confident about the powers of the asset class to boost overall profitability while at the same time diversifying their portfolios over the long term.

American institutional managers said returns were realized despite major market slowdowns in the early 1990s and since 2000. For them, this affirms the long-term nature of private equity and the need for a patient and sustained commitment to the asset class.

Based on this experience, American institutions cautioned against a "market timing" approach to private equity, whereby activity is guided by short-term trends. This strategy, which is better suited to public markets, will undermine returns from private equity and ultimately sour fiduciaries towards their programs. (It can be argued that this has been a core problem in Canada, where many institutional managers committed to private equity funds in the 1980s and then withdrew from the asset class several years later. See Section 5).

Enthusiasm in the American institutional community helps to explain rising private equity allocation targets between 1995 and 2003, documented by Goldman, Sachs-Russell (Figure IV). With time, American pension and endowment funds have steadily enlarged their presence in the buyout and venture capital sectors, while American insurance companies have given most emphasis to mezzanine investments.

Market Success Depends on Talent, Experience and Relationships

American institutional managers indicated they were faced with the same challenges as their Canadian counterparts are: an unfamiliar market with high entry costs, limited availability of information, oversight difficulties and so on. However, they pursued the perceived opportunity for superior returns and overcame impediments in the process.

The survey found that creation of private equity programs in American institutions has frequently been led by in-house champions on management teams or on boards of trustees (or directors). Typically, these individuals have been pivotal to decisions to introduce private equity because of their knowledge and their willingness to champion new directions.

Key to creating market exposure was the sourcing of expertise. Some institutions did this by recruiting seasoned managers internally, which in turn meant they had to adopt adequate financial compensation systems. Others looked to external professionals such as gatekeepers for support (see below). Regardless, the growth in private equity activity stimulated relationships and networks inside and outside institutions, which allowed for the flow of information and advice. For many American institutions, this process also involved peer group interaction, through forums like the Institutional Limited Partners Association (ILPA). It was suggested that similar activity would be beneficial to Canadian institutions.

Resources are Available to Support Institutions and Benchmark Performance

In the 1990s, growing demand for private equity investments among highly motivated American institutional managers generated a new American industry of specialty advisors and customized resources.

The survey found that the most important of these resources have been funds-of-funds (see below) and gatekeepers, these being professionals who provide one-stop market research to clients and sometimes act on their behalf in the market as intermediaries. In addition, institutional demand prompted traditional investment consultants to enhance advisory services to include private equity.

Over the years, these resources have supplied American institutions of all types and sizes with the tools and vehicles required to become active participants in the private equity market. Taken together, these tools comprised the infrastructure needed to cost-effectively launch and maintain programs. The consequence of a growing American industry of private equity-specific advisors and resources was, in time, greater and more diversified institutional participation.

The role of external agents is to keep clients informed on an ever-larger population of American and global product offerings, to facilitate introductions, and to help access reliable market and performance data so clients can evaluate funds and benchmark returns. Surveyed institutions confirmed the broad availability of market intelligence for these purposes, through such firms as Cambridge Associates and Thomson Venture Economics.

Funds-Of-Funds are Useful, Especially to Smaller Institutions

Survey respondents in American institutions acknowledged funds-of-funds as a valuable resource, given their ability to pool assets, house expertise, screen opportunities and select top-tier GPs. Though always evolving in design, the fund-of-funds model has two essential varieties: the commingled and the captive fund-of-funds.

Institutional managers said that commingled funds-of-funds, which pool the assets of multiple investors, have proved especially useful to small and medium-sized institutions, for which private equity may otherwise be too costly.

For smaller institutions wishing to undertake a program, this vehicle (along with other market innovations) contributes to "relative capacity" (i.e., available staff with skill sets, along with complementary resources, in this case located externally). Doubtless, funds-of-funds partly explain why even American institutions with assets of $1 billon or less have managed to create some significant private equity exposure (see Figure V).

The captive funds-of-funds — or pools based on the assets of a single investor — may be more appealing to large institutions, such as the California Public Employees Retirement System and Oregon Public Employees Retirement Fund, for strategic reasons, such as extending the reach of institutions into a wider network of GPs and private equity funds.

As a result, funds-of-funds have become a crucial fixture on the private equity landscape. According to Private Equity Analyst, there are now close to 125 active fund-of-funds worldwide, the bulk of them in the U.S. Most were formed between 1994 and 2003, when over $US70 billion was raised, chiefly from increasing numbers of American pension funds, endowments and other investors entering the market, or from expanding existing programs.

Misalignment of GP–LP Interests Continues, but the Situation is Better

American institutional managers agreed that they are often at odds with GPs when negotiating and administering private equity fund agreements. In these situations, the financial interests of institutional LPs are seen as being misaligned with those of GPs. Items of contention can include management fees charged, carried interest, operating expenses, claw-backs, distribution practices, key man provisions and co-investment rights.

However, it is interesting to note that American institutions have often sought to participate in private equity funds with first quartile historical performance, despite the fact that many of these funds generally have the highest management fees and the highest carried interest.

Surveyed institutions also observed that perspectives on key terms tend to shift with market cycles, particularly with fund-raising cycles. At the moment, they attest to a fairly congenial environment in the U.S. When GP–LP relations are less harmonious, American institutions have not been shy about flexing their growing market muscle. For instance, in the 1990s, public sector pension funds and other investors fought for — and won — greater alignment of partnership interests on such priority issues as GP equity stakes, sharing of fee income and preferred returns (or hurdle rates).

Private Equity Opportunities in Canada are not Sufficiently Distinct

In recent years, there has been unprecedented growth in the flow of capital from American private equity funds into Canadian companies. This has occurred mainly as a result of American buyout and venture funds discovering opportunities in Canada, particularly in the telecommunications sector in 2000 and 2001. While the flow has ebbed with the post-bubble decline in private equity activity, it nevertheless raises the question as to whether American institutions might eventually commit more capital to funds in the Canadian industry.

The survey did not find this to be the case, at least among managers representing top American institutions. Generally speaking, they see Canadian private equity in the context of a fairly uniform North American market. In other words, Canadian investment opportunities are not perceived as being significantly distinct from those in the United States. Canada is therefore seen as an extension of the American market rather than as a distinct geographic region with unique opportunities.

In practice, this means that American pension funds, endowments and fund-of-funds are unlikely to pursue diversification in Canada, at least in the same way they might in Europe or Asia. Instead, they will simply directly compare Canadian fund offerings with those available in the United States. Unless Canadian fund managers can articulate a clear competitive advantage, or demonstrate top tier performance, they will probably not be able to attract much American institutional attention.

American Institutional Investors Want Access to Top-Tier Funds

Most American institutional managers believe the American private equity funds in which they already participate can ensure access to premium transactions located in Canada. However, the survey also found that responding American institutions were aware of a few Canadian buyout, mezzanine and venture funds with very experienced GPs and solid track records. They are also open to information about others with similar credentials, particularly in the buyout sector.

Of the 20 American pension, endowment and fund-of-funds managers surveyed, one quarter have committed capital to at least one Canadian fund. An additional dozen have met with one or more Canadian management teams to discuss their fund proposals, though several indicated Canadian fund managers rarely approach them.

In a larger universe of American institutions — and particularly in one that includes small and medium-sized entities — the proportion with at least a single commitment to a Canadian fund would be dramatically lower. Furthermore, American survey respondents were selected in part because of their known link with, or disposition towards, private equity in Canada. Therefore it is likely that the interviews greatly overstate American institutions' knowledge of and interest in the Canadian industry.

Very recently, some Canadian GPs have sparked the interest of American institutions through joint fund-raising with American GPs. In this and related strategies, private equity professionals on both sides of the border are able to tap into a deeper reservoir of institutional money. For this reason, this approach could bear more fruit in the future.

Canadian Law May Have a Deleterious Impact on American Institutional Activity

Because of substantial differences in national tax and legal frameworks, American institutions (and other foreign investors) face barriers — both real and perceived — when actively considering participation in private equity funds based in Canada. Some of these barriers can effectively "disqualify" certain types of American investors from participating in Canadian funds, while others are merely inconvenient, and can be addressed through more complex legal structures.

One example of a serious issue is the lack of recognition of limited liability corporations (LLCs) under the Canada–United States Income Tax Convention. In particular, diverse American fund structures often have significant LLC partners, and the lack of treaty relief for these can preclude American exposure to Canadian opportunities.

Another issue that causes some American institutions to avoid Canadian funds is the stricture to file a Canadian tax return, even where no taxes are payable. While this may appear to be just an inconvenience, in fact, it is increasingly common for global funds-of-funds to require that each of their investee funds guarantee there will be no foreign tax filing obligation resulting from a commitment. As these often involve charter requirements, American institutions or their agents may not be able to even consider a Canadian private equity fund in which there are tax consequences.

In addition, there is some uncertainty in the foreign investor community about whether "passive" activity in a Canadian limited partnership involves "carrying on a business," thereby triggering income tax liability in Canada. This issue has been partially addressed by Canadian government policies, but remains somewhat uncertain. Another issue that can increase costs for Canadian funds is the general need to create a separate legal structure for non-resident investors.

Survey respondents in the U.S. were aware of some of these issues and while they did not view tax and other legal hurdles as a primary concern, only a few have in fact had direct experience with a Canadian private equity fund.

By their nature, most of the potential problems arising from these legal issues do not appear in advance, but only with actual experience. When they do appear, unforeseen tax penalties, or the costs of avoiding these, may persuade American institutions to go with less troublesome alternatives in their own country or overseas. There is significant anecdotal evidence of cases where "mere inconveniences," such as delays in their ability to sell shares in a declining market, have cost American investors substantial amounts of money.

What Do American Survey Responses Tell Us?

The interviews confirmed that, after almost two decades of market activity and of "learning by doing," top American institutional investors pursue private equity with even more vigour today. Themes emerging from the survey speak to this finding in the following ways.

• American institutional managers have developed confidence in the ability of the asset class to deliver superior returns over the long term, but patience must be observed.
• American institutions overcame private equity-related barriers by acquiring market expertise and by forging key external relationships.
• Diverse American institutions made a home in private equity through use of specialty advisors and agents, such as gatekeepers, as well as of funds-of-funds and other resources that facilitated their continuous participation.
• GP–LP conflict can ensue over private equity partnership issues, but American institutions have made advances on key terms and conditions.
• American institutions tend to see Canadian private equity funds as an extension of the American market, but they want access to top-tier funds, wherever these may be located.
• Canadian law is not viewed as a major impediment where attractive opportunities exist, but relatively few have tested the regulatory environment by committing to a Canadian private equity fund.