Finding the Key: Canadian Institutional Investors and Private Equity

5. Canadian Institutional Investors and Private Equity

This section reports on the Canadian responses to the survey and puts the results into the context of the American perspective documented in Section 4.

As in the U.S., the Canadian institutional path to undertaking private equity was initially cleared by lawmakers. In the 1980s, regulatory frameworks of pension funds were gradually revised by governments — beginning in Ontario, with the Pension Benefits Act — to account for the "prudent person" rule.

Until then, the private equity limited partnership model was already in use in Canada, albeit by a small number of fund managers. However, government actions had the effect of stimulating some market exposure among Canadian institutions and, above all, among corporate and public sector pensions.

This early experience was not a happy one. In the mid-1980s, many pensions and insurance companies made major commitments, primarily to Canadian venture funds. Activity peaked in 1987, but plunged thereafter, as the market slowed. At the same time, however, the institutional link to private equity was all but severed, as some GPs and LPs fell into disputes over returns and partnership terms. This situation, compounded by the fact that many institutions entered the market too late to benefit from the prior boom cycle, caused many to quit the asset class altogether (see Falconer, 1999).

This event was damaging for both the nation's institutional community and its private equity industry. Indeed, many battle-scared institutional managers have since been unwilling to reconsider the asset class, irrespective of industry evolution, inside or outside Canadian borders.

In the 1990s, the market role of Canadian institutions was renewed, led by a handful of large public sector pension funds. During this period, the latter emulated Americans by developing private equity programs that were broadly diversified by market focus and by geography, even including international exposure.

Trends over the course of the 1980s and 1990s illuminate the findings of Greenwich Associates in Figure III (Section 3). Because many entered or re-entered the market in the past decade, public sector pensions now lead other institutions in Canada in overall asset exposure. By contrast, many previously active corporate pensions have elected to steer clear of private equity.

FIGURE VII
Canada's Largest Institutional Funds in Private Equity, 2003

Name	Total Assets	Market Focus	Target (%, Assets)
* Investment managers of multiple pension plans and other fund types.
CDP Capital*	$129.6 billion	All private equity	11%
Manulife Financial	$73.9 billion	All private equity	N/A
Ontario Teachers Pension Plan	$68 billion	All private equity	10%
CPP Investment Board	$62 billion	All private equity	10%
British Columbia Investment Management Corporation*	$60 billion	All private equity	5%
Ontario Municipal Employees Retirement System	$34 billion	All private equity	7.5%
Alberta Revenue*	$33 billion	All private equity	4%
Hospitals of Ontario Pension Plan	$17 billion	All private equity	N/A
BIMCOR	$12 billion	Venture capital	3%
New Brunswick Investment Management Corporation*	$5.8 billion	All private equity	3%

Figure VII highlights the 10 largest Canadian institutions with active programs in 2003. It is interesting to note that of the top six institutions by size, four have professional management teams in-house and deploy a significant share of their private equity allocation through direct investments in businesses.

This practice appears to be unique to Canadian institutions, as most large American institutions participate in the market chiefly through limited partnerships. The preference of some large Canadian institutions for some direct activity may well have inadvertently slowed the rate at which supporting infrastructure (discussed in Section 3) has evolved in Canada, as market veterans have not yet created the same demand for comparable resources.

5.1 Profile of Survey Responses in Canada

To shed light on the patterns noted above, the survey targeted 94 Canadian institutional investors, 74 of which (79%) agreed to an interview. The final sample is a blend of corporate and public sector pensions, insurance companies, endowments and other investment funds based in all regions of the country. It is important to remember that, as discussed in Section 2.1 (Research Methodology), this sample is biased towards larger institutions and those active or interested in private equity. In addition, interviews were obtained with this country's investment consulting firms and fund-of- funds managers.

Canadian institutional managers were asked about their attitudes and perceptions concerning private equity (see Appendix II). Selected statistical findings of the Canadian survey are summarized in Figure VIII. Here are some of the major findings.

• Sixty-one percent of all institutions surveyed had active private equity programs in 2003.
• The market participation of Canadian institutions has grown very recently, as 31% of those with programs (or 14 institutions in all) launched these in 2000 or 2003.
• Four institutions have plans to launch new programs soon. Among the largest is the $8.5 billion PSP Investment Board, which had announced plans to create 5% asset exposure.
• With some major exceptions, most large public sector pension funds have private equity programs.
• Over half of corporate pension funds are without active programs and have no plans to establish these in future.
• In 86% of all surveyed institutions without private equity programs, managers, trustees or directors recently considered this option in a formal review of asset allocation policy, but decided against it.

FIGURE VIII
Canadian Institutional Investors and Private Equity: 2003 Survey Overview

	Public Sector Pension Funds	Corporate Pension Funds	Life Insurance Companies	Endowments and Others	Total
* Investment managers of multiple pension plans and other fund types.
Institutions Surveyed	43	21	6	4	74
Institutions with Active Private Equity Programs	32	8	3	2	45
Institutions without Active Private Equity Programs	11	13	3	2	29
Institutions Launching Private Equity Programs	2	2			4
Institutions that Recently Considered Private Equity but Declined	9	11	3	2	25

5.2 Themes Emerging from the Canadian Survey

Lower Values in Public Exchanges Make Private Equity More Attractive

In the 1990s, bullish public equity markets attracted institutional investors in droves around the world. During this period, the survey found that Canadian institutional resources available for all alternative assets, including private equity, were apparently squeezed (a contrasting circumstance was evident in the U.S., where private equity allocations continued to skyrocket). Once public stock values began to fall in 2000, Canadian institutions were encouraged to reconsider these asset classes.

In fact, the survey found that the advent of weaker or more volatile public markets has created an opportunity for many Canadian institutions to become familiar with private equity for the first time. Several of the 14 institutional funds that reported having launched a program over the past four years cited this as an important influence in their decision.

Falling public stock values also affected the programs of those already established in private equity. This is apparent in Goldman, Sachs-Russell survey data, which indicate rising asset allocation targets during this period for most institutional categories across North America and particularly in the U.S.

Some Managers Have Limited Knowledge of Private Equity and Little Incentive to Learn

The survey discovered a greater awareness of private equity in Canada's institutional community than has probably existed for some time. According to respondents, this awareness prompted some to recently launch a program. Where this has occurred, internal champions once again proved a key motivating force. As in the U.S., these champions have

tended to be experienced individuals in the ranks of fiduciaries who were prepared to carry proposals forward. Among the 45 surveyed institutions with active private equity programs, 78% acknowledged the importance of internal champions in establishing these programs.

Where programs do not exist, there was also anecdotal evidence of more frequent, and more serious, discussions of private equity during regular reviews of investment policies. In such instances, the survey found a stumbling block remains. Many institutional managers still lack motivation to thoroughly investigate the potential benefits of the asset class that might lead them to proposing a change in direction.

Of the 29 institutions that are not currently market participants, 72% signalled there was no significant pressure being applied to managers by trustees, directors or advisors to change course. Instead, these managers were inclined to "hug the benchmark." Given the orientation toward larger funds in the sample, it is reasonable to assume that this inclination is also prevalent across the majority of smaller institutions in Canada.

It is unlikely that Canadian institutions in this situation will be able to move from awareness of private equity to an informed perspective. The American experience confirms this observation, as a great deal of importance was placed on having highly motivated managers taking steps to access market expertise, resources and relationships.

Venture Capital Will Typically be One Part of a Broader Program

Some Canadian institutions surveyed equate private equity with venture capital and, more specifically, Canadian venture capital. This can be an impediment, in and of itself, to introducing a private equity program. While American institutions had the luxury of building a portfolio of private equity fund commitments in their own market, the Canadian market is not sufficiently developed to offer sufficient diversification on its own.

Furthermore, experienced institutional managers argue that the asset class reflects a much broader market than just venture capital and one that it is international in scope. Within the private equity market are different investment options with their own risk and return characteristics. The managers emphasized that private equity, like any other financial activity, must be diversified to realize optimal returns.

In practice, this means a private equity portfolio should be diversified by market focus (buyout, mezzanine and venture capital), by the number of fund commitments (or direct investments), and by geography. In the opening phase of a newly launched private equity program, Canadian institutions may make their first capital commitments to funds based in the U.S., where extensive supporting infrastructure already exists. Once they are more experienced in the market, they can turn to other locales.

Institutional veterans in private equity argued that most programs should be designed along these lines. In fact, by taking a diversified approach, investors increase their ability to participate soundly and prudently in domestic venture capital. Evidence on both sides of the border backs this conclusion. Among American institutions, the California Public Employees Retirement System, the Colorado Public Employees Retirement System and the State of Wisconsin Investment Board each have broad programs that now focus on viable local activity.

Through diversification, which can yield a rich experience in a broad market sphere, these pension funds have developed the capacity to successfully identify and assess opportunities that suit their returns goals, including those that focus on their "local" market. Some Canadian institutions have also taken this approach, including the British Columbia Investment Management Corporation, CDP Capital and the New Brunswick Investment Management Corporation.

It is Too Difficult to Access the Necessary Market Information

Canadian institutional managers were clear that accurate data are crucial to any decision to enter the market and to evaluating opportunities and monitoring activity once there.

Above all, there is a need for credible performance data, against which they can benchmark private equity investments against other asset classes.

Of the 74 institutions that participated in survey interviews, 42% believed there was a shortage of relevant, market- specific information in Canada, particularly as it pertained to returns performance. Many institutions, and especially those without active programs, reported having difficulty accessing relevant data. The survey found this was also a problem for investment consultants (see below), who often try to locate performance data to help them advise clients. Perhaps as a result, some Canadian institutional managers and consultants concluded that private equity could probably not be accurately measured.

Unfortunately, a large number were unaware that aggregate returns data for Canada's market do exist. Fully half of institutions surveyed were not aware that the CVCA and Réseau Capital had recently released performance benchmarks for buyout, mezzanine and venture capital funds in Canada, based on several years of national industry performance.

The American experience suggests that market intelligence expands with the availability of advisors, agents and other resources specializing in private equity. All of this intelligence is available to Canadian institutions, although they are likely to seek it out only if they have decided to pursue private equity.

Most Made-In-Canada Returns are Unlikely to be Superior

The survey encountered serious doubt in some institutions about the ability to capture superior, risk-adjusted returns in Canada's private equity market. Of the total polled, 38% reflected this point of view. Some institutional managers felt that many funds in the national industry were too new or too young and, hence, still in the process of developing track records. Some pension fiduciaries referred to bad memories of performance in the 1980s, when funds were even younger.

Canadian institutions with extensive market experience took a different view. Survey respondents in this camp argued that private equity must be seen in an international context and returns sought wherever they are optimal. In other words, institutions interested in the asset class should consider a full menu of options — for instance, participation in the American market where long-term, superior returns are well established — and not just focus on a Canadian context.

For institutional veterans, exposure should ultimately include Canada, where the market has evolved in recent years — and certainly since the 1980s — to produce an array of top-tier fund managers in the buyout, mezzanine and venture sectors.

Some pointed to the CVCA-Réseau Capital returns data as increasingly confirming this outlook. As Canadian industry players are diverse in nature, the data show wide dispersion of returns to date. However, the upper quartile, which largely represents the performance of institutionally supplied funds, is competitive across the full spectrum of private equity as compared with the upper quartile of American funds (see Thomson Venture Economics).

For a detailed description of the research methodology behind the CVCA–Réseau Capital database, along with returns data for the period ending December 31, 2002, see Appendix V.

Some Investment Consultants May be Unprepared to Advise on Private Equity

Many institutional managers and trustees in Canada depend on a small group of independent consulting firms for advice on investment decisions. In fact, 23% of the 74 institutions surveyed indicated their reliance on external advisory services of some kind. For this reason, consultant views, and their knowledge of private equity, are vital.

Canadian consulting professionals noted that very few of their clients are currently active in private equity or have plans to do so. When policy reviews take place, they have tried to provide data that speak to the viability of the asset class as an alternative to public market securities. However, some noted that they are unlikely to recommend such investment where clients have not already expressed a strong interest.

For this reason, several consultants believe that change must first occur inside Canadian institutions. Respondents in some institutions suggested that they have received negative advice on private equity from some consultants.

Some consultants were frank about lacking the in-house expertise and resources to guide institutions on this topic. Several were also sceptical about American and Canadian sources of performance data. Consequently, client discussions tend to focus on barriers to market entry, as opposed to strategies for overcoming them. Interestingly, multi-national consulting firms, which generally advocate this asset class in the U.S., often advise against it with their Canadian clients, although it is unclear why this should be so, given their status as professional experts in pension investment.

The Myners report (2001) looked at the British client–advisor relationship, noting a certain "inertia" that can obstruct informed decisions about investments, including private equity. Myners recommended that fiduciaries interested in the market should only seek direction that is clearly grounded in specialist knowledge.

The Smaller the Institution, the Less Likely It Will Embrace Private Equity

As Figure III in Section 2 revealed, Canadian institutional activity in private equity drops precipitously below $5 billon in total assets. This points to the issue of "relative capacity," as many small and medium-sized institutions generally do not have adequate personnel to handle a program that demands time, resources and skills.

Canadian survey sample data shed light on this circumstance. On average, institutions of $5 billion-plus had 50 investment managers, while those with less than $5 billion on average had five investment professionals. Moreover, as was noted in Section 2.1 (Research Methodology), institutional fund size even had a bearing on the survey's response rate, as smaller entities were less likely to agree to participate in interviews.

Participating institutional managers gave some priority to this issue. For instance, at least one-fifth of all respondents felt challenged in undertaking private equity due to limited in-house resources. In addition, 34% of key informants that reported having recently considered private equity, but declined, cited "size" of their organization as a primary concern.

Problems of "relative capacity" are likely to be particularly relevant to endowments and foundations, which typically have a relatively small asset base, and to smaller institutions headquartered in Canadian regions. Even some larger institutions encounter this dilemma, such as corporate pension funds that outsource a substantial portion of investment management.

By contrast, many American institutions that have less than $5 billon in assets also have private equity exposure, which suggests the importance of market infrastructure. As discussed in American survey responses (Section 4), commingled funds-of-funds (see below) and other kinds of external support (such as U.S.-style gatekeepers) can offer a cost-effective solution to smaller institutions.

Canadian institutions interested in private equity can currently access American infrastructure by investing in an American-based fund-of-funds, although for the most part, they do not. As more resources are developed in Canada to support those wishing to participate in the market, they may also be able to turn to these funds-of-funds.

Funds-Of-Funds Can Facilitate Market Entry, but May Have Some Downsides

In 2002, the first fund-of-funds vehicles were launched in Canada. TD Capital Private Equity Investors was created primarily to give mid-sized Canadian institutions an opportunity to pool their capital and together gain access to top-tier private equity funds in North America and Europe. Two other funds-of-funds — Edgestone Venture Capital Fund of Funds and Kensington Fund of Funds — were subsequently established, both of which are closer to the captive variety.

The lower rate of Canadian institutional activity in private equity in past years no doubt limited the interest of U.S.-based funds-of-funds in marketing in this country, and probably delayed the introduction of comparable Canadian-based vehicles. The decision of several of the larger institutions to hire their own private equity professionals and invest directly also probably extended this delay by eliminating some of the larger investors that might contribute to critical mass.

Regardless, the introduction of the fund-of-funds model to Canadian private equity is significant. A key piece of developing Canadian infrastructure, the fund-of-funds addresses market inefficiencies, both as a pooling vehicle and as a way of taking management-intensive duties out of the investor's hands. As the American experience has demonstrated, this tool is appealing to diverse institutions, particularly those that are small, regionally based, and with low-cost operations.

Fund-of-funds vehicles also attract new market entrants effectively. This may give them special significance in Canada. The majority of survey responses agreed that funds-of-funds can effectively facilitate private equity activity. This being said, one-third did not know about the first-time inception of made-in-Canada funds-of-funds last year. Three of the four institutions that disclosed plans to soon launch private equity programs indicated they might use funds-of-funds in Canada or the U.S.

On the other hand, some institutional managers argued that there were potential downsides to funds-of-funds, such as excessive fees, staffing and overhead, which might offset whatever value they may offer.

GP And LP Interests Are Frequently Misaligned

Like their American counterparts, Canadian institutional managers flagged the potential for misalignment between GP and LP interests in private equity funds. Sometimes, this has resulted in conflict and protracted negotiations as funds are established, as well as during their administration and wind-up.

The survey found Canadians raising the same issues as Americans (see Section 3 for examples), with a particular focus on management fees. However, as previously noted, the funds providing the best returns in the U.S. tend to have the highest fees and carried interest, so partnership terms will not always be an overriding variable.

Of the 74 institutions that participated in survey interviews, 27% identified disputes between GPs and LPs as a major challenge to private equity activity. Most feedback came from institutions currently in the market or those with past experience. The latter group spoke of severe disputes in the late 1980s, when pension manager relationships with Canadian GPs deteriorated swiftly over a range of partnership concerns. This experience contributed to the "long memory" of many fiduciaries when it came to reconsidering this asset class later on.

By all accounts, the American (and Canadian) institutional demands of GPs in the past decade have resulted in more transparent, and better aligned, partnerships practices across North America. In fact, many of today's standard partnership terms and conditions — often viewed as "best practices" in private equity circles —were originally put forward by institutions.

Industry Valuation Practices are Seen as Being Inconsistent

Some Canadian institutions were frustrated by a perceived inconsistency in how private equity funds value their unrealized portfolio assets. They argued that valuation practices varied widely from fund to fund and that, in some cases, practices lack clarity and transparency. As valuations are linked to interim performance outcomes, this is a major concern. Interestingly, while valuations are the subject of on-going discussion in the U.S., institutions have not forced the industry to adopt valuation guidelines. The focus has been, and continues to be, on cash-on-cash returns.

The CVCA and Réseau Capital recently acknowledged the importance of establishing clear industry standards in Canada, within the context of more consistent and precise global standards. To this end, they are currently working with relevant groups, including the International Limited Partner Association. In the interim, the CVCA and Réseau Capital are urging their members to adopt valuation guidelines published by the European Venture Capital Association, allowing for some adjustments relevant to industry practices specific to this country.

Near-Term Liabilities Restrict the Investment Freedom of Corporate Pensions

Data provided by both Greenwich and by Goldman, Sachs-Russell (see Figures III and IV, Section 3) attest to the leading position assumed by American corporate pension funds in private equity. Indeed, the actual and targeted asset allocations of American corporate pensions to the market have long surpassed those of American public sector pensions.

The situation is very different in Canada, where corporate pension funds are much less active. The survey confirmed this, as 40% of the corporate pension managers invited to participate in an interview declined, primarily due to a lack of interest in private equity. Of those that did agree to an interview, over half were without programs.

According to survey respondents in corporate funds, private equity's illiquid nature presents a hurdle. Some of these funds are quite mature and have many more retired plan beneficiaries than active plan members. A good example is seen in one of this country's largest plans, CN Railways Pension, which currently has 45,000 beneficiaries and 20,000 active members in Canada.

Consequently, liquidity is a concern, as these funds must meet very substantial liabilities in the near term. However, given that many corporate pension funds in the U.S. face the same challenge, but solidly embrace private equity nonetheless, liquidity cannot be the sole determining factor for those based in Canada.

Another factor is the impact of a negative market experience in the 1980s. The survey discovered that this experience continues to shape perceptions of private equity among Canadian corporate pension managers.

It is likely that these two variables, when further complicated by those applicable to all Canadian institutions, explain much of the reluctance expressed by corporate funds.

Government Regulations Pose Some Limitations

Most survey responses did not give top priority to tax or government regulations in decisions concerning the market participation of institutions. However, problems related to the tax treatment of private equity partnerships as foreign content were cited most frequently. Under the current rules, Canadian institutions are effectively discouraged from investing in Canadian private equity fund partnerships as they are treated as foreign property for tax purposes. This result flows from the standard commercial terms applicable to a fund that typically does not meet the technical requirements of "Qualified Limited Partnerships" (QLPs).

Three-quarters of institutions surveyed were generally aware and supportive of promises made by federal authorities to address some of these problems through amendments to the QLP rules. Most commentary on foreign property, QLPs and other tax issues came from pension funds with deep roots in the market, suggesting that other respondents might have brought them up if they had programs or more extensive experience.

Life insurers raised regulatory issues as a major concern. Capital adequacy rules from the Office of the Superintendent of Financial Institutions (OSFI) specify capital set-asides that are far greater for private equity relative to private debt. The effect of OSFI rules is to inhibit market entry or continuous exposure to private equity. This situation also explains in part why insurance companies with active private equity programs tend to prefer mezzanine investments. Life insurance managers also mentioned forthcoming international standards (Basle 2) that they believe may impose further reserve requirements on their activity in the asset class.

What Do Canadian Survey Responses Tell Us?

The interviews confirmed that while more Canadian institutions may be expressing an interest in private equity, very substantial challenges remain to achieving participation at American levels. Themes emerging from the survey speak to this finding in the following ways.

• Declining public market values and a somewhat greater awareness of private equity has encouraged some Canadian institutions to consider, or reconsider, participation in the private equity market.
• However, many institutional managers in Canada still have a low level of awareness of and knowledge about private equity, in large part because they do not feel any particular motivation to investigate its potential benefits.
• Many Canadian institutions see private equity activity in a strictly "Canadian" context and, in so doing, may neglect the advantages of broader diversification, including American exposure.
• Many institutions and their advisors see the lack of data as being relevant to decisions concerning private equity. Relevant to this point is the fact that many respondents were unaware of returns performance data in both Canada and the U.S.
• Some external consultants may not possess adequate knowledge, information or other in-house resources with which to effectively advise fiduciary clients on private equity activity.
• Small and medium-sized institutions in Canada (as well as some large institutions) do not have the "relative capacity" to undertake private equity programs and consequently require new forms of external support if this is to occur.
• Made-in-Canada funds-of-funds and other examples of emerging infrastructure in Canada offer key sources of market leverage to institutions of different types, sizes and location across the country. Institutions can already avail themselves of the highly advanced infrastructure in the U.S.
• To attract more institutional investment, the Canadian private equity industry must observe best practices with regard to limited partnership agreements and valuation policies.
• Government regulations are not seen as onerous burden on institutional activity in private equity, but the regulations should be improved to make it easier to enter the market, both in Canada and outside of it.
• The private equity exposure of insurance companies appears to be restricted by the capital adequacy rules imposed by government regulation.