Finding the Key: Canadian Institutional Investors and Private Equity

6. Finding the Key: Conclusions and Recommendations

As stated at the outset of this report, the objective of Finding the Key: Canadian Institutional Investors and Private Equity is to stimulate a national debate about the role of institutional investors in venture capital and other types of private equity.

Section 6 of this report attempts to draw together the findings contained in sections 3, 4 and 5. To inform forthcoming discussions, this section also presents a series of recommendations organized around the main themes emerging from the surveys and supporting data and analysis.

What Does the Research Tell Us?

Various data comparing American and Canadian institutional activity in private equity (Section 3) indicate that American pension funds, endowments and other institutions have embraced the asset class to a far greater degree than have their Canadian counterparts. At present, private equity exposure in the U.S. includes all major institutional types and fund sizes. By contrast, in Canada, only public sector pensions, and funds with assets of $5 billion or more, are similarly engaged in the private equity market.

Consequently, while American institutions have assumed a highly influential role in private equity, both domestically and globally, Canadian institutions occupy a much more moderate position, irrespective of the locale. Interviews with senior managers of American pensions, endowments and funds-of-funds (Section 4) shed light on the reasons why this gap exists.

After more than 20 years of sustained activity, American institutions have developed confidence in the ability of private equity investments to deliver superior returns and diversification benefits over the long term. This occurred through a process of "learning by doing," whereby structural barriers were gradually overcome.

In addition, diverse American institutions have developed infrastructure that enables them to participate in the market, as shown in the range of specialty advisors and agents (such as gatekeepers) and other customized resources that have emerged in recent years. In particular, funds-of-funds have proven useful, especially to smaller investors, given their ability to pool assets, house expertise and select top-tier funds.

In other words, despite the impediments they encountered along the way, American institutional managers found the means to persevere in private equity and obtain the returns they originally sought. The American experience appears to indicate that success lies in finding the right key.

The situation in Canada has evolved differently. Survey respondents in Canada (Section 5) suggested that while there has been some growth in awareness of private equity in the institutional community in recent years — which has, in some cases, prompted market entry — many institutions remain on the sidelines due to real and perceived challenges.

It is clear that some of the attitudes and perceptions expressed by many corporate and public sector pension managers flow directly from a negative experience in the Canadian industry of the 1980s. Regardless, the private equity challenges raised in Canadian interviews as a whole are, by and large, the same as those discussed by American survey respondents in the early days of developing their private equity programs.

Canadian institutional concerns are linked to private market inefficiencies, such as high entry costs, limited availability of information and conflicts engendered by certain opaque industry practices.

Some Canadian institutions, most of which are very large, have overcome these barriers. As in American institutions, Canadian institutions have done this by "learning by doing," by using American-style infrastructure and, in some cases, by setting up in-house programs to invest directly.

However, it seems that many other Canadian institutions (of all types and sizes) view the private equity market within the confines of Canadian borders and have not availed themselves of American opportunities, such as access to supporting infrastructure, that would introduce this asset class into their portfolios.

Changing the Status Quo

This report's introduction noted that the research behind Finding the Key builds on a body of international literature concerning the role of institutions in private equity, including prior reports issued in Canada (e.g., Macdonald, 1987, Falconer, 1999). Like past reports, Finding the Key discovered in Canadian survey responses a range of concerns about the asset class, its market context and the practical ability of institutions to establish related programs.

Indeed, a great many of the issues raised by Canadian institutional managers in the 2003 survey are identical to those raised previously, as in the 1998 PIAC survey which served as the basis for the Falconer report of 1999. This suggests that, for a good number of institutions in Canada, the challenges associated with undertaking private equity have remained largely unchanged with the passage of time or events.

Why is this the case? One compelling explanation is, as noted above, the long shadow cast by an unhappy market experience in the 1980s, as many current institutional managers in Canada are veterans of that period.

Apparently, the major growth and development since then in the Canadian private equity industry (and even more so in the American industry) cannot set aside institutional memories of that history. This may not be surprising if, as the survey also found, a substantial number of Canadian institutional managers also feel no particular pressure to investigate (or re-investigate) the potential benefits of asset exposure.

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 institutions found a home in private equity through a variety of strategic solutions. For many, this was finally achieved after several years of developing "institution-friendly" infrastructure and resources.

The efforts of American institutions ultimately had a transforming impact on the private equity industry itself. Finding an inefficient marketplace, American institutions and their

agents sought to compensate for inefficiencies, always with the motive of obtaining superior returns, diversification and so on. As more institutions embraced the asset class, the American industry adapted to receive them. This process helped to clear a path for even more institutional participation.

A similar process must take place in Canada if private- independent funds — based on the institutionally supplied limited partnership model — are to prosper. However, more Canadian institutions are unlikely to embrace the asset class unless they are confident about the returns promised by a mature industry of GPs with strong track records. To create this confidence, GPs must be able to access capital supply while simultaneously drawing on a reliable base of Canadian entrepreneurial and business management talent that merits the backing of buyout, mezzanine and venture financing.

In other words, the national ecosystem for private equity investment in an array of increasingly competitive, high growth companies in Canada's technology and traditional sectors must continue to grow and evolve.

This ecosystem reflects a wide array of component pieces, including government support for basic research and commercialization, private sector expenditure on R&D, a highly skilled and productive workforce, the availability of high quality graduates in science and engineering, Canadian business sectors that focus on competing in a global economy, a more vibrant angel market, and an increasingly diversified and specialized industry of venture capital and other private equity funds.

Only by making progress in all of these areas can specific efforts to facilitate a greater degree of Canadian institutional activity in private equity be fully justified and rewarded. Only in so doing, can there be movement beyond the status quo.

American and Canadian survey responses indicated that an important first step in moving beyond the status quo was increased communication and education — not just among institutional managers, but among trustees, directors and advisors as well — based on active pursuit of the right market expertise, resources and relationships. 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.

To ensure the broadest possible private equity activity of institutions, irrespective of size, type or regional location, Canadian institutions should also learn from the American experience about the value of market infrastructure: advisors, intermediaries, resources and pooling vehicles, such as funds-of-funds.

Where possible, government tax and other regulatory policies must also be amended or clarified to ensure that Canadian law does not impose unnecessary costs and restrictions on private equity activity.

Finally, experience in both Canada and the U.S. has demonstrated that successful private equity programs must be widely diversified to secure optimal returns. This means diversification by market focus (buyout, mezzanine and venture capital), by number of portfolio investments and by geography.

By following this model, institutions can develop the capacity to participate successfully in the private equity market situated anywhere in the world. The evidence suggests that this preparedness to invest in quality funds regardless of location will, in time, lead to a deeper and more dynamic fund environment in all regions of the country.

An Agenda for Canadian Multi-Stakeholder Discussions

It is recognized that, to an extent, the research contributing to Finding the Key has raised as many questions as it has answered regarding institutional activity in venture capital and other types of private equity. This should not be surprising given the immense size of the topic, as well as its importance to multiple stakeholder groups in Canada.

This fact also points to the validity of a national debate involving senior representatives of Canada's institutional community, the private equity industry, government and other interested parties, in amplifying on report findings, deepening awareness and understanding of related issues, and considering alternative strategies for action.

To help shape an agenda for discussing the subject of institutional investors and private equity, the following are recommendations linked to the primary survey and other research themes.

Communication and Education

1. The CVCA and Réseau Capital should form a closer relationship with PIAC and other industry associations linked to Canada's institutional community to facilitate both increased dialogue and education. The initial goal of this relationship should be to foster an on-going dialogue between institutional and private equity fund managers with a view to further defining and addressing some of the issues raised in this report.
   
   This initiative may include a series of jointly hosted seminars that would involve a cross-section of institutional managers, trustees/directors, investment consultants, private equity professionals and other relevant advisors in major centres across Canada. Seminars would aim to share data about the nature of the successful private equity programs of Canadian and American institutions, as well as a range of strategies (as discussed in Finding the Key) used for overcoming barriers to market entry and long-term participation.
   
   It is believed that this process could play an important role in raising awareness within the Canadian institutional community about private equity and in determining what steps need to be taken to ensure that community members can successfully and permanently introduce this asset class into their portfolios.
2. The CVCA and Réseau Capital should initiate a variety of formal and informal interactions with senior representatives of American institutions, fund-of-funds, gatekeepers and other interested parties concerning the Canadian private equity industry.
   
   Such initiatives would have a two-part focus. One objective would be to broaden the understanding and appreciation of American institutional investors, as well as their agents and advisors, for attractive investment opportunities in Canada. A second objective would be to help educate Canadian private equity professionals about the criteria and procedures used by American institutions when assessing and evaluating Canadian GPs and their fund proposals.
   
   Finally, the CVCA and Réseau Capital should work with officials in relevant federal and provincial government departments and agencies to consider strategic alternatives for further communicating with American institutions about the distinctive strengths of the Canadian private equity industry and its domestic sources of quality investment opportunities. Industry association and government representatives should next discuss how an appropriately crafted message should be delivered.

Government Taxation and Regulation

The CVCA, Réseau Capital and the federal Department of Finance should continue their efforts to achieve tax and regulatory reform on behalf of Canadian entrepreneurs, private equity funds and institutional investors.

These efforts should focus both on issues pertaining to Canadian institutional participation in Canadian limited partnerships (such as foreign content rules and QLPs) and issues pertaining to American and other non-resident institutional participation in these, as well as related concerns. OSFI should also be involved in the dialogue to ensure that current regulations, or forthcoming ones (such as Basle II), do not unnecessarily impede insurance companies from participating in the private equity market.

By engaging in an open and thoughtful national dialogue in all of these respects, it is believed that means can be found to grow 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.