A comprehensive PE education
Hugh Wheelan finds that European pension funds are at different stages along the private equity learning curve
Exposure to an asset class such as private equity demands a
comprehensive approach from pension funds, but those schemes getting it right are reaping the rewards.
Tony Watson, manager of the pension fund at Hermes Investment Management, which runs, amongst others, the £30bn (e49.3bn) scheme of BT, the UK’s telecoms giant, comments: “The BT scheme has had private equity investment both directly and in funds for a number of years.”
He points out, though, that while many investors went into private equity in the 1980s, the subsequent market recession of 1991 proved it to be not such a good strategy. However, Watson believes market conditions today demand a more comprehensive look at venture capital. “Given that the returns on market’s generally going forward may be somewhat lower in both nominal and in real terms, there is an interest in getting some premium on returns by investigating other asset classes. BT is such a big scheme – the largest in the country – that it became appropriate for it to define a comprehensive policy on private equity.”
Watson says the BT trustees agreed in the third quarter of last year to establish private equity as a separate sub-set of its equity exposure and approved a programme building an exposure to that. “This exposure is not only in the UK but in other parts of the world in both directly held investments and funds – mostly through limited partnerships. We are in the process of building out that portfolio with a view to adding returns over and above that attainable in the listed equity markets.”
Watson says BT is looking for a 5% premium over the listed equity markets on its private equity investment. “The theory is that firstly, the market is less efficient, and secondly, given that the fund can bear the illiquidity involved with investing in private equity it should receive a premium return for that over listed investments.”
Watson says the amounts of money involved mean that in the event of unforeseen contingencies BT would not be looking to the private equity portion as a source of liquidity. The fund’s target, he says, is to allocate 3% of its total equity exposure to private equity on a 60/40 basis in favour of funds.
“In the past there was no target. The whole effort now is to put together a more comprehensive programme with a performance measurement process which can also measure the investment returns. “The desire is to make the whole portfolio and the performance deriving from it the responsibility of a separate team within Hermes – just as for listed equities, bonds and property.”
Watson says Hermes is fairly open minded as to the private equity investments it makes. “One of the key issues is to guard against one’s fallibility in terms of the cycle.
The only way to manage that is to invest through the cycle and not spend all your money at once.”
Although Watson notes that the requisite team is in place, he adds: “We could use external help if it was needed. Our position, though, is to get in the middle of the deal flow both in terms of funds and direct investments.” He adds that the Post Office pension fund, another of Hermes’ clients, is also in the process of putting together a private equity team.
Arto Sirvio, who runs the e600m investment portfolio for Finnish telecommunications giant Nokia from Geneva, says that although the fund has a minimal private equity exposure at present, it is very much on the agenda. “We have one small portion of domestic private equity in Finland. It represents 0.1% of the portfolio. However, we believe that a long-term pension investor has to have an exposure in this asset class and we are going to do it also in the next two to three years.” Sirvio says the fact that the fund started with a very low equity weighting and only began investing outside Finland for the first time three years ago means the focus is still on building up its listed equity exposure. “We must do that before we start adding exotic products to the portfolio. We are going to increase it but we don’t know what the total will be. It could be up to 5% of the total portfolio.”
Sirvio believes the fund’s most likely route into the market will be via a pan-European vehicle. “Most of the people we talk to about this are domestic players in the Finnish market where there are so many players. The question is, though, whether the deal flow is big enough there that investors will have the free will to decide what chances they pick up. We don’t want to restrict ourselves to a small market. It would be nice to find an umbrella fund that invests in the European-wide private equity market where the deal flow is much bigger.” And he says the Nokia fund would rather go down the funds route than direct private equity route due to the size of its investment team.
Joe Barnes, deputy chief executive at the Sheffield-based CMT Pension Trustee Services, managing £25bn in assets for the coal industry pension funds, says the fund has a 3% strategic allocation to private equity amounting to £807m with 77% of this investment having been placed since 1997. “The fund invests through 37 different investment companies, not funds, through one external manager Cinven, the former in-house venture capital arm of CMT.”
He notes that the mandate is ostensibly discretionary with a few underlying investment factors handed down by the fund trustees. “The trustee investment sub-committee meets with Cinven on a quarterly basis to review the situation.”.
The fund’s objective is a premium of 5% on the FTSE All Share on a rolling five year basis, which Barnes points out is viewed as reward for the risk premium taken.
And performance, he notes, has been strong: “The five-year annualised results come out at 21% on the All Share plus 1%. The results give the All Share plus 5% on the last five rolling periods.” However, Barnes points out that the golden period for performance was five years ago and that at present it will be difficult to achieve such returns.
He predicts that future developments will see the fund raise its allocation from 3–5% giving a total of £1.4bn in private equity.
And his message for the future is
“diversify, diversify, diversify” – noting the diversification options of managers,
vehicles (fund of funds/gatekeepers), stages, geography and types of development of the underlying investments themselves.
He notes a potential problem with this diversification, though – trustee expectations. “If we expand the manager arrangements and have say six to 10, there will be a problem in organising quarterly meetings. There is also the issue of keeping the fund in balance – if we take 2% for private equity it has to come from somewhere, and therefore it becomes difficult to model the balance of the portfolios.”