Choosing horses for courses
A decade ago private equity was the vogue investment in the pensions arena. Buoyed by a thriving equity market, the allure of private equity saw pension fund managers often making allocations to the class without taking advice from consultants.
Typical of the trend was the approach of the €12.5bn Canton of Zurich civil servants’ fund (BVK) which made an initial 1% allocation to the class in 1996. Back then, says Daniel Gloor, head of asset management, the “healthy market meant that BVK didn’t feel that outside professional advice was required before going ahead with this investment”.
Responding to this need, niche consultant firms have developed offering advice on the development of private equity allocation and strategy for pension funds willing to venture into this alternative universe. However, pension fund executives hold differing views as to whether the use of third party advice is the optimum way to achieve the extra premium from this class.
BVK believes it is at the point in the private equity learning curve where professional expertise is definitely required when increasing the scheme’s allocation and it opted to use a locally-based specialist consultancy SCM. Says Gloor: “We realised greater professionalism and efficiency was required before increasing our exposure to private equity so we got together with SCM as we wanted diversification in the portfolio beyond buy-outs and venture cap in the US, where the existing 1% was predominantlyinvested.”
But his decision took time. “We had looked at SCM for four years before finally opting to work with them,” says Gloor. He identifies the four main reasons behind the choice of SCM. “They are local, I have known the personnel for some time, they have a good track record and they have an impressive client list,” he says. “There are very few consultancies in Switzerland that can provide the kind of service provided by SCM.”
Following SCM’s advice, BVK is “planning to allocate CHF100bn (€64.3bn) to private equity on an annual basis, the overall aim being to increase our weight in this class to 4% over the next three to four years,” Gloor says. “Originally we wanted to allocate 5% of our assets to private equity but following SCM’s analysis we decided that 4% would suit the scheme’s optimal balance and allow further diversification.”
Pension funds that take matters into their own hands believe that the extra premium from private equity investments can only be gained by doing their own work with individuals dedicated to the sector working in-house. The €1.75bn Suez-Tractebel pension fund in Brussels manages its private equity portfolio in-house. “We spoke only to private equity managers when arranging to increase our allocation to 5% from 1.5% in 2003,” says Olivier Poswick, CIO at the scheme. “No consultants played a part.”
Outlining the rationale behind this policy, Poswick says: “It’s better to understand the class oneself so one can speak directly with managers. A consultant will give you a shortlist of managers to choose from but we have no knowledge of these firms. We want to discuss with managers not only about their processes but also their opinions on the market. It’s impossible to get all the essential information just from looking at a shortlist.”
As might be expected with an allocation on this scale, a careful and rigorous approach to manager selection prevails. Says Poswick: “When managers come to our offices, ready to show us their Powerpoint presentations, I say to them: ‘Let’s forget about the presentation – let’s talk about the market. Then let’s talk about your investment strategy over the past two years or so and your performance over this time.’ We ask them why they played the market in the way they have and what do they consider to be the main change to affect the market in the coming year or two? For instance, do they anticipate being forced to modify their investment philosophy in the coming years in any way?”
The importance of being able to scrutinise potential managers is echoed by the CIO of a major UK defined benefit scheme with over €10bn in assets which has been investing in private equity at an impressive rate since making its first allocation in 1992 and where all private equity investment-related decisions are taken in-house. “Picking a manager is an art not a science and different skill sets are required for choosing different types of managers,” he says. “The most crucial of all considerations is whether they are hungry. Team chemistry has to be good, and we also look at skills within a team to see if they have exceptional individuals working for them. We want to look at their processes and the ways in which they filter their investment options. For example, when looking at buy outs, how do they whittle down their list from 100 companies to the final three or four?”
Currently, his scheme is slightly under its target of a 7% allocation to private equity and the portfolio consists of investments in 40 specific funds, of which mid buy-outs are the most numerous. ”A firm’s reputation for integrity has to be considered as well,” he adds. “Are they people we want to do business with?”
Pension funds with the competence to manage private equity investments in-house must also face the attention of investment managers whose business it is to know the market. Reactions to the direct approach vary.
A portfolio manager at a major industry-wide pension fund in Denmark says in his experience private equity firms “are very aggressive in their drive to capture new business. It is an aspect of the sector we are not happy with, particularly as these are firms that have such a lack of transparency”.
Since the scheme has no plans to raise its present allocation, it’s policy is not to talk to private equity firms, he says. Other pension funds managers take a different approach, wanting to keep abreast of developments at private equity firms even when not planning to alter their portfolio. “It’s always nice to talk to these people as it allows me to develop my knowledge of the sector,” Poswick says. “However, since we do not need any more allocations I cannot discuss anything at length with them.”
The CIO at the major DB scheme in London says the fund is the object of pitches from private equity managers on a frequent basis as its well known within the sector that it has an appetite for the class. “We will only be interested in outside pitches if they fit in with the scheme’s specific private equity focus,” he says. “For example, if a firm proposes investment in a fund focused on mid buy-outs in the Asian IT sector we would not be interested in taking discussions with them any further because those areas do not fall within the parameters of our private equity focus. But if following a pitch we are able to tick all the relevant boxes on our private equity focus criteria it then becomes possible to think seriously about the manager as a future service provider. Indeed we have decided to use some firms as our managers partly because their pitch matched the scheme’s private equity focus.”