For all the right reasons
When the French Fonds de Reserve pour les Retraites (FRR) launched a manager selection process for its private equity programme last December, it was embarking on the next stage of an ambitious strategy which may well form a blueprint for other first-time investors in this asset class.
The FRR, a nationwide pension scheme for private sector employees, was created at the end of 2002 as a means of financing the expected funding gap after 2020.
Having awarded 38 mandates to manage its equity and bond portfolio in mid-2004, it has now started the tender process to manage €1.5bn-worth of private equity investments. This will make up just under 6% of its invested assets.
There are four main segments to the planned portfolio, each using funds of funds, which the FRR is obliged to use as its constitution does not allow it to manage investments directly.
Lot 1 (worth a minimum of €450m) will invest in the EU, Switzerland and Norway, concentrating on development and buy-outs. It will include funds of all sizes searching for mid- to large cap transactions, and will include a predominantly technological venture capital allocation. It will access big pan-European funds with big underlying operations.
Lot 2 (€250m) will cover the same geographical area but focus on one or more local markets, using funds searching for small and mid-cap transactions.
Lot 3 (€450m) will cover North America, and as well as development and buy-out equity will include venture with a technological focus.
Lot 4 (€150m) will cover both Europe and North America, giving the FRR potential liquidity through secondary positions in private equity funds diversified in terms of strategy and sector.
Although the FRR is looking for one manager per lot, the two biggest lots may each be split between two managers.
The main reason for using private equity is that it offers a way of diversifying global risk because of its lack of correlation with bonds and public equities, Antoine de Salins, board member, points out.
It also dovetails neatly with the specific features of the FRR’s liabilities.
“We have very long-term investment horizons, which are consistent with the time horizon of investing in private equity,” says Jean-Louis Nakamura, the FFR’s chief investment officer. “We will not pay out any money from the scheme before 2020. So we will not suffer from the J-curve as much as other pension funds. And typically, private equity offers a good liquidity premium, so we can benefit from this without suffering any lack of liquidity.”
FRR, advised by private equity specialists Campbell Lutyens, wanted to set up an initial portfolio as diversified as possible.
De Salins says that two very different methods of determining asset allocation were considered.
“The first was to make arithmetic calculations using expected returns, correlation between segments, and so on,” he says. “However, because of the lack of quality and consistency in the data, we preferred a more pragmatic approach.”
This involved looking at past returns in the context both of the current market, and of the FRR’s own expectations for the following year. The FRR’s long-term technical assumptions for private equity returns led to levels of expected returns which are slightly lower than actual returns claimed by private equity managers.
“For instance, we do not take for granted the historical data on US venture capital, since it has been hugely affected by the bubble at the end of the 1990s,” says Nakamura. “So we decided over the next 10 years to use figures which we deliberately pitched lower than the accepted returns for US venture. The rate of private equity returns are the success of a happy few asset managers. But when you take into account the real average, without the survival bias and so on, the reality is a little less bright.”
These more cautious figures are intended to be broadly consistent with the structural changes which FRR thinks may appear in the private equity market, making it slightly more similar to the public equity market – “with a bit less risk, but also a bit less expected return, as it becomes more efficient,” says Nakamura.
The FRR decline to say what level of internal rate of return they are expecting from their private equity portfolio, but they believe that the asset class will pay for itself in terms of reducing global risk.
The regional asset allocation was then arrived at by reviewing past performance and trying to understand how it is explained by structural features and their stability at the time.
“For instance, while US venture returns relative to European venture have been inflated by the bubble, they have also been favoured by the quality of the IT markets in the US, compared with the European IT markets,” says Nakamura. De Salins adds: “We think that that structural feature will last for a while, so it is unlikely that the gap between returns from US and from European venture will close very quickly.”
Partly because of the competition in accessing good US venture capital funds, FRR will put considerable amounts into European venture. However, it will avoid exposure to the most risky segments – for instance, it will not invest seed money, he notes.
As an institution funded by public contributions, FRR’s highest priority is to maximise returns. This is the aim, for instance, behind the targeting of smaller European companies in lot 2.
“A very strong rationale for investing in these companies is because they are part of the most inefficient markets,” says Nakamura. “Investing in large caps could help us a lot at certain phases of the economic cycle, but on a more permanent basis, we think we can earn more money by financing SMEs offering higher liquidity and information premiums, than for large efficient markets.”
But doing this could achieve a “double dividend” by complementing maximised returns with support for innovation throughout Europe, and beneficial results in terms of ethical, environmental and social considerations. Although SRI is not embedded in FFR’s private equity strategy, it is a cornerstone of its investment philosophy for some traditional assets.
One of the unusual features of the private equity programme - for a first-time investor - is the inclusion of secondary funds.
De Salins says: “Once we start to commit our funds, we will be entering the market at a certain price level – and many people think prices are already high. We do not want to concentrate all our initial purchases at the same price levels. So we will tell our asset manager to take their time in investing the funds, and encourage them to buy secondary funds in order to increase the vintage diversification over time.”
One of the reasons for selecting such a small number of managers is to avoid the risk of an overlapping of investment universes.
“We cannot be 100% sure there is no overlap,” says Nakamura. “But we will try to define the specialised core strategies of each mandate in order to avoid duplication. However, there are some non-core strategies where there is a small possibility that two of our fund of fund managers will compete to enter the same underlying funds. We want to avoid this, and it might be possible to have a procedure for asking one of these managers not to compete.”
There is likely to be a bias in favour of the big managers, at least on lots 1 and 3, as FRR will only award mandates to managers already running portfolios of a similar size.
US private equity managers can tender for mandates without being established in the European Economic Area. But in that case they will have to apply through an applicant entity within the EEA. However, managers can still submit their application before the requisite legal arrangements - for instance, the setting-up of a new subsidiary within the EU - are in place.
Initial applications are being asked for by mid-February, with the assessment process taking up to two months.
Shortlisted candidates will then take part in a technical interview, (“competitive dialogue”), after which FRR will draft the final contract and investing rules. These will be sent to candidates along with a questionnaire, in order for them to submit their final proposal. At this stage, candidates will set out their fee structure for the first time.
It is hoped to award the mandates before the beginning of August, and to start committing money by the end of the year.
“When we start paying money partly depends on the quality of the manager’s access network, but the initial idea is to commit the money over a three to five year period,” says Nakamura. “We should then see it invested on an overlap period of say four years, after which we will start to disinvest. The total length of the programme until complete liquidation will be 12 years.”
This initial programme will probably be followed by others, implemented in a broadly consistent manner, although possibly with more specialised strategies and targets.
FRR hopes to make plans for its second programme at the end of 2006.