Everyone loves cutting out the middle man. So what more tempting target than private equity managers with their massive fees?
The Ontario Teachers’ Pension Plan has blazed a trail. Having built up its own private equity capability – and a strong record of returns on direct buy-outs – it is mulling a jump into the big league. The OTPP is sounding out Providence Equity Partners and Canadian institutions about a pursuit of Bell Canada’s parent BCE, which has a market capitalisation approaching C$30bn. Meanwhile, the Wellcome Trust, the UK’s largest charity, has teamed up with private equity firm Terra Firma to consider a bid for retailer Alliance Boots.
Does this make sense? Yes and no. Seasoned investors in private equity funds such as the OTPP and Wellcome believe they can squeeze extra returns from direct involvement. This, of course, can be true. The route avoids the 2 per cent management fee and 20 per cent of profits third-party managers otherwise cream off.
It must be particularly tempting for the biggest investors in alternative assets. They have money with a number of different private equity managers. Big deals, where managers club together, can magnify a pension fund’s exposure to a single buy-out, while still leaving it on the hook for multiple sets of fees. So judicious co-investments, alongside its preferred managers, allow a pension fund to hang on to more of the benefits.
The equation changes somewhat if pension funds start taking really big, concentrated bets of their own on single transactions. The established private equity funds might be willing partners for such arrangements. They could get access to capital to do large deals, without having to dilute their control too much. For example, Wellcome would presumably take a back seat to more-experienced Terra Firma in the day-to-day oversight of Alliance Boots – in a way that, say, Blackstone would not. But charities or pension funds could find themselves painfully exposed if they leap into oversized positions in single companies at this stage of the cycle.
If institutions are really serious, they should make a long-term commitment to building a private equity team in-house. On that score, the OTPP is ahead of others, and is doing a good job. It has built a strong investment track record through making direct investments in buy-outs of no more than a few billion dollars. That track record might give it the confidence to try something bigger.
Others should, however, take note of the data showing quite how much the best private equity managers outperform their peers. Private Equity Intelligence, for example, has data for 900 buy-out funds around the world. Not only are the top performers pretty consistent. But even the worst funds in the top quartile have outperformed the median by an average of 11 percentage points annually over the past 14 years. The outperformance by private equity’s elite is even starker. It paints a very different picture from the much more tightly grouped performance of long-only equity managers.
Doing-it-yourself is cheaper. But pension funds need to ask themselves if they can produce the same quality as they get (after fees) from the best private equity funds. And if they have the stomach, for example, to work through problems in portfolio companies themselves, if things turn sour. After all, frothy debt markets, low default rates and the economic stability that have fuelled the private equity boom will not last forever.
For most large institutions, cutting their teeth on big buy-outs when private equity has already enjoyed a golden run seems over-aggressive. At least in the short term, they might do better using their scale to try to drive down the private equity industry’s extravagant fee structure – rather than trying to join the party when it is already at its height.