The role of private equity as an effective and proven provider of returns for institutional investor portfolios has become increasingly apparent in today’s economic climate, says private equity veteran Edi Truell, recently appointed chairman of local government pension scheme London Pensions Fund Authority (LPFA).
He says, “I am a great believer in private equity, and it has shown it has the potential to produce exceptional returns.
“Private equity really does have a role, particularly for long-term portfolios. This has become clear in recent years. The illiquidity premium for private equity should produce four to six per cent per annum better returns – net-net – than a public equity portfolio.”
That being said, Truell is particularly outspoken as to where he feels the industry needs to go to improve and ensure that it remains a successful asset class, for both LPs and GPs.
He says, “In today’s market, I feel that GPs have got to completely change their way of operating – away from the 2 and 20 fund model. As an LP, we are just no longer prepared to pay what can often equate to a ten per cent per annum management fee on the actual amount invested.
Truell adds, “I don’t think LPs can afford this any more, and it is increasingly an issue of fiduciary duty.”
Having previously operated within private equity as a fund manager – as founder and former CEO of UK mid-market private equity firm Duke Street – he says he is eager to work with GPs in a more “collaborative” way. In order to ensure this, scale is important prerequisite, as without the necessary size, value-add areas such as co-investments are often not an option.
“Unless you can put up £30m or £50m for a particular deal, and effectively assess the co-investment opportunity in good time, then it is not going to be something that your GPs will feel they can bring to you,” he says.
“[At the right size] you can also negotiate a fee structure that is more closely aligned with your activities. The issues are not all about fees, but it is just one area where size as an LP can bring with it a more efficient and effective means of operating.”
Discussions have moved on as GPs become more open to co-investments with their LPs. However, there is a “deficit” on the part of the LPs, he says, many of whom may not have the mechanisms in place to follow on with these kinds of transactions. “You have to be quite sophisticated and very responsive; and there are very few who are able to operate in this way,” he adds.
And while certain LPs are clearly able to operate across the spectrum of investment activities – and reap the benefits along the way, private equity simply may not be appropriate for those institutions that need to maintain a level of liquidity.
“Certain insurance companies need to be able to liquidate their assets swiftly, so are not well suited to the lifespan of a private equity fund,” he adds. “However, for others, it is a perfect fit. It should be front and centre for pension funds and life insurers.”
An industry fragments
The private equity industry is currently undergoing a fragmentation, Truell says, as sectors and investors develop. Infrastructure offers an immediate example. “Here we can see it break up into clean energy, housing, transport and a number of quite specific sub-sectors, with their own particular characteristics. There is a reasonable concentration into more areas, which is what is needed,” he says. “There is the potential to deploy billions of pounds in a sector such as energy, but there are still only a limited number of specialist managers suitable to invest with. This is changing.”
As a result, many LPs – Truell included – favour dedicated, sector-specific funds, reflecting this increased fragmentation and subsequent need for specialisation.
“I much prefer to invest with a real specialist than a broad brush fund,” he says. “There is a de-conglomeratisation of private equity – from straight buyout funds we then saw geographic specialists, then sector specialists, and if anything we’re now seeing sub-sector specialists. This expertise should be of value, particularly as LPs look to drill down in greater detail and better understand their portfolio.”
This greater complexity, alongside discussions over topics such as co-investments, further illustrates the growing need for the LP to be increasingly clued-in as to the opportunities on offer. “There has been an uplift in LP capabilities and correspondingly many GPs have responded to what their customers want. Those that haven’t, I suspect, are doomed, ultimately,” Truell says.
This in turn leads to a drive towards the professionalisation of LPs, in particular the issue of appropriate pay, especially those operating within public institutions.
“There is a tension there and we’re starting to run LPFA in a private-sector way. We are lucky in that we have people in the team who are very good and stand up against the best of the private sector,” he adds.
“We are somewhat hamstrung by some ridiculous policy about paying people properly. It is mad, as we have billions of pounds to invest and, for the sake of a tiny fraction of that, you can’t employ who you need to employ to get the best results.”
In terms of wider industry challenges, regulation unsurprisingly looms its head as the most pressing threat to the health of private markets investment. In Europe, in particular, Truell bemoans “some remarkably stupid things coming out of Brussels”.
He says, “The rules such as Solvency II could materially impact the ability of insurers to invest in private equity. I then see the same body, IORP [Institutions for Occupational Retirement Provision], having considerable impact, despite having no idea what makes a good investment and setting the rules as to how capital is allocated. It is dangerous.”
Amid this wider regulatory challenge, Truell maintains that GPs still have some way to go on the road to ensuring a sustainable industry and satisfactory relationships with investors.
Sign of the times
Intending to offer greater access to infrastructure investments for UK institutional investors, the launch earlier this year of the dedicated Pensions Infrastructure Platform (PIP) provides something of a forecast for the future of the UK pension fund industry. The landmark agreement saw ten institutional investors commit £100m to the PIP, including LPFA. The announcement raised wider questions as to the role of UK institutional investors, as well as the broader impact on the UK pension fund space, according to Truell.
“It is really important to understand the economies of scale in this situation,” he says. “The idea of gathering all of London’s public sector pension funds together is long overdue because they are often too small to deploy money effectively.”
For Truell, the programme is a step in the right direction, and one that offers a real glimpse as to the future opportunity for UK institutional investors.
LPFA administers a £4bn pension fund, and while it is one of the largest local government pension schemes in the UK, when compared to many institutional investors across the globe, it is all but dwarfed by some of the larger, full-service investment groups. And scale has shown to have a material impact on the effectiveness of an institution when it comes to investing, particularly in private market assets such as private equity, real estate and infrastructure.
“With private equity, an LP might have £350m allocated to buyout funds,” says Truell. “It is a decent size, but you can’t afford to employ a large team focused on this area for this current size and allocation. Whereas with £2bn or more in private equity, you can afford a specialist in-house team that focuses on areas like co-investment and complex areas such as secondaries, which can then work to actively add value.”
He adds, “Infrastructure is a case in point. These projects can frequently range up to billions of pounds in size, therefore you need to have sufficient scale to be able to operate properly.”
And while he welcomes the advent of a programme such as the PIP, Truell also warns of missing the boat on what could be a genuinely transformative step change for UK investors. “The formation of the PIP is a start, but what I would like to see is a £20bn unit, rather than a £2bn unit,” he says. “This applies across asset classes – the same principle applies.”
The prospect of amalgamating pension funds into a consolidated investment unit could seem at first to be an administrative nightmare. In addition, the challenge of streamlining existing commitments and relationships and downsizing the services of various external funds, advisers and gatekeepers, may not be universally welcomed.
Rather than being daunted by such a seemingly overwhelming task, he points to the example of Pension Corporation, a £6bn provider of risk management services to UK defined benefit pension funds, which he founded alongside his brother Danny – another prominent figure in the UK private equity space.
“I have the benefit of coming from Pension Corporation, which we started from absolute scratch some years ago,” he says. Since its launch, Pension Corporation, the umbrella brand for insurance arm Pension Insurance Corporation (PIC) and reinsurance group Pension Security Insurance Corporation (PSIC), has done more than 55 pension deals, establishing itself from a standing start. Truell adds, “Compared to that task, it is certainly not an impossibility to aggregate all these pension funds into one pot, though there have been some kickbacks from a few of these local pension managers who don’t want to upset the status quo.”
As is often the case, Canada’s leading edge institutions set the paradigm for sophisticated institutional investment. Truell offers the example of Borealis, the 160-strong infrastructure investment arm of Canadian pension plan OMERS – which lacks an equivalent in the UK.
“It’s a real powerhouse of a specialist investment manager,” he says. “The Canadian pension plans have put their money behind it and are reaping the rewards.”
Another reason for seeking scale in areas such as infrastructure is that while it is an asset class that has much to offer institutional investors, from an LP perspective, many fund managers appear under-resourced and unsuitable for investment. He says, “Many lack track record and credibility – operationally, as well as financially. They might be financially savvy, but they will have a shortfall when it comes to operational expertise.
Building value
“They tend to come from a securitisation background as opposed to being long-term investors. They might be used to packaging up PFI deals, securitising them and selling portions of bonds off to people. They didn’t always care what happened once it had been packaged up and re-sold.
“I haven’t found that many people, nor a really good team, that are looking to invest for the long term, with an understanding that an asset may have a 25-year lifespan, if not greater. I want to see [infrastructure firms] who can build value over 25 years, rather than just sell bonds on the basis of some spurious rating.”
Truell adds, “This is what I feel is lacking, in the UK at least. What I like about the Dutch and Canadian pension funds is that they have operational people in house and can do their own due diligence and challenge the assumptions made by the promoters.
“I do not feel it is an unrealistic expectation and see no reason why you could not put these things together.
“I have a tendency to think big, as with PIC – why could we not be a £20bn pension insurer? Equally with the London Pension Fund Authority, I see no reason why one body could not run all of London’s pension funds.”
“I know we can save the taxpayer something like £200m in London alone if we amalgamate these schemes and run them properly,” says Truell, pointing only to potential cost savings around the streamlining of its administrative operations.
He adds, “This is not taking into account the improved investment approach and economies of scale that could come with deploying serious amounts of money into areas such as infrastructure and private equity. It is very straightforward when you look at it like that. It is simply a function of harnessing the right political drive and then acting on it.”
One of the challenges is that within many institutions, both public and private, the investment side is often not well understood – with issues such as overall liabilities not even considered. “The liabilities of a pension fund might have gone up £1bn because of a fall in interest rates, but many people in our industry don’t fully appreciate the issues facing them. It is not so black and white.”
As a result, institutions are finding they have to re-examine their entire investment strategy. It is this re-assessment that has seen many investors alighting on areas such as infrastructure as potentially providing the answer to their long-term capital quandaries. The challenge arises when LPs seek to assess and analyse funds or projects in areas such as infrastructure, that in practice differ widely from more established and familiar private equity opportunities, says Truell.
“I think infrastructure must be viewed as a different asset class in this respect. It does not necessarily offer the same pool of managers as private equity, and we have seen certain institutions finding success with direct investments, providing they have the right amount of expertise in their team.”
There have been high-profile successes, with private equity GPs packaging up infrastructure deals and making good money out of them, notably with the privatisation of UK railways.
“Much of the UK private equity industry did extremely well out of railways,” he says. “They took it over and sorted it out operationally, then sold it on. This is not a 25-year investment though, with all the associated risks around construction and long-term management. I’m not knocking it, I don’t mind making a 35 per cent IRR, but these days you are not going to deploy a significant amount of money this way.”
Warning to GPs
“I think GPs have to go a lot further,” he says. “There still seems to be a reluctance for GPs to address some of the cute deals they may have done – it might be investee company fees or deal fees. I don’t want to dwell on fees, but I do feel it is symptomatic of wider issues in the relationship between these two groups.
“Please let us know what you are doing and why, it should not be up to us to ask.
“I’ve seen a strong correlation between underperforming GPs and delusional valuations of their portfolio companies, and sometimes almost a concealment of those areas that are not doing so well. It just destroys trust between the LP and the GP.
“What to do about it? I think there are going to be a lot more no-fault divorce clauses and I know some LPs that simply will not subscribe without one. This approach of taking money and not being forthcoming with information is coming to a very rapid end,” he says.
Truell also sounds a warning as to the harsh reality of the industry’s development in recent years.
“I’m not sure we have actually moved forward as much as the industry likes to think it has. Some GPs, for example, have reverted from quarterly reporting to semi-annual reporting. A lot more transparency between the parties is required.”
The fault does not rest purely with the general partner, he insists, and it again comes back to the need for limited partners to continue to improve their operations and understanding.
He adds, “It does require more involvement from the LP, and I think in the future this should be how things are done. It does help distinguish the good GPs from the poor GPs. The good ones are very happy for their LPs to be involved and know what is going on. LPs now have that capability, and in many cases their eyes have been opened.
“It’s no longer the case that LPs are happy to sit back and let their managers get on with it as long as the returns are coming in. I need to understand why the returns are good – what did they get right and what did they get wrong?
“Sometimes you just get lucky, and I’d like to know if that’s the case. If you get lucky repeatedly, then that’s an advantage in itself,” he adds.
The prospect of the UK’s LP community gaining scale and further sophistication clearly offers something of a boost to a private equity industry still in recovery, though also offers a telling warning for GPs to make sure they come up to scratch.
This article first appeared in Limited Partner, the quarterly magazine focused on providing the institutional investor perspective on private equity.
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