Global access: Australian LPs and international PE

When MLC Private Equity examined its travel budget last year, it found that senior team members were spending three-and-a-half out of every 12 months on the road. The group, which is part of National Australia Bank's wealth management division, has 90% of its A$5 billion in assets deployed with overseas managers, so the itineraries were a fair reflection of the underlying interests. But was it a sensible way to allocate resources?

"We have a team of 13 and historically they have all been based in Australia," says John Brakey, MLC's head of private equity. "Now we are putting more people offshore where the activity is. We have hired a head of Europe who will be based in London. We will also hire a head of the Americas to be based in the US, covering North and South America."

Alongside QIC - an investment manager set up by the Queensland government - and sovereign vehicle Future Fund, MLC is an outlier in the Australian superannuation industry. They are relatively mature programs with a strong interest in international private equity and an acceptance of the costs that come with building up of in-house expertise.

After years spent focusing almost exclusively on domestic managers, superannuation funds are increasingly - and more proactively - looking overseas. But at the same time, Australia remains gripped by a crisis of its own making about the fees incurred by pension plans. Private equity is an expensive asset class. While exposure to international managers might offer the potential of higher returns, these must outweigh the associated costs by a satisfactory margin.

Some superannuation funds opt to commit internal resources to private equity with an eye on long-term gains; others have largely or completely retreated from the asset class; and still more have yet to make up their minds.

Divided market

"We will see a split in the super fund industry between those that see themselves as the low end, and they will struggle with traditional private equity, and those who focus on selling net returns and benefits to investors," says Michael Lukin, managing director and global head for private markets investment at Macquarie. "Private equity will be a big part of their alternatives exposure."

According to Ray King, head of Australia private equity at Mercer, cost concerns have made superannuation funds more conservative in the last few years but recently activity have begun to rise again. He estimates that 80% of the capital being deployed in PE is going to managers overseas. And it is coming from a smaller pool of investors writing larger checks, with commitments rising from $10-20 million to $30-50 million at the low end.
Larger fund portfolios are a factor here, as is the degree of consolidation taking place within the superannuation base. But it is also a function of the split Lukin sees in the market.

Few superannuation funds will be able to emulate MLC and QIC in opening offices overseas. Even those two players recognize the risks involved in this approach. By maintaining a small team in a single location, an LP ensures common standards regarding benchmarking and global best practice and a common knowledge of what is happening across the wider portfolio. MLC's Brakey notes that a more disparate team might lose its discipline.

QIC sought to offset this risk by staffing its offices in the US and Europe with staff who possess international experience but were initially hired to work in Australia. The idea, explains Marcus Simpson, group's global head of private equity, was that the QIC investment DNA would have time to spread.

There is also the question of whether offshore programs can be sustained. Some pension plans in Europe built international private equity teams but failed to hang on to them because wages and long-term retention incentives were lower than industry standards. Canada's pension funds have fared better, in part because they are willing to pay competitive salaries. Given the public pressure on costs in Australia, an LP has to be very sure of itself to do the same.

Simpson places QIC at the mid-point between the likes of Canada Pension Plan Investment Board - the latter's asset base is more than twice the size of QIC's and it has a larger internal team - and US pension systems that have only 1-2 people devoted to private equity and are mandated to use outside consultants.

Most Australian superannuation funds would place themselves closer to the US pension systems. QIC and MLC have always invested in overseas private equity, the former forging direct relationships with GPs from the outset while the latter used fund-of-funds until the late 1990s.

AustralianSuper, meanwhile, made its first commitment to domestic private equity in 1995 through co-mingled vehicles run by Industry Funds Management (IFM). International exposure came five years later, with IFM again acting as the intermediary. Around the same time, AustralianSuper began to establish direct relationships with domestic GPs and adopted a similar approach internationally in 2007. Private equity accounts for 4.5% of the fund's A$80 billion overall portfolio and, of that, 40% is deployed overseas. The majority of unfunded commitments are foreign

"We didn't have the resources to invest directly in funds at the beginning so fund-of-funds was the obvious choice, but we now have the resources and scale where we can pursue a direct strategy," says Terry Charalambous, investment manager, equities, AustralianSuper. "It's cheaper and if we execute well it should deliver better returns."

Hamilton Lane advises the fund on its international private equity program and there are currently no plans to replace the arrangement with a larger in-house operation. In this respect, AustralianSuper reflects the changes taking place in the wider market. Five years ago, only 20% of the top 30 funds had a private capital specialist on staff; now most of them do, and they are suitably emboldened.

"Their internal teams are growing in size and they are recruiting people with more experience," says Gary Gabriel, managing director for Asia Pacific at Wilshire. "They are operating in a much more strategic and targeted way and this is enabling them to go offshore."

This tends to involve swapping out fund-of-funds relationships for advisory mandates. It is a classic LP decision between paying an extra layer of fees to an active manager with a direct interest in investment performance or going to a cheaper consultant that does not. Charalambous adds that AustralianSuper now backs a more concentrated portfolio of managers - half a dozen globally - than it would get through a typical fund-of-funds and there is also the opportunity to build direct relationships.

With superannuation funds considering secondary and co-investment programs as well, these ties could prove fruitful.

Differentiated demand

At the same time, it is unwise to generalize. Mercer's King says that the majority of top 25 superannuation funds have eschewed the fund-of-funds approach in favor of direct commitments made with the support of gatekeepers. These 25 accounted for A$575 billion in assets at the end of 2012, according to the Australian Prudential Regulation Authority, and at least two have abandoned their private equity programs. A further A$277 billion lies with the 175 funds that fill out the top 200.

Within this target market are clients with very different needs. For example, a younger superannuation fund may decide to skip a generation and opt for a direct model rather than a fund-of-funds, or it might decide that co-mingled products are appropriate for niche strategies. Alternatively, it might go with a strategy that excludes private equity entirely.

Sebastiaan Van Den Berg, managing director at HarbourVest Partners, notes that his firm's product offering has evolved beyond traditional co-mingled funds and is now focused on a variety of private equity solutions.

"Every client is different - they have their own objectives and are at different stages in their investment lifecycle - and so what works for one investor might not necessarily work for another," he says. "When we sit down with a client, we ask about their current portfolio, risk appetite, investment objectives and timeframe. Then we start working on creating a solution that works for them."

There is certainly no shortage of willing service providers. The question for Australia's private equity industry is how much demand there will be as the recent structural and regulatory changes finally bed down. The one virtual certainty is that those who remain committed to the asset class will continue to broaden their horizons.

"We are starting to see some super funds come to market and talk about A$1 billion-plus portfolios," says MLC's Brakey. "They are definitely keen to invest offshore."

 

SIDEBAR: Super fund allocations - The cost conundrum

Cost management has been a feature of the superannuation industry for years, but the issue gained a voice - and a sharp set of teeth - with the publication of the Cooper Review in 2010. Under pressure to cut the management expense ratio (MER) of the pension plans they managed, superannuation funds balked at the high fees in private equity compared to other asset classes, regardless of how ill-judged such comparisons might be.

The introduction of MySuper as a low-cost alternative to the incumbent providers presented another complication. Suddenly members were able to switch programs at short notice, with significant implications for cash flow and asset liability management. Private equity was damned not only for its fees but also for its long-term and illiquid nature.

Faced with a choice between investing in one asset class where performance was uncertain but fees were certainly high and another that offered lower fees but less potential upside, many superannuation funds went with the budget option.

Since then the mood has eased and performance is once again receiving proper consideration. "The debate is changing a little bit from simply looking at the overall fee burden to net returns," says Michael Lukin, managing director and global head for private markets investment at Macquarie. But how much does it cost to participate in private equity and how must the asset class perform?

According to Marcus Simpson, head of global private equity at QIC, it costs 600-800 basis points to invest in private equity via traditional fund structures. Two thirds of this cost is the management fee, the rest is the performance fee. If a superannuation fund has a total MER budget of 70 basis points and a private equity allocation of 5%, PE will use half of the budget for a fraction of the portfolio, with no guarantee of investment outperformance. Additional costs come with implementation, with fund-of-funds being the most costly

Furthermore, the fees are calculated based on committed capital, not invested capital. "Because the expense ratio is based on fees across the entire commitment, private equity is off the charts - it doesn't matter what kind of fund you invest in, the MER is going to be high until you start to see returns," a regional gatekeeper tells AVCJ.

Viewed in this context, private equity must deliver sizeable returns to justify a place in the overall portfolio. Terry Charalambous, equities investment manager at AustralianSuper, notes that fees on invested capital for private equity are roughly four times the average expense or MER and so it is expected to outperform other asset classes by a similar margin. If the overall plan is delivering excess returns of 1-2% per annum, then the excess return target for PE is in the 4-8% range.

"A 5% allocation to private equity contributes roughly 20% of the overall plan's MER so we would expect to see our PE portfolio deliver 20% of the overall plan's excess returns" he says, adding that AustralianSuper's overseas PE portfolio is on target to meet its performance targets. 

While the situation can be boiled down into data points, perception is still a weighty factor: CIOs from a public markets background are less willing to buy into the long-term commitments with higher returns proposition extolled by PE managers; and where existing PE programs have underperformed as a result of poor implementation - due to over-allocation to domestic venture capital, for example - there is a natural hesitancy to commit more capital.

Those that do participate still have one eye on the bottom line and they differentiate to minimize cost burdens. "They are seeking ways to invest where there is a closer association with the assets in the ground," says QIC's Simpson. "For example, investors like co-investment, where costs are lower, and secondaries, where the NAV is there from year one. The traditional 2/20 fee structure has become fragmented. The goal is to reduce the gross-to-net return spread.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Fundraising
• LPs
• Australasia
• MLC Private Equity
• Hamilton Lane
• HarbourVest Partners
• Australia
• LPs