Pension Fund Investments in Private Equity: Implications for the Stewardship of Workers’ Capital

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Pension Fund Investments in

Private Equity:

Implications for the

Stewardship of Workers’ Capital

The economic and financial crisis: Elements to construct a new paradigm

8th December 2008, ITUH, Brussels

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I. The Landscape

– The boom in 2002-2006, assessing PE performances– Freeing up the investment policy

II. The Arms Race

– Risk-based allocation, management and regulation– Single fund, fund-of-funds, strategic partnership or co-

investments?

III. The Workers’ Capital

– The concept & the new conglomerates– Back to the stone age of governance

IV Concluding remarks

– Trade union and government trustee guidance– Re-regulation in the aftermath of the crisis

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Double standard behaviour?

British House of Commons, hearings on private equity (2007)

– Paul Myners: “Investors can be quite lethargic… [we] should ask why they invest in private equity with its association with aggressive capital structures, high incentives for management and a minimalist approach to governance … while adopting an entirely different approach when investing in public equity.”

Source: Private equity, Treasury Committee, House of Commons, 24 July 2007 www.publications.parliament.uk/pa/cm200607/cmselect/cmtreasy/567/567.pdf

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I. The Landscape

I. The Landscape


II. The Arms Race


investments?





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No reliable data on alternative investments

Un-regulated industries = no gvt data, just ‘surveys’

– Pension funds provide at a quarter to a third of PE funding

– more if PF investments in funds of funds are included

– Ad hoc surveys: 3-5% of PF AUM

– 8-10% in the US and Sweden

– Mainly in large pension funds , and in DB schemes

The boom in 2002-2006

– 2-digit returns, favourable macro context

– Including public reserve funds (France FRR, Swedish APs, Korean NPS)

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Yet, some doubts about performance

None of listed equity simplicity applies to PE performance evaluation

– Remaining value

– Exposure: remaining value + un-funded commitment

– Valuation of the remaining value (Phalippou et al 2007)

– End-of-life vs interim fund performance (WSJ)

– Abnormal distribution of risk (Aglietta)

– Leverage effect (M. Gordon, Fidelity)

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CalPERS’ private equity program(since 90, USD Bn)

Total capital commitments

(legal obligation to the private equity fund over several years)

52.8

- Capital contributed (Cash in)

(effective contributions to the fund, including management fees)

29.6

= Un-funded capital commitments

(remaining contributions legally due to the fund)

23.2

+ Remaining Valueof the investments

(as reported by the General Partner)

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= Total Exposure (un-funded commitments + remaining value)

43.2

Cash Out (proceeds distributed back to the investors)

22.5

Investment Multiple (cash out + remaining value) / cash in

143%

Source: CalPERS website

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Doubts about PE performance

Source: JP Morgan Alternative Asset Survey (November 2007)

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Loosening or removal of investment restrictions

2002-2006

Source: Source: OECD Survey of Investment Regulations of pension funds, July 2008, www.oecd.org/dataoecd/12/46/40804056.pdf

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In need of harmonisation?

Country Quantitative restrictions (% of AUM) Average Exposure (% of AUM)

Austria 30% max in unlisted securities (incl. HF)

Canada None* 1% (federally regulated plans)

Czech Republic 5% max Estimated up to 1%

Denmark Solvency requirements

Estonia 10% max in unlisted securities (incl. HF); Short selling prohibited

Finland Authorised since 1st January 2007 3.10%

Greece 5% max 0%

Ireland 10% max in unlisted securities (incl. HF) Thought to be extremely low

Italy 20% max in CIS (incl. HF); max 1x leverage; short selling, lending & borrowing prohibited.

Negligible

Netherlands Solvency requirements Approximately 2-3%

Poland 10% max in CIS (incl. HF) 0%

Portugal 5% max (to be raised to 10%) 3%

Slovakia Prohibited 0%

Spain 5% max; indirect restriction via caps on fees

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Indirect restrictions to PE allocation

Geographical distinction between foreign assets

– Difference between OECD & non-OECD (ie. countries having signed on the OECD Code of Liberalisation of Current Invisible Operations)

In Europe, difference between collective investment funds

– ‘harmonised’ investment funds (subject to EU directive on UCITS)

– ‘non-harmonised’ funds (private equity & HF)

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The Anglo-Dutch-Japanese group

– No quantitative restrictions, PP standard applies

– AUM, 50-130-25 % GDP

The Nordics

– Several restrictions, including on alternatives

– AUM: 30-130% of GDP

Rest of Europe & Korea

– Various scenarii

– AUM: 1-13% of GDP

The three families

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Asset portfolio composition

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Slova

k Rep

ublic

Czech

Rep

ublic

Korea

Mex

ico

Turke

y (8

)

Hungar

y

Spain

(7)

Polan

d

Ger

man

y

Norway

Sweden

Austri

a

Icela

nd (4

)

Denmark

(3)

Finlan

d

Italy

(5)

Nether

land

s

Portu

gal (

6)

Switzer

land

Canada

(2)

United

Kingdom

(200

5)

United

State

s (9

)

Belgiu

m

Austra

lia (1

)

Alternatives (land & buildings, unallocated insurance contracts, private investment funds,other)Mutual funds (CIS)

Shares

Cash and Deposits, Bills and bonds issued by public and private sector, Loans

AUM > 10% GDP

Source: OECD Pension Markets in Focus 2007 www.oecd.org/daf/pensions/pensionmarkets & www.oecd.org/dataoecd/47/0/39510746.xls

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II. The Arms Race

I. The Landscape


II. The Arms Race


investments?





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The arms race

Diversifying portfolio risks

– Lessons from the IT bubble in 2001-2002– Beta (market generic) vs alpha returns (asset specific)– PE as a return enhancer or a risk diversifier ?– Matching liabilities– Role/influence of advisers

Regulators’ reaction

– Regulated funding rules : assets should mach liabilities, market & longevity risks

– Risk-based regulations (such as Solvency II)• factor in the ‘riskiness’ of the portfolio• Only a few countries so far (Denmark, the Netherlands,

Sweden)

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Implications for PF risk management

Most challenging aspects (JP Morgan)

– selecting & monitoring PE managers

– fees

Say they will increase their allocation

– 50% of those currently investing in PE

– 9% of those not currently investing

Due diligence procedures (Danish ATP)

The fees:

– 2% on annual commitments + 20% on capital gains

– 0,5% max in regulated asset management

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Private equity portfolio strategies

Investor(limited partner)

General Partner(private equity firm)

Portfolio companies

Investor (direct investment)

Individual company

General Partner Portfolio companies

Investor(limited partner)

Fund-of-funds General Partner Portfolio companies

General Partner Portfolio companies

risk concentration management cost(excl. infrastructure & large buy-outs)

2+20%

2+20%

2+20%

2+20%

1+10%

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PF-PE partnerships

Strategic partnerships

– OregonPERS & KKR

– AP4 & EQT

Direct ownership in PE firms

– CalPERS in Carlyle, Silver Lake, Apollo

– ABP & PGGM owned Alpinvest

– Australian Supers’ Industry Funds Management

Mixed strategy

– Ontario Teachers’: Teachers Private Capital & KKR

– AP4 & EQT bid over V&S

– Consortiums

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Swedish PF investments – diverse portfolio strategies

State & occupationalpension funds

PE as % of total AUM

PE in €m (dec. 06)

Portfolio strategy

AP2 0.9% 203 Concentrated (less than 10 funds)

AP3 3% 685 Highly diluted (over 50 funds)

AP4 0.6% 140 Highly concentrated (2/3 in EQT)

AP6 100% 242 Concentrated

AP7 4% 171 Concentrated

Alecta n/a 204 n. a.

AMF n. a. n. a. n. a.

Wallenberg family Investor

13% 1624 of which €952m in EQT

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I. The Landscape


II. The Arms Race


investments?





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Workers as employees& as investors

Representation of workers « as employees »– Collective bargaining– Works councils, EWCs, board representation

Representation of workers « as investors »– Worker trustees in pension funds– On average 20% of market cap in US, UK & Canada

Link between capital market regulation, corporate governance and workers’ rights– Stakeholder corporate governance– UN Principles for Responsible Investment

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Stewardship of workers’ capital

Shareholder activism– ranging from

• ‘engagement’ with the management, to• hostile resolutions at the AGM.

– Aiming at• enhanced financial performance• enhanced corporate accountability

(board composition/remuneration)

Workers’ capital– Asset management shareholder accountability

• asset managers exercise AGM votes• TU-led (or commissioned) proxy voting surveys

– Issue-specific shareholder campaigns• Resolution for Wal-Mart ESG disclosure policy• Burma campaign

– Non-shareholder related

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TUAC’s two pillar framework on corporate governance (2005)

Stakeholder approach

– Shareholders (AGM)

– Board of directors

– Senior management

– Workers

Workers’ capital

– Workers

– Board of trustees

– Asset management


ownership

control

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The stewardship ofworkers’ capital

Conditions to be met

– Relevance of pre-funded schemes– Freedom of portfolio investment (no

restrictions)– Asset management accountability (AGM)– Member and beneficiary ownership &

governance representation (vs employers)– Robust capital market (& TU)

infrastructures

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Back to the stone age of governance

Limited liability partnerships– virtually all control in the hands of the general

partners– Un-regulated, no standardisation

Right of the GP– to keep an investment confidential, should

disclosure “cause a risk of jeopardising that investment or the anticipated returns”

– to establish alternative investment vehicles to avoid “tax, legal, business, accounting or regulatory impediments to the making of a potential investment”

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Workers’ K does not function correctly under PE

Stakeholder approach


– Board of directors

– Senior management

– Workers

Workers’ capital

– Workers

– Board of trustees

– Asset management


Private equity manager




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Double standard behaviour?

British House of Commons, hearings on private equity (2007)

– Paul Myners: “Investors can be quite lethargic… [we] should ask why they invest in private equity with its association with aggressive capital structures, high incentives for management and a minimalist approach to governance … while adopting an entirely different approach when investing in public equity.”

Source: Private equity, Treasury Committee, House of Commons, 24 July 2007 www.publications.parliament.uk/pa/cm200607/cmselect/cmtreasy/567/567.pdf

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A return to the 1950s

conglomerates ?

If so, PE firm and managers’ employer responsibilities could

be activated

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Impact of PE buy-out on the company’s… PF

The case of the UK

– PF funding dependent on the employer covenant

– High profile cases: Boots, EMI, GMB study

– Survey: ¾ of UK trustees would be “worried” about a possible leveraged buyout of the sponsoring company

Pensions Act:

– Expands the The Pension Regulator enforcement powers

– “aggregate resources of a whole group of companies may be considered” (i.e. including those of other portfolio companies in other funds managed by the same private equity firm), in order to judge whether the funding level of the target company’s pension scheme is appropriate”

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I. The Landscape


II. The Arms Race


investments?





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IOPS Guidelines

ITUC General Council (June 2007)

FNV & TUC Guidance

Global Unions (UNI, IUF)

G8 Trade union statements

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Re-regulation in a post-15 September world

– Unsustainable model of growth

– The ‘structured finance’ business and the illusion of risk spreading

– Investment banks, conglomerates and the cost of regulatory arbitrage

– Shareholder value model of corporate governance versus market integrity

– Central banks did not foresee the bubble

– Weak economic & financial governance

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The cost ofcorporate short-termism

Non-OECD SWF

Other funds US gvt injection

Buy-Backs 2006-07

Debts to executives

Bank of America 25 17.5 1.3

Merril Lynch* 8 1.2 14.4 2.2

Citigroup 7.5 25 7.8 5

Goldman Sachs 10 16.8 11.8

JP Morgan Chase 25 12.1 8.2

Bear Stearns ** 1 1.7 1.7

Morgan Stanley 5 7.1

Lehman Brothers**** 4 5.3

*purchased by BoA for 50bn; ** purchased 1.2bn by JP Morgan Chase following offloading of toxic assets valued at 29bn onto US gvt; *** 2007 only; **** entered into bankruptcy on 15 sep

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Re-regulation

– Strengthening financial safeguards & international cooperation

– Diversifying finance & Protecting social development goals

– Spreading responsibility throughout the investment chain







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Re-regulation







– Strengthening financial safeguards & int’l cooperation

• Bank prudential regulation

• Mandate & public accountability of central banks

• Reign in int’l flows of capital

• Offshore Financial Centres

• Staffing of supervisory and enforcement authorities

– (Protecting social development goals)

– (Spreading responsibility throughout the investment chain)

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Re-regulation







– (Strengthening existing safeguards and international cooperation)

– Diversifying finance & protecting social development goals

• Protect households against predatory lending

• Diversifying the financial sector & support community-based financial services

• Protect workers’ pension schemes

• International taxation– (Spreading responsibility

throughout the investment chain)

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Re-regulation







– (Strengthening existing safeguards and international cooperation)

– (Protecting social development goals)

– Spreading responsibility throughout the investment chain

• Reform the credit rating industry

• Regulate credit risk transfers and derivatives

• Regulate private investment funds and conglomerates

• Ensure executives’ and intermediaries’ perverse incentives are reversed

• Combat corporate short-termism

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Re-regulation& private

equity

Financial safeguards & int’l cooperation– Prudential regulation for banks– CB mandate and public accountability– International flows of capital

– Offshore Financial Centres– Staffing of financial authorities

Diversifying finance & social goals– Protect households

– Community-based financial services– Protect pensions– International taxation

Spreading responsibility– Credit rating industry

– Credit risk transfers and derivatives– Private funds & conglomerates– Executive compensations– Corporate short-termism

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Economy & Finance

Pension Fund Investments in Private Equity: Implications for the Stewardship of Workers’ Capital