For years, super funds and their international counterparts have been seeking better alignment of interests with their service providers, particularly funds managers. For the most part, this has centred on performance fees and investment lock-up periods. Now, some funds are exploring partnerships with their own kind as the only way to ever have a true alignment of interests. GREG BRIGHT reports on this and other likely trends to emerge from the latest Global Dialogue conference held by the Australian Institute of Superannuation Trustees.
Last year Victorian Funds Management Corporation (VFMC) joined with Ontario Teachers’ Pension Plan to bid, successfully, for a 48.25 per cent stake in Birmingham International Airport in England, in a deal worth $1.02 billion. One of the sellers was Macquarie Airports Group.
The common denominator in the bid was VFMC’s chief investment officer, Leo de Bever, who until October, 2006, had worked at Ontario Teachers, most recently as senior vice president and head of risk management. Within a few months of joining VFMC, he negotiated the largest co-investment bid by an Australian super fund-owned manager with an overseas one.
While de Bever cut short his contract with VFMC and this month is scheduled to return to Canada in a new role at another Government-owned pension fund manager – chief executive of the Alberta Investment Management Corporation – the Birmingham deal set a new benchmark in co-operation between very large funds, no matter where they are based, looking to capitalise on investment opportunities.
If the mood at the latest Global Dialogue conference, held late June/early July in San Francisco and Sacramento, California, is a guide, there will be a lot more of such deals to come. This represents both a threat and an opportunity for funds managers and investment banks, which have tended to dominate the universe of large-scale infrastructure and private equity deals in the Western world over the past few years.
For super funds, pension funds, and other pools of money governed by fiduciaries, such as most sovereign wealth funds, co-investing with their own like represents the best way to ensure a true alignment of interests, they believe. For instance, Graeme Bevans, vice president and head of infrastructure for the Canadian Pension Plan (CPP) Investment Board, says that it is impossible for a pension fund to have an alignment of interests with a commercial funds manager on the liability side of the balance sheet. “Funds have 50-year liabilities,” he says. “There’s a serious misalignment in giving money to the likes of Goldman Sachs or Morgan Stanley for investments in closed-end funds. We’re going to grow to US$1 trillion over the next 30 years, so buying and selling assets every seven or eight years doesn’t make sense for us. We are much better off to buy and own.”
The CPP currently has funds under management of about US$120 billion, putting it in the top 10 pension funds in the world, and a staff of about 400. VFMC, at $40 billion, is one of only a handful of Australian funds (actually the management arm for a consortium of Victorian Government employee funds) which can participate in co-investments such as the Birmingham airport.
But due to amalgamations, organic growth and increasing co-operation, their number is growing. Bevans told Global Dialogue that a funds management firm, on the other hand, would be unable to write a cheque for more than $1 billion for an investment from one of its funds, because it would need a certain level of diversification. But some pension funds could write cheques for twice that amount. He added: “Why do we give away 30-40 per cent of the return from an infrastructure deal to a manager who doesn’t add any value?”
Global Dialogue, held every two years by Australian Institute of Superannuation Trustees (AIST), involves about 80 fund executives and trustees and 12-14 service providers/sponsors. Australians make up about two-thirds of the attendees and US, Canadian and UK pension fund representatives the rest.
This year the theme was: ‘Global Co-operation for Sustainability, Governance and Long-Term Returns’. For Australian super funds, discussions about sustainability and governance are not new, but the co-operation angle struck a nerve with participants. The possibilities for access to new large-scale investments, new types of investments and better control over all investments through co-operation between funds provided for compelling engagement.
Several concrete outcomes from the conference could signal more significant developments over the next few years. For instance, a staff-swap arrangement announced at the end of the conference may well hasten international co-operation by funds.
CalPERS, the $US380 billion Californian public sector fund, announced it would look at offering three-month staff exchange opportunities with Australian funds, initially among its 150-person investment team. The fund does its own administration, with total staff dwarfing that of most large funds managers at about 2,500. David Atkin, the chief executive of Cbus, said during a conference wrap-up session that the exchange of ideas and discussion across funds was of considerable benefit and that, because of the size of some US pension funds, there were opportunities for leverage in the areas of corporate governance and large-scale investments. “Imagine the impact that US funds could have in an Australian context for investment,” he said. Atkin also said partnerships with super funds could offer sovereign wealth funds an opportunity when they wanted to invest in international markets because it could reduce the political backlash which is sometimes associated with their activities. “It’s an opportunity for them to partner with local funds as passive investors and an opportunity for us to broaden our funds under management capabilities,” he said.
Wilhelm Harnisch, an employer representative Cbus trustee, also said that Global Dialogue could benefit from the inclusion of other types of funds, such as insurance funds, for co-investment discussions or other opportunities. Louise Davidson, manager of sustainability projects for Industry Funds Management, said that it was possible to establish an international framework for ongoing dialogue to fill “gaps” where fund co-operation could be used to advance issues such as funds manager costs and trustee education. Speaking for her discussion group of fund representatives, she said: “We also like the idea of internships but we think that funds should also promote greater engagement with academia, perhaps through the establishment of some research grants.”
Some Australian funds were also taken with the engagement by US public sector funds with their members. CalPERS, for instance, holds an annual ‘retirement expo’ information event for members designed to encourage more involvement and increased savings. Other big funds, such as the TIAA-CREF medical industry group of funds, hold annual elections for the board among its 3.2 million members, and an annual meeting. This sort of member involvement is a vexed issue for Australian funds, where members do not usually even get to vote on something as major as a fund merger, let alone director appointments.
However, Hye-Won Choi, the head of corporate governance for TIAA-CREF, told the meeting that pension funds needed to get their own governance house in order before they told companies how to better govern the businesses in which they invest. Gerard Noonan, the chair of Media Super, the recently merged JUST Super and Print Super industry fund, probably spoke for the majority when he said that “open board meetings or fake stakeholder democracy” was not practical, however, there was probably merit in systematic polling of member attitudes on investment and administration issues. The challenge for funds managers and perhaps placement agencies and asset consultants in all this is that with more co-operation between funds, especially smaller Australian funds linking with larger ones either in Australia or overseas, they will need to redefine their roles in co-investment deals.
Managers, rather than investment banks, are more likely to be successful partners for funds because of their longer-term, relationship-orientated cultures. But they, too, need to address the grievances that funds have, particularly around their fees and charges. Garry Weaven, the chair of Industry Funds Management (IFM), spelled out these concerns at the conference, as he has done many times before. While IFM is also a funds management firm, with its own fees and charges, the concerns voiced are nevertheless real. Weaven said that there were often conflicts of interest in private equity or infrastructure offerings where a manager was able to extract “huge fees” outside its funds management contract from advisory or other services. Also, where a manager holds the asset in a vehicle, and it is impossible for the manager to be dislodged, they may be motivated more by growing the assets of the vehicle than earning an internal rate of return (IRR), he added. Weaven predicted funds would continue to increase their allocations to unlisted markets, partly because of the “substantial cost” involved in running listed vehicles, including the consideration of insider trading.
The credit market crunch and slump in sharemarkets have combined to stall the growth of super fund investments in big buyout-style private equity funds, at least temporarily. However, the increasing power and influence of funds, combined with more co-operation between them, may change the landscape for private equity managers. Weaven said that ‘asset stripping’ was not necessarily a pejorative term and could be economically justifiable, but perhaps a simple change of management would have the same effect. A manager’s time horizon might influence which course of action it took. “Often the only way to change the management is to own the company because boards are often in a comfortable club relationship with management,” he said.
Financial restructuring and exit strategies, which produce a higher IRR in times when debt is cheap, have also lost their lustre for the time being since they depend on something outside the manager’s control – interest rates. Weaven said there was a “gaping hole” in the private equity market for “long-term active owners” but a move to this style of investing would have to be driven by clients. Pension funds had traditionally been too small to have majority interests in companies because of the necessity to be diversified across companies and sectors. “Also, where they have had the capacity, their focus hasn’t matched their rhetoric, because it’s hard,” Weaven said. “And the funds management industry hasn’t had the capability because their own business model is more suited to the broad market.”
The issue of liquidity with a portfolio of unlisted assets, which Australian super funds have this year been reminded to consider by Australian Prudential Regulation Authority (APRA), was often exaggerated, Weaven said. “If you didn’t make a good investment the exit from any asset class will be awful.” CPP’s Graeme Bevans concurred: “It’s a falsehood to suggest that there’s no liquidity, say, in private equity in India. It’s just as much a problem in public markets. If you try to sell 6-7 per cent of a bank it may take two years to exit.” Reflecting or foreseeing a possible trend to active long-term ownership of assets, IFM was now becoming a repository of business management skills, Weaven said, as well as deal generators.
With lower returns from private equity comes closer scrutiny of fees and charges, as well as the benchmarks used to assess relative skill and performance. The CPP has a very sophisticated method of assessing its managers, building customised benchmarks for each. If a private equity manager buys a retail company, say, the client fund will sell the corresponding GIC sector index. So the manager’s company selection skills are assessed against the performance of the appropriate listed market sector returns, rather than the broad market or other general index. A US example of a funds management firm providing a tailored, partnership-style service to a fund is the “Californian Initiative” undertaken by CalPERS in the past few years. This initiative undertook to invest a small proportion of money into “underserved markets” in the local community as part of a social investing project. Paul Yett, relationship manager with Hamilton Lane, said his firm committed 3 per cent of its capital, as a private equity general partner, into a variety of investments divided between partnerships and directly into companies which provided an additional social benefit above reasonable investment returns.
The program, operating since 2001, has generated an annual return of 18 per cent to the fund, according to CalPERS, compared with an initial expected return of just 7.75 per cent. A total of 217 companies have been financed, including small businesses and those owned or operated by minority groups. A research group commissioned by the fund last year estimated that the “total impact” of all CalPERS’ activities on the state of California was a positive US$18 billion a year. The California Initiative involved the injection of US$2.6 billion into “underserved” types of real estate, such as low-income housing, and US$2 billion in private equity.
Rob Feckner, CalPERS board president, said to the conference: “Can you make the same amount of money as well as make social, economic or environmental change? The answer is ‘yes you can’.”
The experience of the much smaller LACERS fund, representing Los Angeles city employees, is probably of more relevance to Australian super funds. The US$11 billion LACERS has devoted 10 per cent of its private equity allocation to social projects such as urban infill, workforce housing and union-friendly construction through the development of a range of partnerships.
Shelley Smith, a LACERS commissioner, said the rate of return had been between 10-20 per cent a year. She said the case could be made for economically targeted investments, but this required advocacy and ownership. “Many US trustees are a little phobic about using words like ‘social’ or ‘responsible’,” she said. “So we had to develop a fiduciary vocabulary. The process has to be well understood and this can take a long time.” She said that if you didn’t have the internal resources of a CalPERS, then you needed to develop partnerships.
There was also a challenge in getting fund staff onboard: “Taking risks is often not the best thing for your career, but following CalPERS is usually a good thing to do.” LACERS hired two specialist consultants to work with the staff and traditional consultants on an innovative investment program in strategic planning. Many of the partners were able to take advantage of green tax credits and urban redevelopment incentives. They were able to acquire land inexpensively.
However, economically targeted investments do not always turn out well for the fund sponsor. William Robson, the chief executive of Canadian policy think tank CD Howe Institute, said that any mandate which did anything other than set out to maximise investment returns was “toxic” to pension plans. He cited the example of the Quebec Pension Plan, which had embarked on a program of “nationalistic investments” and suffered losses from them. The fund had an average return of 4.6 per cent a year over five years before it reviewed its social investments, compared with a peer group median of 5.2 per cent. “I think that an investment-only mandate is critical to any pension plan, especially if members are compelled to join it,” he said.
Cbus David Atkin said that while a fund had to maximise the return to members, as its bottom line, there were a number of dimensions to the goal. “Choice of fund creates its own dynamics,” he said. “We need to have individual relationships with members, who are free to leave. Our members strongly identify with the fund and are very proud of it. Over 20 years it has delivered about 10 per cent a year after fees and tax. So they’ve done well. “We also own a property company. Property makes up 15 per cent of our asset allocation and half of that is our own company. Having their fund investing back into their industry as a developer is a powerful part of our communications. “[Cbus’ property] investments will return 15-20 per cent this year, so it’s very helpful when total fund returns are negative.”
The other major area where super funds have already made big strides in co-operation is in the governance of their shareholdings in big listed companies. The Australian Council of Super Investors (ACSI), a governance organisation formed by a group of large super funds in 2001 and which currently has 42 members, has taken public action against several companies, such as News Corporation, over alleged suppression of minority interests.
However, most of ACSI’s activities involve providing information about corporate actions and voting. Law suits are rare. In the US, where class actions are much more common, Australians have in the past few years been joining in group actions against big companies, including the Enron compensation case. Robert Monks, a long-term corporate activist and founder of several governance bodies including Governance for Owners, told Global Dialogue that in most countries, such as the US, litigation was “the only economically rational strategy for collective action by owners”. He said: “To get anything done, you have to find ingenious ways to litigate. It is up to us to insist that the accounting systems of companies internalise the externalities.” By that he meant that the clear bottom line of company reports needs to reflect the full costs and benefits to the community – a “single bottom line not a triple bottom line”. “At the end of the day, the only thing that has produced results is litigation,” he said.
Monks said that if there was to be a genuine sustainability in corporate functioning, it will be because of the informed involvement of ownership – the shareholders. “It won’t come from directors, nor management,” he said. “It won’t come from government. We will need to harmonise the differing, often conflicting, characteristics of the ownership of securities on a global basis in order to realistically rely on shareholders to assure responsible corporate governance.”
Annalisa Barrett, senior research associate of the Corporate Library, New York, said that increasingly settlements with companies over compensation included agreements to improve specific aspects of their future governance. There had been 12 major cases between 2002 and 2005 which involved improvements in governance. The improvements included board practices and composition, inclusion of independent directors on committees, processes for shareholder nominated directors, compensation practices for better alignment of interests with shareholders, increased stock ownership by directors, improved internal controls over insider trading, and separation of chair and chief executive roles.
Australian funds have been getting more active over the governance of large companies for several years, with a growing belief that, over the long term, they are better off confronting what they see as problems rather than doing the ‘Wall Street walk’ and selling out. One of the outcomes of the first Global Dialogue in Chicago and New York in 2006 was a prompting of several large funds to sign up to the United Nations Principles for Responsible Investing (UNPRI), which encourages such engagement. HESTA, for instance, signed onto UNPRI early last year and has been voting its shares in corporate actions for about 10 years. The fund is also a subscriber to the governance advisory service Regnan, which is owned by a group of funds plus managers BT and Vanguard.
Rob Fowler, executive manager of investments and governance for HESTA, said that a new focus on corporate governance was to engage stock brokers to get them to include ESG (environment, social and governance) analysis in their research on stocks. “Companies tend to have more contact with broking analysts than they do funds managers,” Fowler said.
HESTA is one of three Australian super funds which has joined the Enhanced Analytics Initiative, a European based group formed to encourage stock brokers to also assess companies on ‘extra-financial issues’, such as climate change, corporate governance, employment standards and executive remuneration. The other Australian funds are UniSuper and VicSuper. The greater co-operation between funds may, at first glance, seem inconsistent with the heightened competition between them for members under choice of fund. But it was the big commercial institutions which coined the phrase ‘co-opetition’ in the 1990s to describe how an organisation could be both a client and competitor simultaneously.
In this case, the not-for-profit sector is looking to flex its muscles more by adopting the same open-minded attitude. At the same time, the sector is casting its investment net much wider outside the listed markets and taking account of what are seen as softer concerns such as ESG and SRI factors. There will always be room for argument about how far a fund should go in this regard. One discussion group at Global Dialogue suggested that AIST should ask APRA to clarify its understanding of the Sole Purpose Test for funds, hopefully to provide comfort that they could invest in a sustainable fashion.
Fiona Reynolds, AIST’s chief executive, said later that this was unnecessary. She said that from the APRA fund reviews which had been taking place for the past year, it was clear that there was no question over funds taking account of such issues in the long-term interests of member retirement incomes.
The one clear point of unanimity at the conference was that it was a very worthwhile event which should be continued. Garry Weaven predicted during the last session that one certainty about the next event, which may be held in Europe, is that there would be a lot of discussion about a global standard for carbon trading.