Leo DeBever Takes Direct Aim At Fund Fees

It’s a question that has long inspired do-it-yourselfers: Why pay someone else to do what you can do yourself?

The do-it-yourself ethos has guided several Canadian pensions over the last two decades, particularly in private equity. And perhaps no one has been more vocal about the benefits and drawbacks of the Canadian model than Leo DeBever, chief executive and chief investment officer of the $73 billion Alberta Investment Management Corp., better known as AimCo.

Just last month, DeBever told an audience that AimCo, which is Canada’s sixth largest pension fund, was pursuing three direct investments for as much as $718 million if they were all to pan out. And since 2008, when DeBever was hired, AimCo has made a number of primary investments, including one in Precision Drilling, an oil service firm and one in Autopista Central, a Chilean toll road.

In an interview with Buyouts, DeBever said he was drawn to do-it-yourself private investing because it saved money and made solid returns easier to achieve.

“The problem with private equity,” he said, “is that it’s very, very expensive. You give up roughly a quarter to a third of gross returns if you have a very successful investment, and you give up even more when you have an unsuccessful one.”

The hurdle for earning excess returns on AimCo’s private investments isn’t as high as it would be with private equity funds. “For us, making 5 percent in excess returns is not nearly as difficult as it is under the traditional ‘2 and 20’ model,” he said, referring to the fee structure typically charged by private equity firms.

DeBever arrived at AimCo after having served two years at Australia’s Victoria Funds Management and a decade at the Ontario Teachers’ Pension Plan. “When I came here, it was all in private equity through external managers. The effective cost of that investment, in terms of fees, was 3 ¼ to 3 ½ percent.” As of March 2010, AimCo had about $3.2 billion in private investments, including infrastructure. The pension returned 12 percent during the 12 months to March 2010.

Armed with a mandate to hire as many as 120 new employees, DeBever set out to build a direct investing program. “It’s not like you can get up in the morning and say, ‘it’s time we did our own direct deals. Let’s start tomorrow.’ It takes quite a bit of preparation. It takes a good staff and experienced leadership… And, it takes time.”

“It really stands and falls with the ability to attract good talent,” he said. “If you don’t have the capacity to hire people who can compete with these guys (from PE firms) or have the same knowledge that they have, you’d be foolish to try and do it yourself.”

But hiring and keeping quality people has often been difficult at public pension funds, especially since compensation is often so much higher in the private sector. To narrow the gap, many Canadian pensions have become stand-alone corporations, enabling them to pay top performers salaries and bonuses that are closer to what the private sector offers. In Canada, it is not unheard of, for example, for top performing pension managers to earn salaries and bonuses in the low seven figures.

By contrast, U.S. pensions remain severely constrained on pay since the salaries of investment managers are typically tied to the public sector. “A number of these funds are going through staff at quite a big clip,” said DeBever, “because the moment they find someone good, he gets a more lucrative offer.”

But even with the higher salaries that AimCo is able to offer, the savings from direct investing are substantial. “The cost differential between doing it ourselves and doing this externally is three or four to one… And the differential is even higher in private equity and infrastructure,” he said.

Pitfalls

There are, of course, drawbacks to direct investing. One is that direct investments concentrate a portfolio and reduce diversification. But DeBever has turned those lemons into lemonade, saying the average pension is grossly over-diversified: “I don’t really have a problem with having a number of investments that are 1 to 2 percent of my asset base because concentration is more of an advantage than a disadvantage.”

DeBever is sanguine about the current prospects for private equity. “It’s almost like 2008 never happened,” he said, surprised by the flood of money flowing into private equity. “The valuations and leverage are getting right back to where they were before (the crisis). Even though we have the capacity to make deals, we’re not finding many that look all that attractive,” he said.

In many cases, the money flowing to buyout shops is coming from underfunded U.S. pensions whose assets were decimated by the financial crisis. “The search for returns is very desperate,” he said. “Pensions are getting into private equity on the assumption that it’s their Hail Mary pass, that they’ll get the extra return that private equity promises. I think, unfortunately, that a lot of these pensions don’t realize that… (returns) may be a long time in coming.” Many pension funds, he said, “may be 10 years late in getting into this game.”

One solution to high PE fees, he says, is for pensions to “band together” and see if they can get better terms. “I think institutional capital should try and get much better terms than ‘2 and 20’.”

A second card that U.S. pensions could play would be to leverage their GP relationships for more and better co-investing opportunities. Finally, pensions could take direct ownership stakes in private equity firms themselves, as the California Public Employees’ Retirement System has done with Apollo Global Management, the Carlyle Group and Silver Lake Partners.

Although critical of private equity fees, DeBever often works closely with PE firms on co-investment deals. “If we think we’ve truly got a top-quartile manager, and he’s got a project that is absolutely out of this world, why wouldn’t we make that investment?” he asked.

“Private equity firms like to partner with us,” he said, “for the obvious reason that with our capital, they can tackle a bigger opportunity. And they know we can act quickly and do the analysis as well as they can.”

In addition, AimCo has become a pioneer in ‘relationship investing,’ which is halfway between private equity and public investing. In relationship investing, AimCo takes a large stake in a listed company and then helps the firm restructure financially. One recent example is AimCo’s $330 million investment in Precision Drilling, which DeBever says was stuck with an 18 percent bridge loan after it acquired a U.S.-based competitor. AimCo helped Precision restructure its capital, and the company’s shares turned around, benefitting Precision’s shareholders and AimCo.

So, does AimCo’s direct investing model result in better returns? When it comes to cost savings, DeBever has slashed the fees paid to outside managers from $174 million in 2009 to $120 million in 2010, a savings of $54 million. If AimCo can manage investments internally for one-fourth to one-third the cost, Alberta pensioners have saved as much as $40 million. And if DeBever’s internal managers can do a better job than their counterparts at private equity firms, the benefit would likely be far greater.