Pension funds take on the GPs

Some of the biggest pension funds around the world are trying to boost returns by investing directly in companies and cutting out the fees to private equity firms.

The move has already generated billions of dollars for the pension fund managers, such as California State Teachers’ Retirement System (CalSTRS), Ontario Teachers’ Private Capital, the Netherlands-based AlpInvest, the UK’s Hermes and Turkey’s military scheme OYAK, as well as concern about the risks and a growing competitive threat to buyout firms.

The US$128.9bn CalSTRS fund, for example, had 4.8% of its portfolio (US$6.24bn) in private equity at the end of June. This part of the pension fund posted a 24.9% return in the 12 months to that date – more than 18 percentage points above its benchmark.

But almost hidden within these stellar returns has been a large push into making direct investments in privately held companies.

According to the most recent public records, CalSTRS more than doubled its co-investment holdings to US$389.9m in the 12 months to the end of April. Co-investments are minority stakes in private companies made by pension funds or other institutional investors as junior partners subordinate to private equity firms. They do not have to pay GPs’ management and performance charges.

Since early 2004, the push has seen CalSTRS invest in some well-known companies, such as French electrical products distributor Rexel, UK vehicle breakdown recovery provider the Automobile Association (AA) and US-based acute care hospitals group Vanguard Healthcare.

Real Desrochers, head of alternative investments at CalSTRS, said that the move was not an aggressive strategy, however. “Our co-investments are a very marginal part of our alternative investments and are being built in a defensive or prudent manner working alongside GPs,” he said.

For CalSTRS, the key move in this direction came after a strategic review of its alternative investment programme in February 2003 by consultants McKinsey. One part of this report, which has been broadly followed, recommended a “disciplined expansion” in the types of private equity assets invested in, rather than just putting money with buyout and venture capital funds, and “more aggressive co-investing and perhaps direct investing”.