The price of going direct

Direct investing is well-suited to infrastructure. But anyone looking to pursue it will have to tackle tough questions around compensation and transparency.

Margaret Brown, a member of the California Public Employees’ Retirement System’s investment committee, says her main concern about the pension fund’s proposed direct investment model is undisclosed expenses spent on items like aeroplanes and football tickets.

Brown, a freshman board member who previously managed public-school developments, fears the committee will lose control of two private companies CalPERS plans to form to invest capital on its behalf. The result, she says, will be the pension paying high salaries and expenses viewed as standard for executives at large private equity firms.

“Are we going to pay for their season tickets to the Dallas Cowboys? That’s an operating expense,” she says. “If we end up buying them a jet airplane, I want to be able to tell someone.”

For anyone familiar with the usual LP-GP handwringing over fees, Brown’s concerns will ring a bell. In our 2019 LP Perspectives survey, a majority of investors agreed  the fees charged by funds are difficult to justify. More than half also said they had asked their GPs for more fee transparency over the last 12 months.

And yet Brown’s concerns are not about the pension’s relationship with third-party managers – they are about CalPERS’ plans to move away from them. CalPERS’ investment staff, who manage the pension’s $357.7 billion portfolio, have proposed that the two companies – Pillars III and IV – invest directly into certain sectors of private equity, while reducing management fees and gaining greater control over the portfolio.

Rob Feckner, chairman of the pension’s investment committee, tells Infrastructure Investor CalPERS will not maintain ownership of the companies. This will enable the companies to avoid the salary “constraints” that are in place for the pension fund’s investment staff.

“In order to hire these teams, we need to be able to pay competitively, because they can easily find that kind of compensation in the private markets,” he says.

Clear difference

According to Bill Slaton, the previous chairman of the committee who was replaced by Feckner in May, making Pillars III and IV private companies is necessary in part to manoeuvre around public disclosure requirements. He calls the proposal a “California version of a direct model”.

Slaton says the state transparency requirements for CalPERS’ investment staff would make it difficult for the pension to pay salaries and incentives on a par with private-sector jobs for the skilled finance professionals it wants to hire. “There are people who work in this
industry who do not want their compensation to be revealed publicly,” he says. “That’s just a reality. We had to develop a structure that preserved the ability for the people who work in this not to become public employees.”

Slaton says CalPERS “looked longingly” at what had happened in Canada and the success the country had in managing direct investment programmes: “The question was, ‘How do we emulate that in a way that’s appropriate in the state of California?’”

CalPERS’ Pillars III and IV gambit illustrates one of the challenges faced by anyone looking to get into direct investing. Although the programmes often start with a desire to cut costs, they are not without costs themselves. The question then becomes: what is the appropriate cost level?

Guthrie Stewart, global head of private investments at PSP Investments, a C$168 billion ($125.6 billion; €112.2 billion) Montreal-based pension system, agrees that the success large Canadian pensions have had with direct investing is partly the result of their ability to pay staff well.

“Even though we were created by the government of Canada,” Stewart says, “our board is completely independent. The way we structure compensation, the way we’re able to hire and incentivise our people is completely independent.”

In the US, he explains, “the politics around the governance of pension funds” complicates compensation. In March, CalPERS’ investment committee voted 10-3 to allow staff to move forward with planning Pillars III and IV. Despite being on the losing end of that vote, Brown says she is continuing to speak out against the proposal, which she sees as sacrificing too much transparency.

“What they’re saying is that we have to keep private equity private because it has to be,” Brown says.

Is infra a better match for direct?

Kelly DePonte, a managing director at placement agent Probitas Partners, agrees that most pensions launch direct-investment programmes to save money and create portfolios aligned with their interests. “They believe they can save fees, that it could be more efficient,” he explains.

Nik Kemp, head of infrastructure for the A$145 billion ($100.7 billion; €89.7 billion) AustralianSuper, a superannuation fund, says investors “can’t control decisions” like investing and divesting assets or reducing fee costs when investing through funds.

“The ability to have control over these decisions through negative control rights and board representation at our investments was a significant driver of looking to do direct investments,” he explains.

DePonte adds that cost cutting is especially important for investors seeking core infrastructure.

“Because of the amount of competition, the forecast return is so low,” he says. “If you begin layering on a whole level of fees, especially on committed capital, and then carried interest, it almost makes core investing in [the] fund format not worthwhile.”

AustralianSuper’s management expense ratio fell from over 70 basis points, at the time of the fund’s first direct infrastructure investment in New South Wales Ports in 2013, to 43 basis points in 2018. According to Kemp, this was “driven by exits of higher cost managers and increased exposure to direct investments”.

Long-term asset-liability matching is another factor that makes infrastructure a natural fit for direct investing, DePonte says: “Liabilities go up to 30, 40, 50 years. One thing [pensions] want to do is get assets that also go up 30, 40, 50 years.” In that sense, direct investing raises questions about how to achieve alignment between near-term allocation targets and long-term hold periods.

Kemp says AustralianSuper is on track to grow for “years to come,” meaning “there is less of a need to consider recycling capital” anytime soon.

“This provides us with the ability to make investments which maximise returns for the long term,” he says. “If we are not finding opportunities that deliver attractive risk-adjusted returns, we have the ability to deploy in the portfolio.”

But long-term investing outside fund structures also raises the question of how pensions can know that direct investments are performing well.

It’s a little harder in private equity, according to John Cole, senior portfolio manager for global equities at CalPERS, who is helping plan Pillars III and IV. “The idea of owning companies for a very long time is difficult in private equity because, in order to get paid, you need to sell the company,” he says.

Emmanuel Jaclot, who has led the infrastructure group at the C$309.5 billion pension fund Caisse de dépôt et placement du Québec since 2018, says infrastructure is easier to gauge because cashflows are dispersed in a similar manner to dividends. He also says that CDPQ performs portfolio audits every six months as part of a “valuation exercise”.

Kemp says that in Australia’s superannuation system, independent valuers mark assets to market on a quarterly basis based on the “business dynamics” of a specific asset as well as on macroeconomic factors. He adds that AustralianSuper compiles a “lookback paper” on each asset every three years to review how it has performed.

‘Find out what you can do’

CDPQ’s first direct investment in infrastructure was in 1999, when the pension committed C$250 million alongside partners to acquire Highway 407 in Ontario.

Jaclot says pensions that have gone direct typically follow a similar path. First, an investor commits to funds to gain exposure to an asset class. It then builds expertise through co-investing capital alongside the manager. Finally, a pension large enough to build a management team may consider direct investing.

“The key thing is whether you have the capability,” he says. “I don’t think you can go a little into direct. You either commit to it by hiring a strong team and building your portfolio, or you grow the strategy that is easiest, investing in funds.”

Paul Shantic, director of the Inflation Sensitive portfolio at the $226.1 billion California State Teachers’ Retirement System, says the pension is moving towards more co-investments and separate account structures. However, he says there will always be a manager between the pension and the investment.

“You find out what you can do and then try to do that,” he says, adding he likes how co-investments reduce fees as well and give you the ability to “design your portfolio”. So why stop there? “We have a relatively small staff and don’t have the ability to take on management of assets directly,” Shantic says.

Whether a pension can go direct will depend on its ability to invest in and manage assets, which requires experience.

Andrew Claerhout, a senior advisor at the Boston Consulting Group who previously led the infrastructure and natural resources group at the C$191 billion Ontario Teachers’ Pension Plan, says he was “thoughtful” when building an investment team “with the right degree of skill”.

The challenge was keeping his team together when more lucrative private-sector jobs became available. “Pension plans must accept that they will lose some of their top performers over time,” he says. “But the idea is you bring people in, give them a great opportunity and recognise that some will leave over time.”

Claerhout says this is the case even at Canadian pension funds, which pay their investment staff higher salaries than their counterparts in the US.

For example, CPPIB paid its chief executive, Mark Machin, total compensation including bonuses of C$4.5 million in the 2018 financial year. Marcie Frost, CalPERS’ chief executive, earned $387,000 during the same period.

The base salary for Stewart, who is a senior vice-president at PSP as well as leading the private markets group, was similar to that of Marcus Frampton, chief investment officer at the state endowment Alaska Permanent Fund Corporation. According to Frampton, his salary last year was $350,000 with no incentives, while Stewart’s income rose from a C$350,000 salary to C$2.35 million after incentives, according to PSP’s 2018 annual report.

In the US, Frampton says, “it’s hard to have a government entity where someone’s making seven figures and not have someone upset”. For Canadian pensions, specific salary discussions stop at a pension’s top earners. However, at CalPERS, filling out a Form 700 – the state’s ‘statement of economic interest’ – is a requirement for all investment officer and manager positions.

Form 700s are made available online, so anyone can find out the personal financial information of investment staff and board members. In 2017, one CalPERS board member reported owning stock in oil company Conoco Philips, a retirement account with the American Trust Company and property in Sacramento, and had a spouse making more than $100,000.

Slaton says the current level of disclosure will discourage finance professionals from working for a public pension such as CalPERS.

Whether the pension should accommodate those people represents the debate surrounding Pillars III and IV.

Betty Yee is California’s state controller, a public official who oversees state spending. She also sits on CalPERS’ board and says she is “concerned” about the “unknowns” of Pillars III and IV, including governance structure, fees and costs to run the companies.

“As long-term investors, we expect transparency and disclosure from our portfolio companies that we believe leads to stronger companies and sustainable long-term returns,” she says.

According to Claerhout, Canadian pensions have stayed above the fray of governance politics because they were set up with the idea to “separate church and state”.

“What is often referred to as the Canadian model was set up from the beginning with the right degree of independence,” he says. Claerhout adds that the pension boards are completely independent of their sponsors and comprise people with “deeply related experience in investing”.

“We have people that fund the pension, and we have people who are responsible for investing the pension,” he says.

Kemp argues it is not all about the money. He says AustralianSuper has appealed to potential hires by promoting a good work-life balance and a “culture centred on delivering returns to our fund members and being part of a fast-growing organisation that provides significant career opportunities”.

Never stop questioning

The investment committee vote at CalPERS in March will not be the last word on Pillars III and IV.

As details emerge about the structure, economics and governance of the proposal, opposition could grow or fade. Brown says she is keeping an open but sceptical mind.

“I don’t have a problem with direct investing,” she says. “I love the idea.”

However, she points to the slow approach that CalSTRS is taking with co-investments as a better course. “They’re slowly but surely developing their staff and getting them to learn a system. Right now, we do no co-investments, none at all. That’s low-hanging fruit.”

While the debate at CalPERS plays out, Shantic says CalSTRS will continue to do the things staff there know they can do well.

“We’re going to continue to look at funds, we’ll do co-investments, we’re looking at separate accounts,” he says. “This model allows for us to try to get closer to the investment.”

Even at PSP, Stewart says direct investing hasn’t been wholly accepted as the best investment strategy. “There’s every reason to believe it will continue to work, but we need to continuously question ourselves,” he says. “There’s always a danger in dogmatically viewing your success as a description of the future.”

Daniel Kemp contributed reporting to this story.

Co-investments: the in-between step

Co-investing alongside a fund manager is a middle ground for pension funds that do not invest directly but still want more portfolio control and a greater say over assets

In a Probitas Partners survey of global institutional investors published last year, 33 percent of respondents said they were “actively interested” in co-investment opportunities, while 12 percent said they were looking at direct investments.

Marcus Frampton, chief investment officer of the $65.3 billion Alaska Permanent Fund Corporation, says the state endowment has about $507 million in infrastructure co-investments, which represents 20 percent of its total $2.1 billion portfolio. He says co-investments are likely to move to between 30 and 35 percent of the portfolio over the next three to four years, and that direct investing would require a “gigantic leap in resources”.

“I don’t think we’re at a place right now where we’ve got the resources to take that step from co-investment to direct,” he says. “I think anyone thinking about that should be pretty thoughtful about how different a world it is not co-investing with a sponsor.”

According to Frampton, fund managers to which Alaska Permanent had already committed funds began approaching the investor with larger transaction opportunities offered on a no-fee basis: “When you’re writing $20 million to $30 million cheques and doing deals with firms like GIP, which might be charging 1.5 percent management fees, you don’t have to do too many deals to pay for that headcount position.”

At $226.1 billion in assets, CalSTRS, the US’s second-largest public pension fund after CalPERS, manages the Inflation Sensitive portfolio, which is nearly 75 percent infrastructure.

Paul Shantic, director of the portfolio, says a “collaborative model” CalSTRS approved last year pushes for more co-investments and separate accounts, but in a measured way, “over time”.

He adds that a slow approach to becoming an active investor is necessary to “direct our resources to things we know we can do”.

“We probably passed on a number of co-investments before the first one,” says Shantic. “You just take it slow, get used to the pace and understand what your tasks are in terms of due diligence.”

Co-investments can open relationships with fund managers as well. “We become places of permanent capital that investors know is available,” Shantic explains.