Pension Funds Are Directly Investing in Tomorrow’s Winners. Here’s Why.

In late 2014, Institutional Investor’s Eric Bernstein wrote about major pension funds’ accelerating move away from the hedge fund model. Earlier that year, one of the United States’s most influential pension funds, California Public Employees Retirement System (CalPERS), announced the closure of its in-house hedge fund portfolio, Absolute Return Strategies.

With the benefit of hindsight, CalPERS’s move was a clarion call for other North American pension funds to edge out of what — for many — has proven to be a high-risk, low-reward arrangement.

That’s not to say the continent’s biggest pension systems are admitting defeat and plowing their massive endowments into run-of-the-mill index funds. They’re just being smarter with their capital, and they’re turning to firms with long track records of ferreting out promising investments.

Pension Funds

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Throwing Their Weight Around

Pension funds are fully aware of their heft. With approximately 1.8 million members and nearly $300 billion in assets under management as of June 2016, CalPERS can exercise awesome influence over its investment partners. In 2015, the fund’s decision to cut ties with about half its external fund managers sent shockwaves rippling through the U.S. financial industry.

Hard-charging chief investment officer Ted Eliopoulos made no apologies for the move, which substantially reduced his organization’s reliance on unaccountable decisions made outside its chain of command and leveled the playing field in its members’ favor.

Private Equity + Pension Systems: Equal Partners?

Many of Eliopoulos’s peers have gone even further in their pursuit of influence, accountability, and market-beating returns. Citing data from State Street, Institutional Investor’s Bernstein noted that some 60% of pension fund managers were looking to increase their private equity allocations.

“Private equity is quickly becoming the attractive third way for pension funds,” he wrote.

In years past, pension funds were largely content to serve as passive partners to private equity firms, in whose expertise they placed tremendous amounts of trust. They’d instead invest in asset funds managed by their private equity partners. Though they’d of course hold their private equity partners accountable for their funds’ performance, they’d exercise little to no control over the composition of those funds.

Ontario Teachers’ Pension Plan Bets on IoT

That hands-off, trusting approach still works for many pension fund managers, but not all. Jane Rowe, Ontario Teachers’ Pension Plan’s managing director of private capital, pursued a more active alternative: She teamed up with RedBird Capital CEO and managing partner Gerry Cardinale to make a direct investment in Compass Datacenters, a Dallas-based data center that specializes in next-generation edge computing and IoT-adjacent applications.

Ontario Teachers’ took a substantial direct stake in Compass — a multi-year commitment that frees Compass’s executive team to pursue its own long-term objectives. In this specific case, Ontario Teachers’ and RedBird are quite literally equal partners: Of the partnership’s total stake in Compass, each party holds precisely 50%.

Roads (and Bridges) to Tomorrow

Ontario Teachers’ isn’t alone in its approach. Along with Canada Pension Plan Investment Board (CPPIB), which manages retirement funds for nearly 20 million Canadian citizens, Ontario Teachers partnered with OMERS Private Markets EVP & Global Head of Infrastructure Ralph Berg and plowed nearly $3 billion into Skyway Concessions Company, the private entity that manages the heavily trafficked Chicago Skyway toll road.

Under the terms of deal, the consortium of CPPIB, OMERS and Ontario Teachers has an interest in Skyway Concessions’ 88-year lease on the road, which remains a public asset. But its stake nevertheless entitles it to a proportional share of toll receipts from the road’s 50,000 daily users.

Investing in Infrastructure Down Under

Chicago is less than a day’s drive from Canada’s capital. Other Canadian pension plans are looking much farther afield for investment opportunities — in at least one case, all the way to the other side of the world.

Caisse de dépôt et placement du Québec, a public pension plan management entity based in Quebec, took a $7.5 billion stake in Transgrid, a power transmission network in the Australian state of New South Wales. The strategy is clear: by investing in critical infrastructure in another developed nation, Caisse de dépôt et placement du Québec is limiting its exposure to the ups and downs of Canada’s resource-based economy.

Democratizing Private Equity?

On a macro level, pension funds’ private equity partnerships have paid off handsomely. According to the Private Equity Growth Capital Council, private equity investments returned greater than 10% annualized through 2012 — twice the rate of return of pension funds’ portfolios writ large.

They’ve also democratized the private equity industry, long a bastion of well-endowed family offices and high-net-worth individuals. According to Investopedia’s Wendy Connett, an even broader democratizing wave may crest soon, as the private equity industry seeks inroads into employer-sponsored 401(k) plans. Such plans account for a much greater slice of the individual retirement pie — some $4.3 trillion, as of 2015. Smaller firms already manage target-date funds that offer private equity exposure to middle-class investors without access to massive pension funds.

Does your pension fund or employer-sponsored 401(k) offer private equity exposure?

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