Meeting documents

Avon Pension Fund

Developing a Strategy

For Private Equity

March 2003

Contents

1. Introduction and Recommendations 1

2. Asset Allocation Strategy 2

3. Asset Class Strategies 4

4. Investment Strategies 8

5. Active Money Exposure 10

6. Legal Issues for LGPS Funds 12

Please note the value of investments, and income from them, may fall as well as rise. This includes equities, government or corporate bonds, and property, whether held directly or in a pooled or collective investment vehicle. Further, investments in developing or emerging markets may be more volatile and less marketable than in mature markets. Exchange rates may also affect the value of an investment. As a result, an investor may not get back the amount originally invested. Past performance is not necessarily a guide to future performance.

1.

1. Introduction and Recommendations

As part of the overall review of the Fund's investment strategy, Bath and North-East Somerset Council, as administering authority for the Avon Pension Fund, has decided to introduce a Private equity mandate of 5% of the total Fund (approximately £60-65m).

Hymans Robertson have been asked to outline ways in which that decision can be implemented.

Recommendations

Our recommendations in respect of the development of a private equity strategy for the Avon Pension Fund are:

a. that the Fund seeks to adopt a broad strategy that secures diversification by financing stage, by geography and through time.

b. that the Fund should consider whether:

c. that a view needs to be taken on the level of commitment to private equity in order to meet and maintain the active money exposure at 5% of the Fund.

d. that consideration be given to the legal issues raised in Section 6.

2. Asset Allocation Strategy

We believe that a key component of successful private equity investing is diversification by stage, by geography and over time. As such we believe that clients should formulate a broad strategy and not be overly distracted by shorter term market considerations.

The US is the largest and most developed Private Equity market in the world and we believe that it should represent a substantial proportion of a client's exposure. However, there have also been significant developments within European Private Equity markets and there are now a large number of funds available investing in this area. We believe that Avon should look to achieve a broad balance between investment in the US and (Western) Europe. We feel it is too early to invest in Asian or other emerging private equity markets in any significant way. Exposure to these latter areas should be limited to less than 10% of exposure.

For completeness we have included at Section 3, a summary and brief description of the various strategies available and the geographic locations that managers seek to apply them in.

In practice the approach to private equity for a pension fund can be simplified as follows:

A fund(s) of funds or segregated account approach allocated broadly as follows:-

Appointing specialists to execute each strategy in each geographic region would result in an over long and complex manager schedule.

Inevitably, therefore, all structures utilise managers that invest in more than one segment and some funds only appoint a single general manager.

In practice most managers will attempt to purchase secondary portfolios on an opportunistic basis and will quite often do co-investments. Managers can be broadly classified into managers who claim to be able to cover the main investment strategies in both Europe and North America (a global diversified manager) and managers who either specialise in one investment strategy or geographic location or whose investment plan is tilted in a particular way (a specialist manager).

It is less common for them to offer "Rest of World" exposure but this is not critical.

As a rule of thumb we classify any manager that would normally expect to invest 80% or more in one region or strategy as a specialist manager.

Manager types can be used in conjunction with each other. For example, a global balanced manager could be used in conjunction with specialist regional or investment stage specialists.

3. Asset Class Strategies

An important aspect of successful investing in private equity is to secure proper diversification by strategy [investment stage], by geography and over time while avoiding over diversification that might simply lead to a return outcome that was equal to the mean return from the asset class. Mean returns from private equity do not generally provide the additional reward for the extra risks taken by investing in the asset class. In selecting managers to execute their private equity strategy investors should be conscious of the opportunity set available to them and be aware when their selection strategy excludes particular opportunities.

The following table summaries the opportunity set available to private equity investors and the following text describes each of the opportunities in turn.

Investing Geographically

North America

The North American, and particularly the US, private equity markets are the most developed and sophisticated in the world. The investment infrastructure is more developed and returns from these markets have generally been better than elsewhere. We would normally expect that a very significant proportion, probably 50% or more, of any properly diversified private equity portfolio would be invested in North America.

Europe

Europe, including the UK, is the next important block of geographic investment opportunity sets. For this purpose Europe is broadly taken to be Western Europe but can include Israel. Eastern Europe is regarded as a developing market and not part of this opportunity set. The European private equity market is gaining rapidly on North America in terms of the investment infrastructure and in recent years returns have been comparable. Indeed some believe that the still maturing buy out markets of Europe may provide better returns going forward than the more developed North American markets. Within Europe, individual markets are at different phases of their development and the UK may be regarded as the most advanced of these markets. We would normally expect a significant proportion (up to 50%) of any properly diversified strategy to be invested in the Western European Private equity markets.

Far East [Including Japan]

These markets, while potentially offering great diversity and opportunity, have a less developed private equity infrastructure and family, rather than corporate, interests can predominate. Again individual markets vary greatly in their sophistication and development, with perhaps even greater divergence than in Western Europe. We would expect investment in the Far East to play only a minor [up to 10%], or even no part, of a diversified strategy at this time.

Rest of the World

For this purpose the Rest of the World would include Eastern Europe, China and Latin America. These markets are very underdeveloped and are probably not well suited to pension fund investment at this time, apart perhaps, from the occasional opportunistic deal. These markets will mature, at different rates, over time and investment managers will need to be researching them. However, we would not expect to see investments in these markets feature to any significant extent, if at all, in investment vehicles available to pension fund investors at this time.

Financing Stage Opportunities

Venture Capital

In many ways Venture Capital is the best known of the various private equity strategies available and many have confused it with the entire opportunity set. For this purpose the term Venture Capital may be taken to mean equity or equity like investments in companies that have underdeveloped or developing products or revenue. Venture capital investing can embrace start up companies and/or development finance where the investor is participating in later stages of fund raising for existing companies.

Expansion Capital

Expansion capital refers to equity or equity like investments in public or private companies that have been operating for a sufficient amount of time to develop a sustainable business. The investment will be used to expand the operations of the company. Managers that specialise in what is known as "early stage finance" often combine both Venture and Expansion capital investing in their fund strategies.

Buy Outs

Equity investments in public or private companies that result in the purchase of a significant portion or majority control of the company. Very often this includes the use of debt [leveraged buyouts]. The buy out market is generally split by deal size into small, medium and large capitalisation deals and some managers will attempt to specialise in one or more segments of the buy-out market depending on where they perceive their strength and advantage.

Mezzanine

Investment in the subordinated debt [i.e. ranking above equity but below senior debt] and/or equity of privately owned companies. The debt holder participates in equity appreciation through conversion features such as rights, warrants or options. Returns are pitched between bond returns and the expected equity return.

Distressed/Restructuring

Radical restructuring of a business with severe economic difficulties [also called Burn-out or Turnaround]. The new third party funds are brought in and stakes of existing shareholders are diluted.

Others [Special situations]

Usually has a special component often related to geographic, economic or social issues [economically targeted investments] but may also include investments in the exploration for oil and/or gas reserves or in the development of proven reserves. It may also include investments in areas ranging from land to harvest timber.

Secondaries

Investors in private equity usually invest in the knowledge that such investments are illiquid and that there is no easy way to realise the value of the investment before the full cycle has matured. However, for a variety of reasons, investors sometimes have to seek to exit their commitments to private equity funds by selling them [usually at a steep discount] in the secondary market. Such secondary investments can be very attractive, not only because of the discount that usually accompanies them, but, because they will have already experienced some write down of the less successful investments [lemons mature first!] and because they can bring earlier returns to investor's private equity strategies. This market place is sometimes divided between mature secondaries [i.e. those where substantial commitments have been made and the primary judgement in the acquisition is finance oriented] and those where substantial commitments require to be made and greater knowledge of the underlying General Partners ability is required [immature secondaries].

Co-Investments

Co-investment opportunities are opportunities to invest in underlying portfolio companies without having to do so through the General Partner's limited partnership vehicle. This has the advantage of saving fees and carried interest which lowers the cost of investing and ought to improve return.

In addition we would also mention the following specific points:

Fund Availability

Funds are open for a limited period of time for investors to make commitments. During the subscription period, the managers begin to make commitments to specific Private Equity funds. Later subscribers effectively pay an interest adjustment to gain access to those commitments that have already been made.

The final closing date may be extended but, once the fund has closed, no new investors can be admitted. In that instance, it is necessary to wait for the next appropriate fund to be launched. This is why the frequency of fund launches can be an important issue.

Fund Structures

The most common structure adopted by US firms is for a fund of funds to be set up as a Limited Partnership in Delaware in the US. In addition, there is sometimes an offshore vehicle in a location such as the Cayman Islands through which non-US investors can invest for possible tax reasons. The Partnership Agreements are drawn up under Delaware law.

European-based investors tend to set the arrangements up in Jersey, Guernsey or Luxembourg.

4. Investment Strategies

Direct Investment

Clearly the greatest opportunities and the least cost in terms of management fees comes from a direct investment relationship with companies that require private equity capital. However, assembly and maintenance of the skill sets required to successfully achieve direct investment on a consistently rewarding and properly diversified basis are so far beyond the resources of a pension fund that further exploration of this option would not be worthwhile.

Investment in Limited Partnerships (Primary and/or secondary interests)

It is a feasible proposition for a large pension fund to develop and invest in a diversified programme of Limited Partnership interests and the very largest funds may also be able to secure co-investment opportunities. In the United Kingdom at the present time, however, it is likely to be a relatively high-risk strategy. Experienced individuals capable of running such programmes are a very expensive commodity, beyond the budgets of most pension funds. The alternative strategy of permitting inexperienced staff develop and assemble the programme raises the unattractive spectre of learning at the expense of returns as well as the very real risk that, having learned, such staff would be worth far more to the private equity market than to the pension fund market. The departure of trained staff would then place the fund back at the bottom of the learning curve but with the added problem of an actual portfolio to maintain.

Listed Private Equity

There are a number of Fund of Fund managers that have stock market listed vehicles and exposure to private equity can be gained in this way. Clearly there is a risk of overlap with quoted equity strategies and the discounts and premia that these listed vehicles experience do not necessarily reflect the underlying investments. Moreover, it is much more difficult to achieve a considered diversification strategy through these means. However, investment in quoted stock offers better liquidity and the opportunity to invest in past vintage years. As such these investments could be used to round out or top up a strategy of investing in Partnerships either directly or through Funds of Funds.

In addition to existing listed vehicles we are beginning to see the emergence of private equity related derivatives linked to the private equity market. These are essentially bonds linked to private equity returns that offer some guarantee of capital at the cost of surrendering a part of the upside return. Such opportunities can have a role to play in achieving/maintaining active money exposure and gaining access to vintage years that are in the past although their products are as yet very new and untried.

Funds of Funds

For most pension funds, however, the principal opportunity to invest in private equity is via funds of funds, notwithstanding the additional layer of cost involved. Funds of Funds managers can access all the underlying opportunities available to investors in private equity via investment in limited partnerships [primary and secondary] and co investment opportunities. Some will also give advice on investment in listed private equity as part of a package of services.

Segregated Portfolios

Funds with at least £40m or more to commit and maintain as an exposure to the asset class are able to engage the services of a Private Equity Gatekeeper. Many of the Fund of Fund managers will manage segregated portfolio on an advisory or discretionary basis. Segregated Portfolios and Funds of Funds are not mutually exclusive components of the overall strategy. For example, the Fund and the chosen Gatekeeper may feel that it is more efficient to make primary investments in limited partnerships that cover US and European Buy Outs but that better diversification would be achieved in the Far East and that secondary opportunities exposure would be more easily achieved via a Fund of Funds. They may also consider that the US venture market was so specialised as to require the services of a specialist early stage Fund of Funds manager. This illustration is not an attempt to prescribe an approach. It is simply one way of looking at the market from an advisory perspective. There are other combinations that could be used and much depends on the skill set of the chosen Gatekeeper.

Conclusion

The Fund should give some thought to whether:

a) it wants to develop an approach that combines some segregated portfolio elements with investment via funds of funds under the supervision of a Private Equity Gatekeeper.

or

b) it wishes to proceed using Funds of Funds only. If this is the case then it needs to consider whether:

5. Active Money Exposure

One of the challenges of investing in private equity as an asset class is managing the active money exposure. While the fund may select and commit to a fund of funds product or products the manager will typically make commitments to primary private equity limited partnerships over a period of one to three years. The General Partners of the primary private equity limited partnerships will in turn typically commit investments to companies over a one to three year period. Money is only ever drawn down in this asset class on a "just in time" basis so it may be that the fund is still paying calls [i.e. fulfilling investment commitments] to the fund of funds manager five or six years after the initial investment.

By this time it is not unreasonable to expect that some of the earliest investments will be beginning to yield returns and as investments are realised cash is returned through the investment chain to the original investor. As investments are returned to the investor further commitments to the asset class are required in subsequent years to maintain the strategic allocation to the asset class. Consequently the investor who takes the strategic asset allocation decision to invest 5% of the fund in private equity but does not commit more than 5% to private equity products is unlikely to achieve his full exposure in active money terms and remains underinvested in the asset class.

Committing also to secondary private equity products, since drawdowns will be made earlier, can initially ease this situation. However, as the underlying funds are also more mature, earlier returns can be expected from such commitments. In effect, therefore, committing to secondary investments, while having some general merit, simply moves the problem of achieving and maintaining active money exposure forward through time.

The simple answer to the problem is to commit more to the asset class than the strategic asset allocation target. However, calculating the degree of over commitment is difficult, primarily because of quoted market fluctuations. An over commitment when markets are plunging will potentially cause the fund to have more than the strategic asset allocation to the asset class in active money exposure. If a stock market decline was steep or prolonged this might cause the fund to sell some of its private equity investments. However, this would very likely crystallise a loss and jeopardise the entire private equity strategy for the fund.

Alternatively, rapidly rising markets can leave the active money exposure far below the desired strategic asset allocation and in extreme circumstances might cause the relevance of the strategy in terms of the impact of the private equity program to be questioned.

Predicting the direction and pace of quoted markets is not easy and few would have the confidence to predict market levels over the ten or twelve years that it will take this year's private equity commitments to be fully returned to the investor. Opinions vary therefore on the degree of over commitment required to approximately achieve any given level of strategic asset allocation to the asset class.

In a recent exercise we gathered the views of eight leading Fund of Fund managers and Gatekeepers and summarise the views below:-

All managers stressed the need to achieve time diversification in the establishment of the programme. Periods of three to five years were typically suggested.

Because Private Equity is a self liquidating asset class the level of commitment needs to be renewed every three years or so in order to keep the Fund's exposure at the desired level. At Fund level the effect is similar to having a series of three yearly programmes investing in Private Equity.

Our view is that 150% of the strategic asset allocation is a suitable target to aim for in terms of commitments. This target can be reviewed with the manager or managers when appointed and kept under review as subsequent commitments to the asset class are determined.

6. Legal Issues for LGPS Funds

One of the issues that the fund should be clear about, preferably before the interview process commences, is their view as to the standing of the type of private equity service provider that they wish to appoint. Will that provider be regarded as an advisor, in which case either the elected members or the officials of Bath and North East Somerset Council should be regarded as making any investments, or will he be regarded as a manager? If the service provider is to be regarded as a manager to what extent does he require to be regulated?

Local Government pension schemes are governed by regulations. Amongst other things the Regulations define who may be regarded as an investment manager.

The Local Government Pension Scheme (Management and Investment of Funds) Regulations 1998 paragraph 4 state

"4(1) This regulation described those persons who count as an "investment manager" for these regulations.

(2) A person is an investment manager if he is authorised under the Financial Services Act 1986 to manage the assets of occupational pension schemes.

(3) A person is also an investment manager if he-

a) does not transact investment business (within the meaning of the Financial Services Act 1986) from a permanent place of business in the United Kingdom;

b) has a head office situated outside the United Kingdom in a member state;

c) is recognised by the law of that state as a national of a member state;

d) is authorised under that law to engage in one or more of the activities specified in Part II of Schedule I to the Financial Services Act 1986 (activities constituting investment business);

and

e) is not prevented by that law from managing the assets of occupational pension schemes or assets belonging to another person"

Some of the Fund of Fund managers that will express an interest in becoming involved with Avon's private equity strategy either do not have appropriate registration as described above or there is some doubt over that registration. Many of these managers will have excellent credentials and some may be prepared to secure appropriate registration if they were to win business.

However, there are also alternative arguments about registration that can be considered.

There is a possible argument that an investment by a local authority in, say, a unit trust or some form of pooled vehicle is not the appointment of an investment manager but an investment decision taken by the local authority itself (which they are entitled to do).

A further line of argument is that this part of the Local Government Pension Scheme Regulations has been overtaken by the regulatory regime created through the Financial Services and Markets Act 2000 (FMSA2000). In particular managers may be deemed as an "overseas person" under the FMSA2000 and not have a permanent place of business in the United Kingdom. As such they claim the ability to conduct regulated activities in the United Kingdom without the need to be authorised by the UK's Financial Services Authority within the exemption set out in Article 72 of the FSMA2000 (Regulated Activities) Order 2001.

However, not everyone would accept these arguments. Hymans Robertson are not solicitors and cannot give legal advice. We can only point out what appears to be a current difficulty within this asset class. It is the case that a number of local government pension funds have invested with at least one fund of funds provider that claims this exemption. BANES will need to take a view on this issue and decide what they will be most comfortable with.