As a company that has grown over 100 years into the largest package delivery company in the world, UPS is an organisation that should know a thing or two about how to scale up. It is a subject close to the heart of Brady Hyde, portfolio manager for private equity investments, when he’s sizing up prospective managers.
“The thing in today’s environment that we’re concerned about is that since managers are increasing their fund sizes and increasing their fund sizes very quickly, it forces them up market,” he says.
The average fund size has hit a post-crisis high of $759 million in the first quarter, up more than $100 million from the first quarter in 2016 and a large increase on the $540 million seen for the five years spanning 2008-12, according to PEI data.
When faced with a manager moving up the scale, Hyde and senior investment analyst Jason Burger deepen their due diligence. They try to figure out whether the general partner can continue to invest and implement its approach on a larger scale using the same skillset, whether the team is big enough or experienced enough to be able to support the larger fund, and whether the second tier of investment professionals and the resources at the firm are robust enough to support not only larger transactions but also more transactions.
“It’s a whole different ball game,” Hyde says. “If we don’t believe the skillset of the manager is applicable to larger deals, we typically won’t invest with the manager.”
Another element that has made fund selection more challenging in the past year is the increased use of subscription lines of credit and the lack of transparency around performance that can go with it. To circumvent that, the UPS team wants to understand how the underlying assets perform independently of the line, both from an internal rate of return and from a multiple perspective.
“I’d rather not have subscription lines but they are pretty much used by every GP at this point,” says Hyde. “If you can get comfortable that the underlying assets still have a sufficient performance, we would do the deal. But if there’s a point where managers start using a subscription line to improve IRR and allow them to go over the hurdle so now they’re in the carry, that to me is a massive problem. We wouldn’t invest with the manager.”
Until 2012, UPS’s private equity programme, which began in the early 1990s, was staff constrained and as a result focused mainly on funds of funds, secondaries funds and large buyout funds. As part of a larger transformation across the entire private market portfolio, which began after the financial crisis, the UPS private equity portfolio has followed a familiar route to many private pension plans, shifting from this passive approach to more active management.
“Historically, because they were smaller, corporate pension plans had more of a fund of funds exposure,” says an investment professional at a manager that specialises in other discretionary accounts. “They got to a certain scale and more and more are doing SMAs so they can customise their portfolios. They’re really expanding their skillset and expertise.”
That has certainly been true of the delivery company, which now counts three separate accounts in its private equity portfolio. It has also made eight co-investments in the past two years, plus one direct investment in which UPS is the sole GP of an energy company.
“If we don’t believe the skillset of the manager is applicable to larger deals, we typically won’t invest with the manager.”
In total, these types of investments represent about 40 -50 percent of the $3 billion private equity portfolio, which has $1.8 billion in net asset value and the rest in unfunded commitments. The other 50 to 60 percent of the portfolio is made up of fund investments.
Hyde and Burger declined to disclose the private equity portfolio’s returns, noting only that it is in the double digits and it is the best performing asset class at UPS this year.
This more active investment strategy is helping UPS minimise fees, according to Hyde, who added that SMAs, in particular, also offer flexibility in terms of the timing of commitments.
He believes this could be helpful once the economic cycle turns. For example, the three separate accounts, which still have unfunded commitments, have broad mandates and can invest in a variety of strategies depending on the conditions.
“We have flexibility in SMAs to go into transactions at a scale that would allow us to capitalise on market dislocations or forced sellers,” Hyde says.
Beyond its separate accounts, the UPS Group Trust private equity team has sought exposure to distressed debt and turnaround managers who can take advantage of market turns.
“We […] have fund managers that are going to perform better in more challenging and more difficult environments where there are some distressed and operational challenges,” Hyde adds. “Choosing the best managers able to operate in different environments is going to be crucial. We’re not trying to be overly cautious or defensive in our portfolio but also we have the ability to flex into these asset classes should there be a slowdown or a downturn.”
Hyde says the pension can deliver a verdict on a co-investment opportunity in as little as two weeks. “Since these deals are more time-sensitive and add significant value, we should be very willing to roll up our sleeves and essentially drop everything else we have going on to dig into these deals and to understand the assumptions, the risk and the mitigating factors,” he says.
On average, the team can turn around a co-investment deal in four to eight weeks thanks to, says Hyde, a more flexible governance structure compared with other pension plans, particularly US public plans, echoing structures more often found at endowments, foundations and family offices.
While Hyde and Burger are dedicated full time to private equity, they meet on a weekly basis with the private market team and their investment committee, which is made up of heads of public and private markets, the head of operations and UPS’s chief investment officer. If a co-investment deal is moving quickly, the team can bring it up to the investment committee’s attention to speed up the approval process.
LEANING ON RELATIONSHIPS
Since UPS is still a young co-investor – it made its first in August 2015 – it continues to spend a significant amount of time on due diligence of potential investment opportunities, according to Hyde, the strength of the relationship with the GP allows it to short-circuit the diligence to some extent.
“We have a thorough diligence process, but we’re not going to go and remodel everything,” Hyde says. “What we do goes back to the underwriting process for the fund managers. We already know after doing our analysis and the fund underwriting what types of deals these fund managers are best at.”
Hyde declined to disclose GPs in the UPS portfolio but noted that it recently committed to a very large buyout fund, the sixth fund it had backed from that manager.
“There’s a handful of names I would consider our core managers where we’ve backed anywhere between two and six funds,” says Hyde. “It’s a relationship game but we have a very attractive investor profile as well that definitely helps us get access.”
“Ultimately, the key to getting access to good managers is to meet the managers early in their fundraising process and after their previous final close.”
The two-man private equity investment team sits in about 15 to 20 manager presentations a month, ranging from phone calls to in-person interviews.
On average, out of these hundreds of meetings a year Hyde and Burger hold with managers, they end up committing to four to eight GPs, including about three to four new relationships.
As of August, the team had made about $500 million in commitments, compared with $515 million in 2016. That pace keeps the private equity actual allocation at 5 percent, at the low end of its 5 to 10 percent target allocation, as distributions have been high in the past couple of years. UPS also has 5 percent of its $35 billion assets under management in real estate and 1.5 percent in private debt, according to PEI data.
“Ultimately, the key to getting access to good managers is to meet the managers early in their fundraising process and after their previous final close,” Hyde notes.
When it comes to the slew of questions UPS may throw at managers during due diligence, Hyde has one last bit of advice: “‘Trust me, I know what I’m doing’, is not a good answer to those questions,” he says.
Brady Hyde left UPS Group Trust at the end of September.